Langley Clinics Inc. Buys $400,000 In Medical Supplies Annua

Langley Clinics Inc Buys 400000 In Medical Supplies A Year At Gro

Langley Clinics, Inc. purchases $400,000 worth of medical supplies annually from its primary supplier, Consolidated Services. The terms of trade are 2.5/10, net 45, meaning the company can take a 2.5% discount if paid within 10 days, otherwise, the full amount is due in 45 days. Currently, Langley pays on Day 45 but is contemplating taking advantage of the discount by paying on Day 10 and replacing the remaining trade credit with a bank loan that costs 10% annually. The assignment involves calculating the value of free and costly trade credit, the annual percentage cost of the costly credit, and evaluating whether replacing trade credit with a bank loan is financially advantageous. Additionally, it considers how much of the trade credit should be replaced if using a bank loan.

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Langley Clinics Inc.’s decision to optimize its working capital management involves a careful analysis of its trade credit terms with Consolidated Services and the comparative cost of alternative financing options, such as bank loans. This analysis offers insights into the financial efficiency of utilizing supplier credit versus borrowing funds from a bank, which is crucial for operational and financial planning.

First, understanding the concept of free trade credit is essential. Free trade credit refers to the period during which the company can utilize supplier credit without incurring additional costs. Under the terms of 2.5/10, net 45, Langley can avail a 2.5% discount if payments are made within 10 days; otherwise, the full amount is payable within 45 days. Currently, Langley is paying the total amount on Day 45, which means it is not taking advantage of any early payment discounts and, consequently, is accruing the full credit period. If the company changes its payment schedule to pay on Day 10, it effectively secures the discount and minimizes the trade credit period.

Calculating the amount of free trade credit requires understanding the timing of payment. The free trade credit can be viewed as the period during which the company benefits from supplier financing without expense, i.e., from Day 0 to Day 45 under current conditions; however, the net period where the company gains advantage depends on the actual payment timing. Since Langley currently pays on Day 45, it effectively uses the entire 45-day credit period. When considering taking the discount, if the company pays early, it relinquishes part of this period but benefits from the discount, which effectively reduces its cost of financing. When paying on Day 10, the company receives a 2.5% discount on the $400,000, which equates to $10,000.

The value of free trade credit is calculated as the number of days for which the company benefits from supplier credit without paying, usually up to Day 45. However, the effective free trade period—if the company pays early—is from Day 0 to Day 10, when it pays to avail the discount. Therefore, the free trade credit that Langley gains from the supplier is 45 days minus 10 days, which amounts to 35 days of free credit, assuming no early payments are made without taking the discount. In this context, the free trade credit corresponds to the period during which Langley can finance its purchases at effectively no cost, which is from Day 0 to Day 45 if it pays on the due date, but if it opts for the discount system, the period is from Day 0 to Day 10, capturing the advantage of early payment at a reduced cost.

Next, the costly trade credit refers to the credit period where the company does not utilize the discount and pays after Day 10, up to Day 45, effectively paying a higher interest rate on the deferred amount. When paying after Day 10 but within Day 45, Langley effectively incurs a financing cost equivalent to the implicit interest cost of not paying early and taking the discount. The annual percentage cost of this costly trade credit can be calculated based on the difference in payment timing and the cost of delaying payment. Specifically, the opportunity cost of not taking the discount becomes significant if the company pays the full amount after Day 10, and this cost can be approximated as an interest rate over the period from Day 10 to Day 45.

To estimate the annual percentage cost, we first determine the cost of forgoing the discount. The discount amount is $10,000, for payments made within 10 days. If the payment is delayed from Day 10 to Day 45, the company effectively incurs a financing cost on the $400,000 for the period of 35 days (from Day 10 to Day 45). The implicit interest rate over this period can be approximated, and annualized to find the percentage cost. For example, using the formula:

Interest rate = (discount foregone / (invoice amount - discount amount)) × (360 / days between the discount period end and payment due). Applying these calculations, the approximate annual percentage cost of the missed discount should be around 17-20%, indicating the significant expense of not taking advantage of early payment discounts when financing through more expensive sources.

Considering whether Langley should replace its trade credit with a bank loan involves a comparison of costs. The bank loan carries an annual interest rate of 10%, which translates into a monthly or daily interest cost. Replacing trade credit with a bank loan is beneficial only if the effective annual cost of trade credit exceeds the 10% interest rate, after adjusting for the period and costs involved. Given the estimated implicit cost of late payment being around 17-20%, it appears that the bank loan's 10% annual rate is more cost-effective than foregoing the discount, especially if the company needs to finance additional operations or expects to pay after the early payment window.

Finally, determining how much of the trade credit Langley should replace with a bank loan depends on their cash flow situation and the relative costs calculated above. If the costs of late payment or missing discounts are higher than the bank loan rate, it is advisable for Langley to replace the entire trade credit period with a bank loan. Conversely, if only part of the credit period is more expensive or the company can optimize its cash flow to pay early when advantageous, a partial replacement could be optimal.

In conclusion, Langley's decision to utilize early payment discounts and replace trade credit with bank borrowing hinges on a detailed cost-benefit analysis. Given the high implicit interest rate of delaying payments (approximately 17-20%) compared to the bank loan rate of 10%, the company benefits financially from paying early and financing the remaining purchases through a cheaper bank loan. This strategy reduces financing costs, optimizes cash flow, and enhances overall financial efficiency. Effective management of trade credit and bank borrowing, therefore, requires precise calculation of costs and strategic timing of payments to minimize expenses.

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