I know that this sounds like some new Country and Western
dance step. But it is actually a short cut procedure for calculating, in two
steps, the benefit to a seller for offering a cash discount to its customers
for making early payment. I’m sure that some of you, after having reviewed this
calculation in the BOK (see references below), have decided that if it is on
the CTP exam that you will guess at the answer.
This is understandable given the complexity of the equations
and therefore the difficulty of committing them to your memory. And while a
guessing strategy gives you a 25% chance of getting the correct answer, I think
that this two-step procedure is easier to learn and therefore using it might
increase you chances of answering this type of calculation question correctly.
But before I outline how the two-step procedure works, I’d like to briefly
review the concept of Accounts Receivable Carrying Cost.
Carrying Cost is the cost to your company of not having the
use of the cash, for a period of time, that your customers owe you for their
purchases of your products or services. This time period (i.e. the Collection
Period) is the number of days between invoice issuance and receipt of payment.
And it is primarily a function of the credit terms you’ve granted to your
customers to induce them to purchase from your company rather than from your
competition .Typically, Carrying Cost is determined by using the company’s
Weighted Average Cost of Capital (WACC) and is calculated as follows:
(Invoice Amount x WACC x Collection Period) / 365
Now let’s move ahead with the two-step procedure to
calculate the Present Values (PVs) and the Net Present Value (NPV) of a sellers
proposal to offer early payment terms of
2/10 Net30 to their customers. I’m using the same example that is
presented in the BOK so that you can compare the results of this procedure with
those of the BOK equations.
The general form of the two-step procedure is as follows:
| Step 1 |
Step 2 |
| Present Value = Invoice Amount - Discount |
- Carrying Cost |
And by applying it to the BOK example you can calculate the
PVs for payment by the customer on day 10 and day 30 as follows:
PV (Customer takes discount, pays on day
10)
| |
Invoice Amount |
= $100,000 |
| Step 1 |
Less: Discount Amount ($100,000 x .02) |
= (2,000) |
| Step 2 |
Less: Carrying Cost ($100,000 x .15 x 10) / 365 |
= (411) |
| |
|
__________ |
| |
PV |
= $97,589 |
PV (Customer does not take discount, pays
on day 30)
| |
Invoice Amount |
= $100,000 |
| Step 1 |
Less: Discount |
= (0) |
| Step 2 |
Less: Carrying Cost ($100,000 x .15 x 30) / 365 |
= (1,233) |
| |
|
_________ |
| |
|
= $98,767 |
| NPV |
= PV (pay day 10) |
- |
PV (pay day 30) |
| |
= $97,589 |
- |
$98,767 |
| |
= -$1.178 |
|
|
| |
= - $1,200 Rounded |
|
|
When you compare this NPV with the BOK NPV you see that they
are very close and are the same when rounded to the nearest hundred.
| NPV (BOK) |
= $97,599 |
- $98,782 |
| |
= - $1,183 |
|
| |
= - $1,200 Rounded |
|
Given this, you might want to consider studying this
two-step procedure because by doing so you will be preparing yourself to answer
a Sellers Discount calculation question correctly rather than just guessing at
its answer.
So, if you find yourself confronted with this type of
question on the exam, rather than thinking “let’s guess on this question” you
can say, with some degree of confidence because you’re armed with this two-step
procedure “let’s dance”!!!
- George Schilling, CTP
References:
AFPLearning System: Treasury, Module Three, Chapter 7, Pgs. 3-75 to 3-77
Essentials of Treasury Management, 3rd ED.,
Chapter 7, Pgs. 241 to 242 |