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Working capital management – Accounts receivable and payable

Question 6

Early payment discount

A supplier has offered a one off discount to Hudson Co on a large invoice of
$1,500,000. If Hudson Co pays within 10 days instead of the usual 45, the
supplier will allow Hudson to take a 1% discount.

If Hudson Co funds working capital at a rate of 12%, should the discount be
accepted?

If Hudson takes the discount, cash will be paid out earlier meaning that extra
working capital will be needed for 35 days on the $1,500,000 value at a cost of
12%:

$1,500,000 × 35/365 × 12% = $17,260 extra finance needed.

The benefit of the discount is that less cash is paid.

Saving = $1,500,000 × 1% = $15,000.

As the cost of funding the $1.5m for an extra 35 days is greater than the saving
made from paying a lower amount, the discount should not be accepted.

Illustrations and further practice

Now try TYU questions 5 and 6 from Chapter 9

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