- Submitted By: gashcraft07
- Date Submitted: 03/23/2014 9:33 AM
- Category: Miscellaneous
- Words: 303
- Page: 2

Otherwise,

the buyer has 40 days to pay the balance in full from the date of delivery.

In this case, the seller is off ering to lend the buyer money for an additional 30 days. How

expensive is it to the buyer to take advantage of this fi nancing? To calculate the cost, we need

to determine the interest rate the buyer is paying. In this case, the buyer pays 97 percent of the

purchase price if it pays within 10 days. Otherwise, the buyer pays the full price within 40 days.

Th e increase in the payment (and therefore the interest implicit in the loan) is 3/97 3.09

percent. Th is is the interest for 30 days (40-10). To fi nd the annual interest rate, we need to

compute the eff ective annual interest rate (EAR), which was introduced in Chapter 6. As you

recall, the EAR conversion formula accounts for the number of compounding periods and

thereby annualizes the interest rate.

Th e formula for calculating the the EAR for a problem like this is shown in Equation 14.4,

together with the calculation for our example. Notice that to annualize the interest rate, we

compound the per-period rate by the number of periods in a year, which is 12.1667 (365 days

divided by 30 days in a period).

The previous chapters dealt with long-term investment decisions

and their impact on fi rm value. These capital investment

decisions typically commit a fi rm to a course of action

for a number of years and are diffi cult to reverse. In contrast,

this chapter focuses on short-term activities that involve

cash infl ows and outfl ows that will occur within a year or less.

Examples include purchasing and paying for raw materials,

selling fi nished inventory, and collecting cash for sales made

on credit. These types of activities comprise what is known

as working capital management.