BUSI 320 Week 4 Discussion Board Forum 2 Example

Discussion Board Forum 2: Trade Credit and the Cost of Forgoing a Cash Discount

BUSI 320 Finance Principles, Discussion Board Forum 2 (Thread and Replies)

Thread by [Student Name]

The supplier terms and the classmates are composites; the textbook, research and Scripture cited are real.

Thread

A small business should almost always take an early-payment discount if it can borrow the cash more cheaply than the discount is worth. Picture a produce wholesaler whose invoices to a family restaurant read 2/10, net 30, meaning the restaurant may deduct 2 percent by paying within ten days or pay in full by day thirty. Block et al. (2017) give the cost of forgoing the discount as the discount percent divided by 100 minus the discount percent, times 360 divided by the final due date minus the discount period. Here that is 2/98 times 360/20, or about 36.7 percent a year.

That figure surprises many owners because 2 percent sounds small. The math is harsh because the extra time is short: the owner gives up $2 on every $100 invoice just to hold $98 for twenty additional days. Letting the supplier's discount lapse is, in effect, borrowing at nearly 37 percent. If the restaurant can draw on a bank line at 9 percent, using the line to pay inside ten days wins on every invoice.

Why, then, do so many firms pay late? Petersen and Rajan (1997) found that firms with limited access to bank credit relied more heavily on trade credit, using it as a source of financing despite its cost, while suppliers were willing to extend it partly because they knew their customers well. For a young business without a credit line, the supplier may be the only lender available.

Scripture speaks to the related temptation to stretch payables past the due date. Proverbs warns against telling a neighbor to come back tomorrow when you have what is owed (English Standard Version Bible, 2001/2016, Proverbs 3:27-28). Taking the discount when possible, and paying on time when not, is both sound finance and honest dealing.

Reply to Marcus

Marcus, you suggested paying suppliers at 45 days instead of 30 to keep cash longer. It does lower the annual cost of the credit, but Block et al. (2017) note that stretching payables can damage a firm's credit reputation, and suppliers may respond by cutting credit or requiring cash on delivery. For a restaurant that depends on daily deliveries, losing credit terms could be far more costly than the interest saved. Would a short-term bank loan be a safer way to ease the cash squeeze?

Reply to Priya

Priya, your example of $5,000 growing at 6 percent for ten years to about $8,954 was correct and clearly shown. One step further makes the time value of money even more vivid: at monthly compounding, the same deposit grows to about $9,097, because interest earns interest twelve times a year instead of once. Block et al. (2017) show that the effective annual rate rises as compounding becomes more frequent. That difference matters when comparing a savings account that compounds monthly with a bond that pays annually. Which would you choose for an emergency fund, and why?

References

Block, S. B., Hirt, G. A., & Danielsen, B. R. (2017). Foundations of financial management (16th ed.). McGraw-Hill Education.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Petersen, M. A., & Rajan, R. G. (1997). Trade credit: Theories and evidence. The Review of Financial Studies, 10(3), 661-691. https://doi.org/10.1093/rfs/10.3.661