Solutions Manual

CHAPTER 14

SHORT-TERM SOURCES
FOR FINANCING CURRENT ASSETS

Answer to 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.
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

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 warehousing whereby the same procedures are conducted on the borrower’s
property.
7. A secured loan is backed by the collateral that a borrower puts up. This
collateral could be accounts receivable, inventories, or other major tangible
assets like property. An unsecured loan has no backing and relies on the credit
standing and the reliability of the borrower. An example of an unsecured loan is
a bank line of credit.

8. Firms establish a relationship with banks because they wish to have a ready
source of cash to take care of their temporary needs for cash and working
capital. They could borrow at lower cost by issuing commercial paper or short-
term notes, but it is always helpful to have a line of credit with a bank without
having to do the paperwork and arrange a pubic or private offering. Also, banks
provide many services that are important to a firm.

9. Commercial paper is issued by large corporations with high credit ratings. It is

paper having a maturity date less than 270 days, and the cost of borrowing by
this method is lower than borrowing at a bank. The firm sells this paper at a
discount from face value and it usually costs ½% to 1% more than the rate paid
on a 3-month Treasury bill.

10. Accounts payable are a form of trade credit. This is an indirect way of financing
the purchase of goods and services for a specified period of time. If a firm paid
cash, it would have to draw on internal or external sources of funds to finance
these purchases. We can consider this credit a loan that must be paid after a
short period of time. Suppliers provide trade credit to attract customers, and they
give discounts of 1% to 3% of the value of the goods bought if the customer
pays up before the designated payment date.

Answer to Problems

Problem 1

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

Interest expense = .10 x P200 million x 180 / 360 = P10 million

The effective cost of credit can now be calculated as follows:

RATE = P10 million + P125,000 1

P200 million  P125,000  P10 million = 180 / 360

RATE = 46%

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Problem 2

a. Interest for two months = .14 x  x P500,000

= P11,667
Loan proceeds
(for P500,000 loan)
= P500,000  (.2 x P500,000 + P11,667)
P11,667 12
= P383,333
P388,333 2

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.

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 August trade credit the firm actually pays at the end of the
credit period (the 30th day), so that the cost of trade credit becomes
RATE = (.03 / .97) x (360 /215) = 74.22%
Interest for two 12
c. months
= .12 x x P500,000

= P10,000

Pledging fee = .005 x P750,000

P10,000 + P3,750 12
= P3,750
P500,000 2

RATE = x

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

Problem 3
.18 x P200,000 1
a. RATE = P200,000 x 1

= .18, or 18%

b. RATE = .16 x P200,000 x 1

P200,000 .20 x P200,000 1
= .20, or 20%
.14 x P200,000 1
c. RATE = x
P200,000 .14 x P200,000 .2 x P200,000 1

= .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
Cost of not taking a Discount % 360
cash discount =
100% Disc.% x due date-
Final
Discount period

= 2% x 360 = 2.04% x 8 = 16.32%

98% (55 10)

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%

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 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.

d. P300,000 P300,000 P300,000

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

Problem 6 2 x 4 x P9,000
(P100,000  P20,000  P9,000) x (4 + 1)
a. Trust Bank

Effective interest rate

= P72,000 / P355,000 2=x 20.28%

12 x P9,000
(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.

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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.

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%
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 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.
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.

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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.
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.

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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 = x
1.00 – Discount 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

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.

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 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.

Answer to 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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