Discounts – Various Meanings in Business
The term ‘discounts’ is a broad and varied meaning word when it comes to use in business. It literally has four distinct definitions. Each definition is used within a certain context of business. The first and most dollar expensive use is with original issue discount related to bonds in the market. The second use and most common is as an incentive in business. The seller is simply enticing the buyer by offering a discount. The third use is as a tool to force earlier payment from customers on the amounts they owe. The final use of discounts is with the field of financing in evaluating future cash flows. There is a fifth use with determining marginal value of existing operations; but is not a common use as the other four.
What is interesting is that all four uses of the term ‘discount’ have a common bond. Discounts in business refers to paying lower actual dollars for a higher face value of the item received. Each of the four uses are explained in greater detail below. The goal of this article is to identify how the buyer gets more for lower actual cost which is referred to as a discount in business.
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Original Issue Discount (OID)
Many bonds issued in the market are called original issue discount bonds. It means the buyer pays less than the face value of the bond. This is very common with government issued bonds. With traditional bonds, the seller (issuer) receives face value from the buyer and pays a coupon interest rate on the face value every six months. For example, a GE $100,000 bond with a 4.2% interest payment pays $2,100 ($100,000 * .042/2) every six months to the holder of the bond. With a discount bond the buyer will pay less than $100,000 for a piece of paper that says on its face $100,000. This is true of any denomination related to the face value of the bond. The lesser paid, the higher the effective interest yield over time on the original amount paid.
What is interesting with original issue discount bonds is that the issuer never makes interest payments. The issuer merely pays the face value on the due date. The buyer receives his original investment back plus interest earned which is called original issue discount. At the end of the calendar year of the issuer’s payment, the bond creator identifies this value by reporting to the Internal Revenue Service the interest earned by the buyer via Form 1099-0ID (Original Issue Discount).
As an example, buyer ‘A’ pays $980 on January 1 for a $1,000 face value bond maturing December 31 of the same year. On December 31 he receives $1,000 earning $20. Novice entrepreneurs will state that the bondholder earned a 2% return on his investment; but, did he? His investment was $980 and he earned $20. His return is $20 on $980 or 2.04% which is greater than 2%. Notice the yield is technically higher than a traditional bond. In a traditional transaction they buyer pays $1,000 and gets $20 plus his original principal back at time of redemption (payment). The original issue discount bondholder receives a Form 1099-0ID the following January indicating original issue discount of $20. The traditional bondholder gets a Form 1099-I for interest earned on the bond.
To satisfy the test for the definition of discount, the buyer must pay less for value received. In this case, original issue discount bonds means the buyer pays less for the face value of the bond; i.e. he pays $980 for $1,000 face value.
Incentives
Original issue discount as used in the bond market account for billions of dollars per year on only a few 100,000 transactions. Where the volume of transactions are literally millions per day involving discounts is with retail and the food service sectors. These discounts are known as incentives to buy.
The most common incentive is a sale. A sale entices the customer to act by buying the product at a lower price than its retail value. Other incentives-include:
Coupons – Coupons are used with the grocery industry and restaurants to get customers to try something new or purchase more by discounting the price paid via a piece of paper (coupon) and cash.
Bulk Purchases – Another incentive is to give more value for a lesser price paid in the aggregate. This includes BOGO’s (buy one get one free), two for one’s and other forms of ‘free’ merchandise by buying a minimum.
Cash Payment – This form of discount is often witnessed at gas pumps. Pay by cash and receive four or five cents off per gallon. Convenience stores do this to reduce their overall cost of transacting money. In general, credit card transactions cost the store about 2.5 cents per dollar. Thus, a $3 gallon of gas costs the store 7 to 8 cents per gallon when the customer pays with a credit card. A 4 cents per gallon cash payment incentive saves the store 3 cents per gallon which is significant in this industry. Realize that a typical convenience store will sell 2,000 to 3,000 gallons a day which is worth $80 to $100 per day in savings.
Buy Now – This is a common incentive in the dealership industry to force the hand of the customer to sign the contract. ‘Act now and we’ll apply a $1,500 rebate to the purchase’. In better managed operations, owners want to know how well incentives perform via detailed financial statements. Discounts are recorded against the full retail value of the item sold. Look at this example of the sales section for an RV dealership.
ACME RV
Income Statement (Limited Scope)
For the Month Ending June 30, 2016
New Used F&I Parts Service Total
Sales@Full $1,183,013 $404,701 $97,211 $93,787 $104,616 $1,883,328
Discounts:
– Rebates (39,700) (1,500) (500) (150) (325) (42,175)
– Campaigns:
Mem Day (18,000) (1,100) – (1,414) – (20,514)
Spring (6,200) (450) – (218) (440) (7,308)
– Coupons – – – (463) (840) (1,303)
– General Man (1,200) (600) – – – (1,800)
Adj. Sales $1,117,913 $401,051 $96,711 $91,542 $103,011 $1,810,228
Discts % of Sales 5.57% .90% .51% 2.39% 1.53% 3.88%
Altogether ACME used incentives of $73,100 to discount sales of $1,883,328. Remember discounts are when the buyer pays less for value received.
