Chapter 20 - Answer

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. 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

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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 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 =

x

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 =

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 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

=

x

.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

.18, or 18% .14 x P200,000 P200,000  .14 x P200,000  .2 x P200,000 x

1 1

.20, or 20%

=

x 20-4

Short-term Sources for Financing Current Assets

=

Chapter 20

.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 % = a cash discount 100%  Disc.%

=

x

360 x Final due dateDiscount period

= 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 a. Effective rate of interest =

P5,500 P300,000

x

360 60

= 1.83% x 6 = 10.98% b. Cost of lost discount

=

2% 98%

x

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

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d.

Short-term Sources for Financing Current Assets

P300,000 (1  C)

P6,850 P300,000P375,000 P300,000 P75,000 =.80 (1= .20) P6,850 P300,000

360 60

= 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% b. 12.09% c. 18%

Costs incurred by using commercial paper 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) Placement fee (P4,000,000 x .00125)

P

5,000

=

First quarter cost

P

Funds available for use: 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

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Cost of commercial paper in the first quarter

P 82,500 P3,517,500 =

Cost of issuing commercial paper per quarter: Interest (P4,000,000 x .0775 x ¼) Funds available for use: Funds raised Less: Compensating balance

=

2.345%

P

77,500

P4,000,000 P400,000 77,500

Net funds available per quarter

477,500 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. 20-8

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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 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

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. 20-9

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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: Cost

=

Discount 1.00 – Discount

x

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

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Weight (2) .30 .25 .35 .10 1.00

Weighted Average Cost (1) x (2) .110 .061 .017 .188

Short-term Sources for Financing Current Assets

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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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