![]() ![]() If the cost of credit is higher than the company's incremental cost of capital, take the discount. To complete the example, we multiply 0.0204 by 18 to arrive at a cost of credit of 36.7% for terms that allow a 2% discount if paid within 10 days, or full payment in 30 days. Multiply the result of each of the preceding steps together to arrive at the annualized cost of credit. To continue the example, this is 2%/98%, or 0.0204. Then divide the discount percentage by 100% less the discount rate. For example, if a 2% discount is offered, the result is 98%. In this case, divide the 20 day discount period into the 360-day year to arrive at an 18x multiplier. For example, if the discount must be taken within 10 days, with normal payment due in 30 days, then the discount period is 20 days. The discount period is the period between the last day on which the discount terms are still valid and the date when the invoice is normally due. Use the following steps to determine the cost of credit for a payment transaction:ĭetermine the percentage of a 360-day year to which the discount period will be applied. This occurs despite the inherent cost of credit generally being quite attractive to the buyer. For example, if the buyer's cash is tied up in long-term investments, it may not be able to take an early payment discount. The availability of cash can be the deciding factor, rather than the cost of credit. ![]() In reality, early payment terms are only taken when the buyer has sufficient cash available to make an early payment, and the cost of credit is high. Both parties consider the early payment discount to be an item worth negotiating as part of a sale transaction. The sales department of the seller and the purchasing department of the buyer. The accounts payable department of the buyer uses it to see if taking an early payment discount is cost effective this will be the case if the cost of credit implied by the discount is higher than the seller's cost of capital. The formula can be derived from two perspectives: The formula is useful for determining whether to offer or take advantage of a discount.
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