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**CHAPTER 17 SHORT-TERM CREDIT FOR FINANCING CURRENT ASSETS
**

I. Questions 1. It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of foregoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding an alternate source of funds for 8 to 10 percent. 2. The prime rate is the rate that a bank charges its most creditworthy customers. The average customer can expect to pay one or two percent (or more) above prime. 3. The stated interest rate is the percentage rate unadjusted for time or method of repayment. The effective interest rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days provides a 20 percent effective rate. The financial manager should recognize the effective rate as the true cost of borrowing. The effective rate is also referred to as the APR (Annual Percentage Rate). 4. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporation’s commercial paper as a short-term investment, it is a current asset. Conversely, if a corporation issues its own commercial paper, it is a current liability. 5. Pledging accounts receivable means receivables are used as collateral for a loan; factoring account receivables means they are sold outright to a finance company. 6. Three types of lender control used in inventory financing are a. Blanket inventory lien-general claim against inventory or collateral. No specific items are marked or designated. b. Trust receipt-borrower holds the inventory in trust for the lender. Each item is marked and has a serial number. When the inventory is sold, the trust receipt is canceled and the funds go into the lender’s account. 17-1

Of this. Multiple Choice 1. 41. 33.Chapter 17 Short-term Credit for Financing Current Assets c. P1. 44. 26. Warehousing the inventory is physically identified. 40. 11. 23. 36. segregated. 2. 20. A Supporting computations: 4. 13. 28. II. it is termed public warehousing.080. cost = = Discount % 100 . 24. Typically. 21. 34. 5. 10. 18. 45. 38. D 47. 39. 19. 25. 22.000 (40) = P120. P3. An alternate arrangement is field warehousing whereby the same procedures are conducted on the borrower’s property. 12. Approx.000 is “non-free” credit. 17. D A A A C D C D B C D D C C D 46. while P3. 8. 42. 15. 37. 7. 30. 32. D A B B D B A C D D D C D C D 31. and stored under the direction of an independent warehouse company that controls the movement of the goods.000 (30) = P90.10 2x 98 360 30 17-2 . 6.000 in purchases per day.Discount % 2% x 100% . 29. A B D B D C A D B D A A B C B 16. 4.2% x Days credit is − Discount outstanding period 360 360= 40 .000 of accounts payable on the books at any given time. there will be P3. 3.000 / 360 = P3. 14. 43. 9. 5. 27.000 (10) is “free” credit. If done on the premises of the warehousing firm. 35.

000 / P5.10) = P13.1111 = 11.000 P9.3% P1. = 10. Approximate effective rate = 9. net 70.000 Days credit is − Discount outstanding period 2% x 100% .10 2 x 98 360 60 =12.000 − (P2.2% 360 = 70 . = = = = 0. net 40.Discount % P2.11% Effective rate on the Interest discount loan Face value − Interest Credit terms are 2/10. = = 11. 7.10) is as follows: P2.Short-term Credit for Financing Current Assets Chapter 17 =24. the approximate cost (P2. 17-3 13.13 percentage points less than trade credit. Effective rate .000 (0.000 x 100 .333.000 = 8. the loan cost is 1.400.000) (0.400.10) Approx.5% 6.1% P1.24% Therefore. Assuming no penalty.400.160.000 = 20.0% = P10.000) (0.000 − P10.10) P10. cost = = Discount % 360 P240. but delaying payments 30 additional days is the equivalent of 2/10.000 (0.

= Interest Proceeds = 120.200 III.15 − 0.73 follows: Proceeds Interest expense = .000 = .00 (.000 − 980. (P1.000.000 − 1.15 − 0. The effective rate is equal to net interest expense divided by proceeds received not proceeds borrowed.000 + 1.67% 1 180 / 360 24.333) = P1.000 is required for the compensating balance.93) − .10 (P13.10 x P200 million x 180 / 360 = P10 million The effective cost of credit can now be calculated as follows: RATE = = 46% 17-4 x .200) x 4 1.Chapter 17 Short-term Credit for Financing Current Assets since 0.10 P10 million + P125.000) 1.000.000 − P10 million = 26.333) = P2. 10% Effective rate 1 − 0.20] .06 x 100.000.07 .10 21.000 − 100.15 (P13.000 − 20.67% = 12.000 P200 million − P125.000 = 1 − 0.07 The discounted interest cost of the commercial paper issue is calculated as [1.333 is required for the immediate interest payment.0959 8. and 0. P10.000 − (0. Problems PROBLEM 1 (CAMATCHILE SALES COMPANY) Interest .

