Question

Langley Clinics, Inc buys $400,000 in medical supplies each year (at gross prices) from its major suppliers, consolidated services, which offers Langley terms of 2.5/10, net 45. Currently, Langley is paying the supplier the full amount due on day 45 but it is considering taking the discount paying on day 10, and replacing the trade credit with a bank loan that has a 10% annual cost.
b. What is the amount of costly trade credit?
c. What is the approximate annual cost of the costly trade credit?
d. Should Langley replace its trade credit with the bank loan? Explain

Answer 1

Answer:

a) Langley buys $400,000 (gross) in medical supplies a year from Consolidated. The net purchases (the true cost of the supplies) is only 0.975 x $400,000 = $390,000 because they can be bought at a 2.5 percent discount when payment is made within 10 days. On a daily basis, Langley purchases $390,000 / 360 = $1,083.33. If Langley takes the free credit and pays on Day 10, its payables from Consolidated would total 10 x $1,083.33 = $10,833.33, which is the amount of free credit.

b. If Langley pays after 45 days, its accounts payable will increase to 45 x $1,083.33 = $48,750. Thus, the amount of costly trade credit is Total trade credit – Free trade credit = $48,750 – $10,833.33 = $37,916.67.

c. Langley is foregoing a 2.5 percent discount on its $400,000 of purchases, so the dollar cost of the additional (costly) trade credit is 0.025 x $400,000 = $10,000. Dividing this dollar cost by the amount of additional credit provides the approximate percentage cost of the costly trade credit:

$10,000

Approximate percentage cost = ──────── = 0.264 = 26.4%.

$37,916.67

Of course, the approximate cost could have been found by applying the following formula:

Discount percent 360

Approximate % cost = ────────────── = ────────────────────────

100 - Discount percent Days credit received - Discount period

2.5 360

= ─── = ─── = 0.264 = 26.4%.

97.5 35

d. If Langley can obtain a bank loan for less than 26.4 percent cost, including interest cost and fees, it should replace the costly credit ($37,916.67) with a bank loan.

e. As indicated in Part d, only the costly trade credit should be replaced. Langley should always take the $10,033.33 of free trade credit.