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Business valuations and market efficiency

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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