Why Are Trade Credits so Damn Expensive?∗

Trade credits represent an important source of financing for all corporations. Rajan and Zingales (1995) report close to 40 % of debt financing occurs through the use of trade credits. Trade credits can be, however, a very expensive form of debt financing. The oft-mentioned 2-10 net 30 contracts (a 2 % discount if paid within 10 days, otherwise all is due in 30 days) represents an equivalent 45 % annual interest rate. The goal of this paper is to present a new theory as to why trade credits are so expensive compared to bank financing, and why trade credits are nonetheless such important sources of financing. Although bank financing is superior, it could happen that this source of financing is restricted so that firms in need of financing must look somewhere else. The theory I present is based on the assumption that non-financial firms are unable to commit credibly to auditing a borrower who declares bankruptcy in contrast to banks that can commit. In a world where entrepreneurs have private information as to the state of the world, I show that being unable to commit to verifying the true state of the world − which presumably resembles the situation of vendor financing − generates a higher interest rate on the loan than if the creditor could commit − which presumably resembles the situation of bank financing. Not only can the model predict why trade credits bare a higher interest rate, it also supports predicst borrowers that rely on trade credits use more outside financing