The Supplier Discount Decision
A garment exporter must buy raw material worth ₹12,00,000. Supplier A offers terms '2/10, net 60': a 2% discount if paid within 10 days, otherwise the full amount is due in 60 days. Supplier B offers '1.5/15, net 90': a 1.5% discount if paid within 15 days, otherwise full amount due in 90 days. The exporter can draw a bank overdraft at 12% per annum on a 365-day-year basis, but only up to ₹12,00,000. The firm has no surplus cash and will otherwise pay on the final due date. The purchase manager wants to take every discount because 'a discount is always cheaper than a loan'. The finance manager wants to compare the effective annual cost of forgoing each discount before deciding which discount to finance with the overdraft.
1. Compute the effective annual cost of forgoing the discount for each supplier. Show the formula and the days of free credit.
Read the worked answer
Forgoing a discount means paying 100 instead of (100−d) and delaying payment by the net period minus the discount period. Cost = d/(100−d) × 365/extra days. Supplier A: 2/98 × 365/(60−10)=0.020408×7.30=14.90% p.a. Supplier B: 1.5/98.5 × 365/(90−15)=0.015228×4.867=7.41% p.a. A's trade credit is roughly twice as expensive.
2. Given the 12% overdraft, which discount should be financed and which should be forgone? Support with a rupee comparison.
Read the worked answer
Finance A, forgo B. A: pay 98% of ₹12,00,000 = ₹11,76,000 on day 10. Overdraft for 50 days costs ₹11,76,000×0.12×50/365 ≈ ₹19,332. The discount saves ₹24,000, so net gain ≈ ₹4,668. B: pay ₹11,82,000 on day 15; overdraft for 75 days costs ≈ ₹29,145. The discount saves ₹18,000, so net loss ≈ ₹11,145. Therefore take A's discount with the overdraft and pay B on day 90 without borrowing. The purchase manager's 'always take the discount' rule fails for B.
3. At what overdraft rate would the exporter be indifferent between taking and forgoing Supplier B's discount? Interpret.
Read the worked answer
Indifference occurs when overdraft interest on ₹11,82,000 for 75 days equals ₹18,000: r = 18,000 ÷ (11,82,000×75/365) = 0.0741, or 7.41% p.a. That equals B's effective cost of forgoing the discount. Above 7.41%, forgo B's discount; below 7.41%, finance it. At the current 12%, forgoing is correct.