Cost of Credit Formula

Cost of Credit Formula
The cost of credit formula is a calculation used to derive the cost of an early payment discount. The
formula is useful for determining whether to offer or take advantage of a discount. The formula can be
derived from two perspectives:
 The accounts payable department of the buyer uses it to see if taking an early payment discount is
cost effective; this will be the case if the cost of credit implied by the discount is higher than the
seller's cost of capital.
 The sales department of the seller and the purchasing department of the buyer. Both parties consider
the early payment discount to be an item worth negotiating as part of a sale transaction.
In reality, early payment terms are only taken when the buyer has sufficient cash available to make
an early payment, and the cost of credit is high. The availability of cash can be the deciding factor,
rather than the cost of credit. For example, if the buyer's cash is tied up in long-term investments, it
may not be able to take an early payment discount. This occurs despite the inherent cost of credit
generally being quite attractive to the buyer.
Use the following steps to determine the cost of credit for a payment transaction:
1. Determine the percentage of a 360-day year to which the discount period will be applied. The
discount period is the period between the last day on which the discount terms are still valid
and the date when the invoice is normally due. For example, if the discount must be taken
within 10 days, with normal payment due in 30 days, then the discount period is 20 days. In
this case, divide the 20 day discount period into the 360-day year to arrive at an 18x
multiplier.
2. Subtract the discount rate from 100%. For example, if a 2% discount is offered, the result is
98%. Then divide the discount percentage by 100% less the discount rate. To continue the
example, this is 2%/98%, or 0.0204.
3. Multiply the result of each of the preceding steps together to arrive at the annualized cost of
credit. To complete the example, we multiply 0.0204 by 18 to arrive at a cost of credit of
36.7% for terms that allow a 2% discount if paid within 10 days, or full payment in 30 days.
4. If the cost of credit is higher than the company's incremental cost of capital, take the
discount.
The formula is as follows:
Discount %/(100-Discount %) x (360/Allowed payment days – Discount days)
For example, a supplier of Franklin Drilling offers the company 2/15 net 40 payment terms. To
translate the shortened description of the payment terms, this means the supplier will allow a 2%
discount if paid within 15 days, or a regular payment in 40 days. Franklin's controller uses the
following calculation to determine the cost of credit related to these terms:
= 2% /(100%-2%) x (360/(40 – 15))
= 2% / (98%) x (360/25)
= .0204 x 14.4
= 29.4% Cost of credit
The cost of credit inherent in these terms is quite an attractive rate, so the controller elects to pay the
supplier's invoice under the early payment discount terms.
Economic Value Added
Economic value added is the incremental difference in the rate of return over a company's cost of
capital. In essence, it is the value generated from funds invested in a business. If the economic value
added measurement turns out to be negative, this means a business is destroying value on the funds
invested in it. It is essential to review all of the components of this measurement to see which areas
of a business can be adjusted to create a higher level of economic value added. If the total economic
value added remains negative, the business should be shut down.
To calculate economic value added, determine the difference between the actual rate of return on
assets and the cost of capital, and multiply this difference by the net investment in the business.
Additional details regarding the calculation are:
 Eliminate any unusual income items from net income that do not relate to ongoing operational results.
 The net investment in the business should be the net book value of all fixed assets, assuming that
straight-line depreciation is used.
 The expenses for training and R&D should be considered part of the investment in the business.
 The fair value of leased assets should be included in the investment figure.
 If the calculation is being derived for individual business units, the allocation of costs to each business
unit is likely to involve extensive arguing, since the outcome will affect the calculation for each
business unit.
The formula for economic value added is:
(Net investment) x (Actual return on investment – Percentage cost of capital)
For example, the president of the Hegemony Toy Company has just returned from a management
seminar in which the benefits of economic value added have been trumpeted. He wants to know what
the calculation would be for Hegemony, and asks his financial analyst to find out.
The financial analyst knows that the company's cost of capital is 12.5%, having recently calculated it
from the company's mix of debt, preferred stock, and common stock. He then reconfigures
information from the income statement and balance sheet into the following matrix, where some
expense line items are instead treated as investments.
Account Description Performance Net Investment

Revenue $6,050,000
Cost of goods sold 4,000,000
General & administrative 660,000
Sales department 505,000
Training department $75,000
Research & development 230,000
Marketing department 240,000
Net income $645,000
Fixed assets 3,100,000
Cost of patent protection 82,000
Cost of trademark protection 145,000
Total net investment $3,632,000
The return on investment for Hegemony is 17.8%, using the information from the preceding matrix.
The calculation is $645,000 of net income divided by $3,632,000 of net investment. Finally, he
includes the return on investment, cost of capital, and net investment into the following calculation to
derive the economic value added:
($3,632,000 Net investment) x (17.8% Actual return – 12.5% Cost of capital)
= $3,632,000 Net investment x 5.3%
= $192,496 Economic value added
Thus, the company is generating a healthy economic value on the funds invested in it.
The measurement has benefited from the marketing efforts of consulting firms that want to install an
economic value added measurement system; whether the metric will have standing over the long
term is difficult to say.

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Cost of Credit Formula

The formula is as follows:

Discount %/(100-Discount %) x (360/Allowed payment days – Discount days)

= 2% /(100%-2%) x (360/(40 – 15))

= 29.4% Cost of credit

The formula for economic value added is:

(Net investment) x (Actual return on investment – Percentage cost of capital)

Account Description Performance Net Investment

($3,632,000 Net investment) x (17.8% Actual return – 12.5% Cost of capital)

= $3,632,000 Net investment x 5.3%

= $192,496 Economic value added

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