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Chapter 9

1.4 Early settlement discounts

Cash discounts may be offered by the company to encourage early payment by
customers.

Cost = cash lost from receiving less money from customers (profitability
sacrificed, lower liquidity)

Benefit = cash received earlier = lower receivables balance = lower working
capital funding requirement (liquidity enhanced, lower funding cost)

Discounts may also reduce the number of irrecoverable debts.

Calculation of annual cost of discount:

Annual cost of discount = (1 + (discount/amount left to pay)) no of periods –1

where no. of periods = 365 or 52 or 12
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no. of days or weeks or months
earlier the money is received.

If the cost of offering the discount exceeds the benefit of the saved funding
cost then the discount should not be offered.

Question 2

Early settlement discount

A company is offering a 2% discount to receivables if they agree to pay within
30 days. The current receivables days figure is 65. Receivables are financed
using an overdraft costing 20%

Calculate the effective annual cost of offering the discount and state whether it
should be offered.

Effective annual cost = [1 + 2/98] (365/35) – 1 = 0.23452 or 23.5%

If the company offers the discount, it will save interest at a rate of 20% on its
overdraft but the discount will cost it 23.5% so the discount should not be
offered.

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