Estimating Cost of Short-

Term & Long-Term

Credit
Accruals
• Current liabilities for services received but for which
complete payments have not been made as of the
reporting date.
• Are interest-free sources of financing and do not
involve either implicit or explicit costs.
• Firms can alter the amount of accrued wages by
changing the frequency of wage payments, for
example, but they have less control over other
accruals.
Example:
XYZ Corporation is considering a change in its
payroll period, from biweekly (every two weeks)
to bimonthly (twice a month). The biweekly
payroll is normally P400,000. Assuming wages
accrue at a constant rate, the average level of the
accrued wages account is currently P200,000
(P400,000/2). XYZ has an opportunity cost of 12%.
Solution:
Change in average accrued wages = Average accrued wages – Current
average accrued wages
= (P800,000/2) – (P400,000/2)
= P200,000

Savings by changing the payroll period = Opportunity cost x Change in

accrued wages
= 0.12 x P200,000
= P24,000
Trade Credit
• Credit received during the discount period is sometimes called free
trade credit.
• The view that trade credit is free may be misleading.
• There are costs associated with trade credit, but they are not as
obvious as costs of other forms of financing such as interest charges.
oImplicit/Hidden costs - suppliers of trade credit incur the costs of
operating a credit department and financing accounts receivables.
oOpportunity costs/missed cash discount - trade credit does not
have explicit cost if there is no discount offered or if the buyer
pays the invoice during the discount period.
Trade Credit
Nominal Annual Cost (ANC) = [Discount %/ (100-Discount %)]
x [360 days/(Days credit is outstanding -Discount period)]

Example:
Calculate the nominal annual cost of non-free trade credit
under each of the following terms:
1. 2/10, n/60
2. 2/10, n/30
Trade Credit
Solution:

1. ANC = [2%/ (100%-2%)] x [360/ (60-10)] = 14.69%

2. ANC = 2%/ (100%-2%)] x [360/ (30-10)]= 36.73%

Bank Loans
Interests on bank loans are calculated in five ways:
• Simple Interest – the borrower receives the face value of the
loan and repays the principal and interest at maturity date.
• Effective annual rate simple = Interest/Face Value
• Effective annual rate compound = [1+(Interest Rate/m) m]
– 1 (if less than 1 year)
Bank Loans
• Discount Interest – the bank deducts the interest in
advance or discounts the loan.
• Effective annual rate discount = Interest/ (Face Value
– Interest)
• Effective annual rate simple = [1+(Interest Rate/m) m]
– 1 (if less than 1 year)
Bank Loans
• Simple Interest with Compensating Balances –
Compensating balance is the minimum account
balance that a lending bank requires the borrower to
maintain. Its effect is to raise the effective rate on a
loan because the net withdrawable amount is
reduced.
• Effective annual rate simple/CB = Interest/ (Face
Value – Compensating balance)
Bank Loans
• Discount Interest with Compensating Balances

•Effective annual rate discount = Interest/ (Face

Value – Interest – Compensating Balance)