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You are on page 1of 12

CHAPTER 20

SHORT-TERM SOURCES

FOR FINANCING CURRENT ASSETS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

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 corporations

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

20-1

Chapter 20

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 lenders

account.

c. Warehousing the inventory is physically identified, segregated, and

stored under the direction of an independent warehouse company

that controls the movement of the goods. If done on the premises of

the warehousing firm, it is termed public warehousing. An alternate

arrangement is field warehousing whereby the same procedures are

conducted on the borrowers property.

II. Multiple Choice Questions

1.

2.

3.

4.

5.

A

B

D

B

D

16.

17.

18.

19.

20.

B

A

C

D

D

31.

32.

33.

34.

35.

D

A

A

A

C

46.

47.

48.

49.

50.

D

A

B

B

C

6. C

7. A

8. D

9. B

10. D

21.

22.

23.

24.

25.

D

C

D

C

D

36.

37.

38.

39.

40.

D

C

D

B

C

51.

52.

53.

54.

55.

A

C

C

A

C

11. A

12. A

13. B

14. C

15. B

26.

27.

28.

29.

30.

D

A

B

B

D

41.

42.

43.

44.

45.

D

D

C

C

D

56. D

57. D

20-2

Chapter 20

III. Problems

Problem 1

The discounted interest cost of the commercial paper issue is calculated as

follows:

Interest expense = .10P10

x P200

million

x 180 / 360 = P10 million

million

+ P125,000

1

180 / 360

million

P125,000

P10asmillion

The effective costP200

of credit

can now

be calculated

follows:

RATE =

RATE = 46%

Problem 2

Loanfor

proceeds

a. Interest

two months = .14 x x P500,000

(for P500,000 loan)

= P11,667

P11,667

12

= P500,000

(.2

x

P500,000

+ P11,667)

P388,333

2

= P383,333

RATE =

Note that Jan would actually have to borrow more than the needed

P500,000 in order to cover the compensating balance requirement.

However, as we demonstrated earlier, the effective cost of credit will not

be affected by adjusting the loan amount for interest expense changes

accordingly.

20-3

Chapter 20

straightforward; however, in this case the firm actually stretches its trade

credit for purchases made during July beyond the due date by an

additional 30 days. If it is able to do this without penalty, 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 15 days). Thus, for the July trade credit, Jans cost is

calculated as follows:

RATE = (.03 / .97) x (360 / 45) = 24.74%

However,

for the

trade credit2the firm actually pays at the end of

Interest

for August

two

the credit period

(the

30th

day), so that the cost of trade credit becomes

months

12

RATE = (.03 / .97) x (360 / 15) = 74.22%

c.

= .12 x

Pledging fee

RATE

x P500,000

= P10,000

P10,000 + P3,750

P500,000

= .005 x P750,000

= P3,750

12

2

.18 x P200,000

1

P200,000

1

= .0275 x 6 = .165, or 16.5%

Problem 3

a. RATE

=

=

b. RATE

=

=

c. RATE

.16 x P200,000

P200,000 .20 x P200,000

x

1

1

P200,000 .14 x P200,000 .2 x P200,000

x

1

1

.20, or 20%

x

20-4

Chapter 20

.21212, or 21.212%

carries the highest stated rate of interest. The reason for this, of course,

its that there is no compensating balance requirement nor is interest

discounted for this alternative.

Problem 4

2%

360

Cost of98%

not taking (55 10)Discount %

=

a cash discount

100%

Disc.%

360

x

Final due dateDiscount period

= 2.04% x 8 = 16.32%

=

=

=

Interest rate / (1 C)

14% / (1 .2)

14% / (.8) = 17.5%

The effective cost of the loan, 17.5%, is more than the cost of passing up the

discount, 16.32%. Kiwi Corporation should continue to pay in 55 days and

pass up the discount.

Problem 5

a. Effective rate of interest =

P5,500

P300,000

360

60

= 1.83% x 6 = 10.98%

b. Cost of lost discount

2%

98%

360

(70 10)

= 2.04% x 6 = 12.24%

c. Yes, because the cost of borrowing is less than the cost of losing the

discount.

20-5

Chapter 20

d.

P300,000

(1 C)

P6,850

P300,000P375,000 P300,000

P75,000

=.80

(1= .20)

P6,850

P300,000

360

60

e. Effective interest rate =

x

=

x 6

= 2.28% x 6

= 13.68%

No, do not borrow with a compensating balance of 20 percent since the

effective rate is greater than the savings from taking the cash discount.

2 x 4 x P9,000

Problem 6

(P100,000 P20,000 P9,000) x (4 + 1)

a. Trust Bank

Effective interest rate

=

2 x 12 x P9,000

= P72,000 / P355,000 = 20.28%

(P100,000 P10,000) x (12 + 1)

Northeast Bank

Effective interest rate

=

= P216,000 / P1,170,000 = 18.46%

Choose Northeast Bank since it has the lowest effective interest rate.

b. 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.