however.333 x .Short-term Credit for Financing Current Assets Chapter 17 PROBLEM 2 (JAN MFG.000 17-5 x P500.18026. for the August trade credit the firm actually pays at the end of the credit period (the 30th day). However.026% Note that Jan would actually have to borrow more than the needed P500.667 P500.) a.667 12 15 days).667) P383. so that the cost of trade credit becomes RATE = c.12 x P10. CO. b. for the July trade credit.000 + P11.03 / . the effective cost of credit will not be affected by adjusting the loan amount for interest expense changes accordingly. or 18. Thus.22% .333 2 follows: RATE = (.2 x P500.000 P11. then the firm effectively forgoes a 3 percent discount for not paying within 15 days and does not pay for an additional 45 days (60 days less the discount period of P11.03 / . = = .000 − (.74% However.000 in order to cover the compensating balance requirement. Interest for two months = = = = RATE = = .97) x (360 / 15) = 74.14 x − x P500. as we demonstrated earlier.030043 x 6 = .000 (.97) x (360 / 45) = 24. in this case the firm actually stretches its trade Loan proceeds creditP500. If it is able to do this without penalty. Jan’s cost is calculated as P388. The estimation of the cost of forgoing trade discounts is generally quite straightforward.000 loan) made during July beyond the due date by an (for for purchases additional 30 days.

000 .21212. of course.18. or 21. although it carries the highest stated rate of interest.18 x P200.000 − .000 − .212% Alternative (a) offers the lower-cost service of financing.16 x P200.000 − .000 1 PROBLEM 4 (KIWI CORPORATION) = 17-6 x . The reason for this.750 P200.0275 x 6 = . RATE = Interest for= .20 x P200.000 1 P200. or 18% two months RATE = = .5% .14 x P200.005 x P750.14 x P200.750 P500.Chapter 17 Short-term Credit for Financing Current Assets Pledging fee = . x = .20. or 16. COMPANY) a.000 + P3. RATE = P10.000 x 1 1 RATE = = . . its that there is no compensating balance requirement nor is interest discounted for this alternative. or 20% c.000 = P3.165.000 P200.2 x P200.000 PROBLEM 3 (JELO MFG.000 12 2 2 12 x x 1 1 b.

000 P300.000 amount needed to be borrowed = = = 13.% Final due datec.) (READY (1 − .500 360 P300.68% x 6 = x 2.2) = 14% / (.850 = Discount % x 6 = 12. Cost of lost discount= x P6.80 a. = = 98% (55 − 10) = P375. Effective interest rate No.000 P300.000 60 = 2.850 360 P375.28% x 6 e.8) = 17.20) . because the cost of borrowing is less than the cost of losing the Discount period discount.04% P300.000 PROBLEM 5 (1 − C) FLASHLIGHTS. 17.Short-term Credit for Financing Current Assets Chapter 17 = x P5.000 60 b. Kiwi Corporation should continue to pay in 55 days and pass up the discount.000 Cost of not taking a 360 cash discount 100% − Disc. 2% 360 d.83% x 6 = 10. Effective rate of interest = = x 1. INC.98% P6. P300.5%.32%. is more than the cost of passing up the discount.24% 2. 17-7 .04% x 8 = 16. Yes. do not borrow with a compensating balance of 20 percent since the effective rate is greater than the savings from taking the cash discount.32% Effective rate of interest with a 20% compensating balance requirement: 2% 360 98% (70 − 10) = Interest rate / (1 − C) = 14% / (1 − .5% The effective cost of the loan.000 − P75. 16.

) 17-8 .300.000 / P1.000 = 20.000 Bank.000 = 18.000 / P1.. If compensating balances are maintained at both banks in the normal x 4 Bank should be chosen over Northeast course of business. INC.46% Choose Northeast Bank since it has the lowest effective interest rate.000 − P9.000 = 15.82% c.28% Northeast Bank Effective interest rate = = P216.000costP20. The numerators stay the same as in part (a) but the denominator increases to reflect the use of more money because compensating balances are already maintained at both banks. b.000 x 13) P216. then2 Trust x P9. (4 + 1) effective − of its loan P9.000 (P100.000 / P355.000 − P10. Trust Bank Effective interest rate Northeast Bank Effective interest rate = = P216. The(P100.000 / P455.Chapter 17 Short-term Credit for Financing Current Assets PROBLEM 6 (SUMMIT RECORD COMPANY) a.000) x (12 + 1) Effective interest rate = = P72.170.000) x PROBLEM 7 (ATBP.000 − will be less.62% = = P72.000 / (P100.000) x 5 P72. Trust Bank 2 x 12 x P9.000 / (P100. Yes.000 = 16.

