Abstract

Trade credit is a common form of bootstrap financing among small firms. Trade credit refers to an agreement between the firm and a supplier where the supplier allows the firm to delay payment. This study views trade credit through a real options lens from the small firm’s perspective. Receiving trade credit that provides a discount for early payment creates a real option that directly affects the small firm’s cost of capital. Imagine Firm A pays its full balance on the tenth day and enjoys a two percent discount on the value of the exchange. Its competitor, Firm B, delays payment beyond the discount period therefore incurring a 36 percent annual cost of capital [360 days / 20 days = 18 times/year without discount; 18 x 2% = 36% discount missed on annual basis]. Given the difference in cost of capital incurred by these firms it is interesting that small firms often do not take the trade discounts they are offered. This dramatic affect on small firms’ cost of capital raises the central question that motivates this study: under what conditions do small firms exercise their real option to defer payment and, therefore, forego trade credit discounts when they are offered?

The hypotheses examined in this study are derived from real options theory. In this context, theory predicts the option to defer payment to suppliers is more valuable – and therefore more often chosen – when uncertainty about cash flow is highest.

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