Managing Accounts Payable – Practice Question

“A company wants to approximate the 12% annual interest rate based on a 365-day year it pays on its working capital loan. Which of the following terms should the company offer its customers?”

A) 2.00%, 15, net 45.
B) 1.00%, 15, net 45.
C) 0.75%, 10, net 30.
D) 0.50%, 10, net 30.

For this problem, we need to use the formula of not taking a discount to figure out the ideal discount terms:

Annual Rate = Periods Per Year X Effective Discount Rate The problem is already telling us that the answer needs to be a 12% annual interest rate, and we need to back our way into how to reach this rate.

First, let’s try answer A. We get a discount if paid within 15 days and without the discount we have to pay within 45 days, so there are 30 days we’re giving up by taking the discount. How many 30-day periods in a year are there? 12.17 periods (365/30). The discount rate is 2%. To find the effective discount rate, we divide 2% by (100% minus 2%), meaning we divide 0.02 by 0.98, 2.04%.

Now we multiply 12.17 by 2.04%, which is 25% rounded. A is, therefore, not the correct answer. Option A: 2.00%, 15, net 45. We're giving up 30 days (45-15). How many 30-day periods are in a year? 12.17. Effective discount rate: 2%/98% = 2.04%.

12.17 X 2.04% = 25% Annual Rate

Let’s try answer B now. The number of days is the same in this problem as in choice A. We have 12.17 periods. The discount rate is 1%. The effective discount rate is 1% over 99%, or 1.01% rounded. 12.17 periods times 1.01% is 12% rounded. Answer B is the correct answer.

Option B: 1.00%, 15, net 45. We're giving up 30 days (45-15). How many 30-day periods are in a year? 12.17. Effective discount rate: 1%/99% = 1.01%.

12.17 X 1.01% = 12% Annual Rate