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Business valuations and market efficiency

Question 5

Early payment discount

A supplier has offered a discount to Paxton Co of 1.5% for early payment within
5 days of invoices for which 35 days is the usual payment time.

If Paxton Co funds working capital at a rate of 15% per annum, should the
discount be accepted?

Effective annual benefit = [1 + 1.5/98.5] (365/30) – 1 = 0.2019 or 20.2%

If the company accepts the discount, it will save money from lower payments at
a rate of 20% per annum but it will need to increase its working capital
investment at a cost of 15%. As the saving is larger than the extra funding cost
from investing more in working capital, the discount should be accepted.

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