A project requires 500 cubic yards of concrete at $120 per cubic yard. The supplier offers a 2% discount for payment within 10 days or net 30 terms. If the contractor's cost of capital is 8% annually, should they take the early payment discount?
Correct Answer
B) Yes, the annualized discount rate exceeds the cost of capital
The 2% discount for paying 20 days early (10 vs 30 days) annualizes to approximately 36% (2% × 365/20 days), which significantly exceeds the 8% cost of capital, making it financially beneficial.
Why This Is the Correct Answer
Option B is correct because the early payment discount must be annualized to compare it properly with the cost of capital. The 2% discount for paying 20 days early (day 10 vs day 30) translates to an annualized rate of approximately 36.5% (2% × 365/20 days). Since this 36.5% annualized discount rate significantly exceeds the contractor's 8% annual cost of capital, taking the early payment discount is financially beneficial.
Why the Other Options Are Wrong
Option A: No, the discount rate is less than the cost of capital
Option A incorrectly compares the nominal 2% discount rate directly to the 8% annual cost of capital without annualizing the discount. This is a fundamental error because it fails to account for the time value of money over the 20-day period difference.
Option C: Yes, early payment always improves cash flow
Option D is incorrect because early payment doesn't always improve cash flow - it actually reduces immediate cash availability. The decision should be based on comparing the annualized discount rate to the cost of capital, not on a blanket assumption about cash flow improvement.
Memory Technique
Remember 'ADAPT': Annualize Discount And compare to your Project's cost of capital - never compare raw percentages across different time periods.
Reference Hint
Business and Finance for Contractors - Chapter on Cash Flow Management and Time Value of Money
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