The Early-Pay Discount That Costs More Than It Saves
Your CFO is pushing a 'pay early, save big' initiative. A key supplier offers 1%/10 net 45 on invoices averaging $250,000 per month. Your company's weighted average cost of capital is 9% annually, and you currently have $1.2M drawn on a revolving credit facility at 7.5%. AP has capacity to process early payments without added headcount. The controller asks you to evaluate whether to take the discount on all invoices or only some. Separately, a second supplier offers 2%/10 net 60 on $80,000 per month; a third offers 0.5%/15 net 30 on $150,000 per month. You must recommend a policy and justify it numerically.
1. Calculate whether the first supplier's 1%/10 net 45 discount is worth taking, and show the annualized cost of forgoing it.
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Annualized cost of forgoing the discount (the implied interest rate of paying at day 45 instead of day 10):
- Discount = 1%, so you pay 99% to get 35 extra days (45 − 10).
- Annualized rate = (1 / 99) × (365 / 35) = 0.010101 × 10.4286 ≈ 10.53%.
Compare to cost of capital/funding:
- WACC = 9%; revolver = 7.5%.
- 10.53% > 9% and > 7.5%, so taking the discount beats the cost of funding - but only if you are funding the early payment with the revolver at 7.5% rather than idle cash.
Decision: Take it. The spread (10.53% − 7.5% = ~3.0% annualized) is real value, and AP has spare capacity. But note the margin is thin - a small change in terms flips the answer, so evaluate each supplier on its own numbers.
2. Evaluate the second and third suppliers and recommend which discounts to take.
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Supplier 2: 2%/10 net 60
- Extra days = 50; annualized = (2/98) × (365/50) = 0.020408 × 7.3 ≈ 14.9%.
- Well above 7.5% funding cost → take it.
Supplier 3: 0.5%/15 net 30
- Extra days = 15; annualized = (0.5/99.5) × (365/15) = 0.005025 × 24.33 ≈ 12.2%.
- Above 7.5% → take it, though the absolute saving is small.
Ranking by annualized return: Supplier 2 (~14.9%) > Supplier 3 (~12.2%) > Supplier 1 (~10.5%).
Recommendation: Take all three, but prioritize Supplier 2 if cash or revolver capacity is constrained. If you must ration early-pay capacity, fund in descending order of annualized return. The naive 'biggest discount first' rule (2% > 1% > 0.5%) happens to match here, but only because the terms differ - always compute the annualized rate, not the headline percentage.
3. What operational risks should accompany this policy?
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Risks to manage:
- Liquidity concentration: taking every discount pulls cash forward; model the revolver draw and ensure headroom. A 1% saving on $250K is $2,500/month - small relative to a cash crunch.
- Discount capture reliability: discounts are only realized if payment actually lands by day 10. Track capture rate; missed discounts are pure loss.
- Supplier behavior: some suppliers may raise prices if they see you always pay early; the discount may be priced into the invoice.
- Fraud exposure: early-pay pressure tempts teams to skip verification on bank changes - keep the callback control intact.
- Policy drift: 'take all discounts' can become 'pay everyone early,' destroying the working-capital benefit on non-discount invoices.
Control: Set a policy threshold (e.g., annualized discount rate must exceed the revolver rate by a margin), require AP to log capture rates, and review quarterly.