What is the effective cost and the true effective costs of trade credit under the credit terms of 3/15, net 30?
A trade credit given under the terms 3/15, net 30 requires the payment to be made within 30 days. If the payment is made earlier and within 15 days a cash discount of 3% is offered.
The effective discount rate varies from the actual discount offered as if the buyer does not make the payment within the cash discount period there is a duration of time before the net period comes to an end during which the amount that has to be repaid can be invested in an option that provides a guaranteed risk-free return greater than the discount being offered.
For the seller, the annual effective rate or the cost of giving the discount calculated as an annual figure is given by the formula: i = (1 + D/(1 - D))^(365/(tn - td) - 1
Substituting the values from the terms of the trade credit mentioned in the question, i = (1 + 0.03/0.97)^(365/15) - 1 = 109.8%
The cash discount being offered is 3%. The effective cost of this to the seller is 109.8% annually.