Ruby Bhd., is being offered the terms of sale of “1/7, net 21” by a supplier.

(a) What is the EAR of the cost to Ruby Bhd., if the offered credit is taken up?

(b) If Ruby Bhd., can borrow short-term funds from a bank at the EAR interest rate of 9%, what should Ruby Bhd., do? Explain briefly.

a)

If offer is take up, Interest rate for the term of discount = discount% / (100% - discount%) = 1% / 99% = 1.01%

Effective annual rate = (1+ periodic rate) ^ (number of period in a year) -1

Effective annual rate = (1+1.01%)^(365/(21-7)) -1 = 29.95%

Annualized rate = periodic rate * number of period in a year = 1.01% * 360/14 = 25.97%

So, Ruby Bhd. taking the discount is equivalent to earning almost EAR of 30% a year on money.

b)

If Ruby Bhd., can borrow short-term funds from a bank at the EAR interest rate of 9%, Ruby Bhd. should borrow the money equivalent to discounted payment at 9% EAR and make the payment within the term of discount i.e.on 7th day and avail the discount and repay the loan amount on 21th day.