Professional Documents
Culture Documents
Learning Goals
1. Review the key components of credit terms, accounts payable, and the procedures for analyzing them. 2. Understand the effects of stretching accounts payable on their cost and the use of accruals. 3. Describe interest rates and the basic types of unsecured bank sources of short-term loans.
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Spontaneous Liabilities
Spontaneous liabilities arise from the normal course of business.
The two major spontaneous liability sources are accounts payable and accruals.
As a firms sales increase, accounts payable and accruals increase in response to the increased purchases, wages, and taxes. There is normally no explicit cost attached to either of these current liabilities.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a
supplier extending terms of 2/10 net 30 EOM. If the firm takes the
cash discount, it will have to pay $980 [$1,000 - (.02 x $1,000)] on March 10th saving $20.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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March 30th. To keep its money for an extra 20 days, the firm must
give up an opportunity to pay $980 for its $1,000 purchase, thus costing $20 for an extra $20 days.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Spontaneous Liabilities: Analyzing Credit Terms (cont.) Giving Up the Cash Discount
Cost =
2% 100% - 2%
365 30 - 10
= 37.24%
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Spontaneous Liabilities: Analyzing Credit Terms (cont.) Giving Up the Cash Discount
The preceding example suggest that the firm should take the cash discount as long as it can borrow from other sources for less than 37.24%. Because nearly all firms can borrow for less than this (even using credit cards!) they should always take the terms 2/10 net 30.
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If the firm needs short-term funds, which it can borrow from its bank at 13%, and if each of the suppliers is viewed separately, which (if any) of the suppliers discounts should the firm give up?
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The most common items accrued by a firm are wages and taxes.
While payments to the government cannot be manipulated, payments to employees can. This is accomplished by delaying payment of wages, or stretching the payment of wages for as long as possible.
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Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Loan Interest Rates
Most banks loans are based on the prime rate of interest which is the lowest rate of interest charged by the nations leading banks on loans to their most reliable business borrowers. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrowers riskiness.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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= 10.0%
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= 11.1%
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Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Single Payment Notes
Gordon Manufacturing recently borrowed $100,000 from each of 2 banksA and B. Loan A is a fixed rate note, and loan B is a floating rate note. Both loans were 90-day notes with interest due at the end of 90 days. The rates were set at 1.5% above prime for A and 1.0% above prime for B when prime was 6%.
Based on this information, the total interest cost on loan A is $1,849 [$100,000 x 7.5% x (90/365)]. The effective cost is 1.85% for 90 days. The effective annual rate may be calculated as follows:
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Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Revolving Credit Agreement (RCA)
REH Company has a $2 million RCA. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% As a result, they had to pay 0.5% on the unused balance of $500,000 or $2,500. In addition, REH paid $112,500 in interest on the $1.5 million it actually used. As a result, the effective annual cost of the RCA was 7.67% [($112,500 + $2500)/$1,500,000].
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Generally only large firms in excellent financial condition can issue commercial paper.
Most commercial paper has maturities ranging from 3 to 270 days, is issued in multiples of $100,000 or more, and is sold at a discount form par value. Commercial paper is traded in the money market and is commonly held as a marketable security investment.
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Table 15.2 Summary of Key Features of Common Sources of Short-Term Financing (cont.)
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