Solutions Manual

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 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

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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.

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 borrower’s property.

II. Multiple Choice Questions

1. A 16. B 31. D 46. D

2. B 17. A 32. A 47. A
3. D 18. C 33. A 48. B
4. B 19. D 34. A 49. B
5. D 20. D 35. C 50. C

6. C 21. D 36. D 51. A

7. A 22. C 37. C 52. C
8. D 23. D 38. D 53. C
9. B 24. C 39. B 54. A
10. D 25. D 40. C 55. C

11. A 26. D 41. D 56. D

12. A 27. A 42. D 57. D
13. B 28. B 43. C
14. C 29. B 44. C
15. B 30. D 45. D

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III. Problems

Problem 1

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

follows:

Interest expense = .10P10

x P200 million
million x 180 / 360 = P10 million
+ P125,000 1
The effective costP200 million
of credit  P125,000
can now  P10asmillion
be calculated follows:
180 / 360

RATE = x

RATE = 46%

Problem 2
Loanfor
a. Interest proceeds
two months = .14 x  x P500,000
(for P500,000 loan)
= P11,667
P11,667 12
= P500,000 
P388,333 (.2 x P500,000
2 + P11,667)
= P383,333

RATE = x

= .030043 x 6 = .18026, or 18.026%

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.

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b. The estimation of the cost of forgoing trade discounts is generally quite

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, Jan’s cost is
calculated as follows:

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

However, for the

Interest for August
two trade credit2the firm actually pays at the end of
the credit period
months (the 30th day), so that the cost of trade credit becomes
12
RATE = (.03 / .97) x (360 / 15) = 74.22%

c.
= .12 x x P500,000

= P10,000
P10,000 + P3,750 12
P500,000 2
Pledging fee = .005 x P750,000
= P3,750

RATE = x
.18 x P200,000 1
P200,000 1
= .0275 x 6 = .165, or 16.5%

Problem 3
.16 x P200,000 1
a. RATE = P200,000  .20 x P200,000
x 1

= .18, or 18% .14 x P200,000 1

P200,000  .14 x P200,000  .2 x P200,000 1
b. RATE = x

= .20, or 20%

c. RATE = x

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= .21212, or 21.212%

Alternative (a) offers the lower-cost service of financing, although it

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 % 360
a cash discount =
100%  Disc.% x
Final due date-
Discount period

= x = 2.04% x 8 = 16.32%

Effective rate of interest with a 20% compensating balance requirement:

= 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

P5,500 360
a. Effective rate of interest = P300,000 x 60

= 1.83% x 6 = 10.98%
2% 360
b. Cost of lost discount = x
98% (70  10)
= 2.04% x 6 = 12.24%

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

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P6,850 360
d. P300,000 P300,000P375,000 P300,000 60
P75,000
(1  C) (1= .20) =.80
P6,850
P300,000
= P375,000 amount needed to be borrowed
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.

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Trust Bank

Effective interest rate = P72,000 / (P100,000  P9,000) x 5

= P72,000 / P455,000 = 15.82%

Northeast Bank

Effective interest rate = P216,000 / (P100,000 x 13)

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

c. Yes. If compensating balances are maintained at both banks in the

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% Costs incurred by using commercial paper

b. 12.09% Net funds available from commercial paper
c. 18%

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 ¼) P 77,500

Placement fee (P4,000,000 x .00125) 5,000
=
First quarter cost P 82,500

Funds available for use:

Funds raised P4,000,000
Less: Compensating balance P400,000
Less: Interest and placement 82,500 482,500
Net funds available in first quarter P3,517,500

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Cost of commercial paper in the first quarter P 82,500

P3,517,500

= 2.345%

Cost of issuing commercial paper per quarter:

Interest (P4,000,000 x .0775 x ¼) = P 77,500

Funds available for use:

Funds raised P4,000,000
Less: Compensating balance P400,000
77,500 477,500

Net funds available per quarter P3,522,500

Cost of commercial paper per quarter P 77,500

P3,522,500

= 2.20%

Total annual effective cost of commercial paper

Effective cost = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.)
= .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.

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3. Have a large and frequently recurring short-term or seasonal

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 = P 2,250

Processing .02 x P180,000 / .75 = 4,800
Credit department = 2,500
Bad debt expense .0175 x .7 x P900,000 = 11,025
Expected monthly cost of bank financing 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 = P 2,700

Factor .025 x .7 x P900,000 = 15,750
Expected monthly cost of factoring P18,450

c. The following are possible advantages of factoring:

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.

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2. Factoring removes one of the most liquid of the firm’s 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 firm’s factoring their
accounts receivable.

e. Based upon the calculations in Parts a and b, the factoring arrangement

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 company’s credit terms is calculated

as follows:
Discount 360 days
Cost = 1.00 – Discount x Credit period – Discount period

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

Annual Weighted
Percentage Cost Weight Average Cost
Supplier (1) (2) (1) x (2)
Fort Co. .367 .30 .110
Jester Co. .242 .25 .061
Jam Co. - .35 -
Smitt & Co. .172 .10 .017
Total 1.00 .188

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Average effective annual interest rate is 18.8 percent.

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 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. 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.

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