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Working Capital ManagementSection BWorking Capital ManagementEarly Settlement Discount

ACCA · Question 17 · Working Capital Management

Section B - Case 1: AquaHarvest

Scenario: AquaHarvest operates offshore kelp farms. The company has annual credit sales of $18 million. Currently, customers take an average of 45 days to pay. AquaHarvest finances its working capital through a bank overdraft at an interest rate of 8% per annum. Assume a 365-day year.

To improve cash flow, the finance director proposes offering a 2% early settlement discount to customers who pay within 15 days. It is expected that 40% of customers will take the discount, while the remaining 60% will continue to pay in 45 days.

Question: What is the effective annual interest rate (cost) of offering this discount? (Use the compound interest formula)

Answer options:

A.

24.33%

B.

27.86%

C.

31.20%

D.

48.67%

How to approach this question

Use the effective annual rate formula for discounts: Cost = [1 + (d / (1-d))] ^ (365 / t) - 1, where 'd' is the discount percentage and 't' is the reduction in payment days (45 - 15 = 30 days).

Full Answer

B.27.86%✓ Correct
The cost of offering an early settlement discount is the annualized cost of the revenue given up to receive the cash earlier. Formula: Cost = [1 + (d / (1-d))] ^ (365 / t) - 1 d = 0.02 (2% discount) t = 45 - 15 = 30 days saved Cost = [1 + (0.02 / 0.98)] ^ (365 / 30) - 1 Cost = [1.020408] ^ 12.1667 - 1 = 0.2786 or 27.86%. Since 27.86% is much higher than the overdraft rate of 8%, offering the discount is an expensive way to finance working capital.

Common mistakes

Using 15 days as 't' instead of the days saved (30 days).
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