345% P 77.500 P 82.500 P 77.000 482.500 P4.517.0775 x ¼) Funds available for use: Funds raised Less: Compensating balance Net funds available per quarter Cost of commercial paper per quarter 17-9 = P400.000 x .000 82. INC.500 P3.000 82.500 P P 77.000.500 5.500 P3.00125) First quarter cost Funds available for use: Funds raised Less: Compensating balance Less: Interest and placement Net funds available in first quarter = P400.000 x .09% c. Cost of commercial paper = Cost of commercial paper in the first quarter Cost of issuing commercial paper: Interest (P4.500 P4.000 77.500 . 18% Costs incurred by using commercial paper Net funds available from commercial paper PROBLEM 8 (FAMILIA.) a.522. 11.000.500 P3.500 2.000.000.517.000 x .000 477.500 Cost of commercial paper in the first quarter = Cost of issuing commercial paper per quarter: Interest (P4.522.000.73% b. 12.500 P3.0775 x ¼) Placement fee (P4.Short-term Credit for Financing Current Assets Chapter 17 a.

02345 + 3(. 3. The expected monthly cost of bank financing is the sum of the interest cost.000 Expected monthly cost of bank financing = P 2.95 percent) by greater than 1 percent. should possess in order to deal regularly in the commercial paper market include: 1. and credit department cost. PROBLEM 9 (CANADA COMPANY) a. Have flexibility to arrange for large amounts of funds through regular banking channels.15 / 12 x P180. 4th qtrs. Have a large and frequently recurring short-term or seasonal needs for funds. should choose commercial paper because the cost of bank financing (10. Have the ability to deal in large denominations of funds for periods of one to nine months and be willing to accept the fact that commercial paper cannot be paid prior to maturity.20% 1st quarter cost + 3(cost of 2nd.75 Credit department Bad debt expense .95% Familia Inc.02345 + .Chapter 17 Short-term Credit for Financing Current Assets = Total annual effective cost of commercial paper Effective cost = = = = = 2.500 = 11.) . Have a prestigious reputation.7 x P900.250 = 4.0175 x .000 / .08945 8.02200) .800 = 2.575 17-10 . The characteristics Familia Inc. bad debt expense. b. 3rd. be financially strong.06600 . 4.4 percent) exceeds the cost of commercial paper (8. The calculations are as follows: Interest .000 Processing . 2. processing cost.02 x P180. and have a high credit rating.025 P20.

It may mar their credit rating and increase the cost of other borrowing arrangements. The calculations are as follows: Interest . as well as the margin of error inherent in the estimation of the source data used in the calculations for Parts a and b. 3.000 Factor .000 x . e. = P 2.70 x . the factoring arrangement should be continued. The expected monthly cost of factoring is the sum of the interest cost and the factor cost.000 x . Based upon the calculations in Parts a and b. the other services offered by the factor and bank would have to be evaluated. 2.000 and the bank will loan P472.750 P18.025 x .000 (P900. The administrative costs may be excessive when invoices are numerous and relatively small in peso amount. d. The annual percentage cost of each company’s credit terms is calculated as follows: 17-11 .000 Expected monthly cost of factoring c.450 PROBLEM 10 (BILLY MADISON CORPORATION) a. The following are possible disadvantages of factoring: 1. Factoring removes one of the most liquid of the firm’s assets and weakens the position of creditors. Customers could react unfavorably to a firm’s factoring their accounts receivable.90). 75) and the factor will lend P567. Factoring is a flexible source of financing because as sales increase. Factors specialize in evaluating and diversifying credit risks. Using a factor eliminates the need to carry a credit department.500 (P900. The following are possible advantages of factoring: 1. the amount of readily available financing increases. Before arriving at a final decision. The disadvantages of factoring are relatively unimportant in this case.7 x P900. 2. 3. especially since Canada Company has been using the factor in the past.700 = 15.70 x .Short-term Credit for Financing Current Assets Chapter 17 b.015 x P180. The additional borrowing capacity needed by Canada Company is irrelevant because the firm only needs P180.

1. Yes. 1. . 2.Chapter 17 Short-term Credit for Financing Current Assets Cost = x The cost of each supplier must be weighted by the proportion of the total Discount 360 days provided by the supplier. 17-12 . .30 . Fort Co.7%. b. No.7% and should be paid on day 10 only if the cost of borrowing is less than 36. the average effective annual interest rate does not indicate whether they should borrow funds to take advantage of the terms on a specific account.367 . with certain specified limitations.172 .017 Total 1. has an effective annual interest rate of 36.061 Jam Co.10 .35 Smitt & Co.25 .188 Average effective annual interest rate is 18.110 Jester Co. A line of credit is a loan agreement in which the borrower has. . . The borrowing decision should be based on the effective annual interest rate of each supplier’s credit terms. Money should be borrowed to pay within the discount period only when the cost of borrowing is less than the effective annual interest rate of the credit terms. c. control over the amount borrowed (up to some maximum) and when the funds are repaid.00 . a line of credit would be appropriate for Billy Madison if the company needs to borrow short-term money to take advantage of the cash discounts. For instance.242 .00 – Discount Credit period – Discount period Annual Weighted Percentage Cost Weight Average Cost Supplier (1) (2) (1) x (2) Fort Co.8 percent.

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