Calculate the effective interest rate of a 2/5, net 25 terms of sale, using a 365-day year.
A)24.5%
B)36.5%
C)42.5%
D)55.5%

Question

Quizplus · Accepted Answer

The term 2/5 means that the buyer receives a 2% discount if payment is made within 5 days. Otherwise, the full amount is due in 25 days.
To calculate the effective interest rate, we need to consider the cost of the credit if the buyer does not take the discount and pays in 25 days.

Effective Interest Rate = (Discount % / (100% - Discount %)) x (365 / (Full payment days - Discount days))

= (2 / (100-2)) x (365 / (25-5))

= 0.02457 or 2.457%

Therefore, the effective interest rate is 2.457% if the buyer does not take the discount. However, if the buyer does take the discount, the effective interest rate would be even lower.

To calculate the cost of credit if the buyer takes the discount, we can use the following formula:

Effective Interest Rate = ((Discount % / 100%) x (365 / (Full payment days - Discount days))) + ((100% - Discount %) / (100%) x (365 / Net payment days))

= ((2 / 100%) x (365 / (25-5))) + ((100%-2%) / 100% x (365 / 5))

= 0.03561 or 3.561%

Therefore, the effective interest rate would be 3.561% if the buyer takes the discount.

Since this is higher than the effective rate of 2.457%, it is in the buyer's best interest to pay within the 5-day discount period.

Hence, the best choice is B.

Calculate the Effective Interest Rate of a 2/5, Net 25