20-6

Chapter 20

Trust Bank

Effective interest rate

= P72,000 / P455,000 = 15.82%

Northeast Bank

Effective interest rate

= P216,000 / P1,300,000 = 16.62%

normal course of business, then Trust Bank should be chosen over

Northeast Bank. The effective cost of its loan will be less.

Problem 7

a. 11.73%

b. 12.09%

c. 18%

Net funds available from commercial paper

Problem 8

a. Cost of commercial paper =

Cost of commercial paper in the first quarter

Cost of issuing commercial paper:

Interest (P4,000,000 x .0775 x )

Placement fee (P4,000,000 x .00125)

5,000

Funds raised

Less: Compensating balance

Less: Interest and placement

Net funds available in first quarter

20-7

77,500

82,500

P4,000,000

P400,000

82,500

482,500

P3,517,500

Chapter 20

P 82,500

P3,517,500

=

Interest (P4,000,000 x .0775 x )

Funds available for use:

Funds raised

Less: Compensating balance

2.345%

77,500

P4,000,000

P400,000

77,500

477,500

P3,522,500

P 77,500

P3,522,500

=

2.20%

Effective cost

=

.02345 + 3(.02200)

=

.02345 + .06600

=

.08945

=

8.95%

Familia Inc. should choose commercial paper because the cost of bank

financing (10.4 percent) exceeds the cost of commercial paper (8.95

percent) by greater than 1 percent.

b. The characteristics Familia Inc. should possess in order to deal regularly

in the commercial paper market include:

1. Have a prestigious reputation, be financially strong, and have a

high credit rating.

2. Have flexibility to arrange for large amounts of funds through

regular banking channels.

20-8

Chapter 20

needs for funds.

4. 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.

Problem 9

a. The expected monthly cost of bank financing is the sum of the interest

cost, processing cost, bad debt expense, and credit department cost. The

calculations are as follows:

Interest

.15 / 12 x P180,000

Processing

.02 x P180,000 / .75

Credit department

Bad debt expense

.0175 x .7 x P900,000

Expected monthly cost of bank financing

= P 2,250

=

4,800

=

2,500

= 11,025

P20,575

b. The expected monthly cost of factoring is the sum of the interest cost and

the factor cost. The calculations are as follows:

Interest

.015 x P180,000

Factor

.025 x .7 x P900,000

Expected monthly cost of factoring

= P 2,700

= 15,750

P18,450

1. Using a factor eliminates the need to carry a credit department.

2. Factoring is a flexible source of financing because as sales

increase, the amount of readily available financing increases.

3. Factors specialize in evaluating and diversifying credit risks.

d. The following are possible disadvantages of factoring:

1. The administrative costs may be excessive when invoices are

numerous and relatively small in peso amount.

20-9

Chapter 20

2. Factoring removes one of the most liquid of the firms assets and

weakens the position of creditors. It may mar their credit rating

and increase the cost of other borrowing arrangements.

3. Customers could react unfavorably to a firms factoring their

accounts receivable.

should be continued. The disadvantages of factoring are relatively

unimportant in this case, especially since Canada Company has been

using the factor in the past. Before arriving at a final decision, the other

services offered by the factor and bank would have to be evaluated, as

well as the margin of error inherent in the estimation of the source data

used in the calculations for Parts a and b. The additional borrowing

capacity needed by Canada Company is irrelevant because the firm only

needs P180,000 and the bank will loan P472,500 (P900,000 x .70 x .

75) and the factor will lend P567,000 (P900,000 x .70 x .90).

Problem 10

a. The annual percentage cost of each companys credit terms is calculated

as follows:

Cost

Discount

1.00 Discount

360 days

Credit period Discount period

The cost of each supplier must be weighted by the proportion of the total

provided by the supplier.

Supplier

Fort Co.

Jester Co.

Jam Co.

Smitt & Co.

Total

Annual

Percentage Cost

(1)

.367

.242

.172

20-10

Weight

(2)

.30

.25

.35

.10

1.00

Weighted

Average Cost

(1) x (2)

.110

.061

.017

.188

Chapter 20

b. No, the average effective annual interest rate does not indicate whether

they should borrow funds to take advantage of the terms on a specific

account. The borrowing decision should be based on the effective annual

interest rate of each suppliers 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. For instance,

Fort Co. has an effective annual interest rate of 36.7% and should be paid

on day 10 only if the cost of borrowing is less than 36.7%.

c. 1. A line of credit is a loan agreement in which the borrower has, with

certain specified limitations, control over the amount borrowed (up

to some maximum) and when the funds are repaid.

2. Yes, 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.

20-11

Chapter 20

20-12

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