A supplier offers a 3% discount for orders over $50,000 but requires full payment within 10 days instead of the standard 30-day terms. The contractor's cost of capital is 8% annually. Should the contractor take the discount on a $60,000 order?
Correct Answer
A) Yes, because the effective annual rate of the discount exceeds the cost of capital
The discount saves $1,800 on $60,000 for paying 20 days early. Annual rate = ($1,800/$60,000) × (365/20) = 54.75%, which far exceeds the 8% cost of capital, making the discount financially beneficial.
Why This Is the Correct Answer
Option A is correct because the effective annual rate of the discount (54.75%) significantly exceeds the contractor's cost of capital (8%). This calculation considers the discount amount ($1,800) as a percentage of the order ($60,000) annualized over the 20-day difference between payment terms. When the effective rate of a discount exceeds your cost of capital, taking the discount creates positive financial value.
Why the Other Options Are Wrong
Option B: Yes, but only if cash flow permits early payment
This option incorrectly states the relationship between cost of capital and discount rate. The cost of capital (8%) IS lower than the effective discount rate (54.75%), which actually supports taking the discount, not avoiding it.
Option C: No, because the cost of capital is lower than the discount rate
This option focuses only on cash flow management while ignoring the substantial financial benefit. The 54.75% effective annual return far outweighs any cash flow inconvenience from paying 20 days earlier.
Option D: No, because 30-day terms provide better cash flow management
While cash flow is always a practical consideration, this option misses the fundamental financial analysis. The question asks whether the contractor 'should' take the discount from a financial perspective, and the math clearly shows it's beneficial regardless of cash flow convenience.
Memory Technique
Remember 'DND' - Discount rate, Net amount, Days saved. If your calculated rate beats your cost of capital, the Discount is a No-brainer Decision.
Reference Hint
Business and Finance for Contractors - Chapter on Working Capital Management and Cash Flow Analysis
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