Your common retail store may have its sales section broken out as follows:
Gross Sales $ZZZ,ZZZ
Discounts (ZZ,ZZZ)
Sales ZZZ,ZZZ
Adjustments:
– Returns ($ZZ,ZZZ)
– Allowances (ZZ,ZZZ)
Sub-Total R&A (ZZ,ZZZ)
Net Sales $ZZZ,ZZZ
Again, discounts are incentives to prompt the customer to act by purchasing products for a lower price. In many cases, once the buyer has acted he may then owe the money to the seller and the seller wants to get the customer to pay sooner. This for of discount is known as early-pay discounts.
Early Payment Discounts
A third type of discount is similar to incentives but is really a reward to a customer to act. The act is making a payment on his account. In many industries customers have accounts with the business. The customer owes money via receivables. The business may have issues with its working capital or a desire to shorten the working capital cycle. The company offers an early payment discount on the amount due. Often the terms offered are 2 percentage points discount if paid within 10 days or 1 point if paid within 15 days.
This may not seem like a lot at first glance, but let’s look at the math. Suppose the customer owes the company $5,000; a 2 % discount means that if he pays now, he may pay the $5,000 owed for $4,900 or a $100 savings. For the customer, paying at the normal time is the same as paying $100 of interest on $4,900 due for thirty days. This is equivalent as paying $1,200 per year on $4,900 or an interest rate of 24.49% on borrowed money. It really is a reward to pay early.
Besides, it meets the test as a discount, the customer pays less for a higher value.
Early payment discounts are common in the following industries:
A) Garment Manufacturing
B) Construction Material Suppliers
C) Medical Supplies Including Pharmaceuticals
D) Appliance Manufacturing
E) Raw Resource Suppliers
Early-pay discounts are rarely if ever offered at the retail level as incentive discounts are the real drivers of action at the consumer level of business.
Early payment discounts are reported as a cost of capital expense on the income statement for both sides of the equation. The capital expenses section customarily has two lines for early payment discounts. The line for amounts provided, i.e. amounts give to customers, has a debit balance. Amounts taken from suppliers for utilizing discounts offered by paying early is recorded as credits, i.e. a negative value, in the capital expenses section of the income statement.
Discounted Cash Flows
A final use of the term discount relates to its use in calculating value for a future stream of cash. This sophisticated tool is designed to determine a value today for future amount(s). The amounts are always in cash. The question is: What is that cash inflow worth today if discounted at a particular interest rate? The interest rate is often the company’s borrowing rate.
This tool is commonly used with the following business decisions:
1) The purchase of an asset that will generate a steady stream of cash inflows.
2) The investment of money to build or construct a manufacturing plant or purchase real estate.
3) The buying of an existing business or the merger of two businesses.
4) Lending of money.
This financing tool requires an interest rate or two of the three variables to calculate the third value. The three variables are: 1) original cash outflow, 2) an interest rate or also called the discount rate and 3) the final cash inflow or payment inflows over time.
Here are a couple of examples:
Buy and Hold
Stephen wants to buy a piece of art from an auction house. His goal is to buy it and sell it two years from now. This piece of art has appreciated at the rate of 15% per year for the last 10 years. He believes he can sell this piece of art for $100,000 in two years. What is the maximum price Stephen should pay today?
Answer: $100,000 discounted at 15% per year is worth $75,615 per the following schedule:
Initial Cash Out $75,615
Value Increase Balance at 15% After 1 Year $86,957 ($11,342 Increase)
Value Increase Balance at 15% After 2nd Year $100,001 ($13,044 Increase Over YR 1)
Stephen needs to consider other issues in this deal including costs to insure the art, security and the expense to auction the piece in two years. But the basic principle is as illustrated.
Purchase of Office Space
Jeff is an attorney with a small practice and currently rents his office for $1,200 per month. Jeff expects to continue paying $1,200 per month for the next 20 years when he will retire. The office space can be bought and the owner wants to receive an offer from Jeff. Jeff believes that the office space will be worth zero in 20 years. Jeff can currently borrow money for 6% and make payments to the bank instead of his landlord. What is the maximum price Jeff should pay?
Answer: Using a financial calculator Jeff inserts 240 payments at $1,200 each at a 6% discount rate’ to determine present value of these payments as $167,497.
Jeff can offer $167,497 and if the seller refuses, it is in Jeff’s best interest to remain a tenant as any offer higher will increase his monthly payment.
Naturally, real estate transactions are much more complicated than this as property rarely goes to a zero terminal value. In addition, other issues impact the transaction such as maintenance, real estate taxes, insurance and closing costs. The idea for the above is to illustrate the discounted value of future cash flows. In this case Jeff’s cash offer of $167,500 is a lower price than 240 $1,200 installments totaling $288,000.
Discounted cash flows uses two separate techniques. Small businesses should restrict their use to the traditional net present value technique which merely values the future cash inflows or outflows to a current value in today’s dollars at a certain interest rate. A second technique called the internal rate of return (IRR) is more appropriate in evaluating large investment options. It is a comparison tool whereby owners decide between similar projects based on the cost of capital.
For those readers not experienced with discounted cash flows, its use is risky without some formal education in how it is done and the associated pitfalls.
Summary – Discounts (Various Meanings in Business)
There are other uses of the term ‘Discount’ in business. An uncommon use is in the purchase of an existing business. Here discounts are applied to reflect risk factors associated with the business considered. But the bulk of its use fall within the four major variances described including:
- Original Issue Discounts (OID) used in the bond market;
- As incentives to get buyers to purchase products;
- Early payment enticements with accounts receivable; OR
- Discounted cash flows.
All four are commonly bound by the same underlying concept – pay less for greater value. Act on Knowledge.