M16_GITM4380_13E_IM_C16.pdf

Chapter 16 Current Liabilities Management 

Instructor’s Resources

Overview This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability, and risk in managing the firm’s current liability accounts. The management of current liabilities requires choosing appropriate levels of financing and involves tradeoffs between risk and profitability. This chapter also reviews sources of secured and unsecured short-term financing, including the role of international loans. Spontaneous sources, such as accounts payable and accruals, are differentiated from negotiated bank sources, such as lines of credit. The cash discount offered on accounts payable and the cost of forgoing the discount are described. Secured sources include bank and commercial finance company loans backed by collateral such as inventory or accounts receivable. Whether borrowing funds as a manager or for their own personal use, effective management of current liabilities is essential, making Chapter 16 relevant at the professional and personal levels.

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Suggested Answer to Opener in Review Question

In the chapter opener you learned that Memorial Sloan-Kettering Cancer Center had created significant cash flows by using electronic invoicing and taking advantage of discounts on accounts payable. Do these gains in working capital efficiency affect Sloan-Kettering’s operating risk, and if so how? Operating efficiency may well be improved through effective use of an online billing system. Use of electronic invoicing reduces the chance of nonpayment, which reduces Sloan-Kettering’s operating risk. When it comes to accounts payable, a firm has to compare its cost savings with the chance that it will not be able to take advantage of future cash flows. Most studies of the cost of forgoing the trade credit show that it is higher than the cost of borrowing from the bank. Firms without sufficient funds to pay within the discount period are going to the bank at a time when their financial position has been weakened, resulting in higher interest rates or possibly the absence of access to short-term funds. Compounding Sloan-Kettering’s operating risk is the chance that it will have to borrow money when the economy has slowed down and other firms are also seeking short-term funds. As is described in the chapter, new issues of commercial paper virtually dried up in October 2008, resulting in issuers of those securities also seeking assistance from the bank at the same time.

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Answers to Review Questions

1. The two key sources of spontaneous short-term financing (financing that arises from the normal operating cycle) are accounts payable and accruals. Both of these sources are spontaneous, since their levels increase and decrease directly with increases or decreases in sales. If sales increase, the firm will purchase more materials and increase employment, resulting in higher values for these items.

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2. There is no cost⎯stated or unstated⎯associated with taking a cash discount; there is a cost of giving up a cash discount. By giving up a cash discount, the purchaser pays the full price for merchandise but can make the payment later. The unstated cost of giving up a cash discount is the implied rate of interest paid to delay payments. This rate can be used to make decisions with respect to whether or not the discount should be taken. If the cost of giving up the cash discount is greater than the cost of borrowing short-term funds, the firm should take the discount. Cash discounts can be a source of additional profitability for a firm. However, some firms, either due to lack of alternative funding sources or ignorance of the true cost, do not take advantage of these discounts. 3. Stretching accounts payable is the process of delaying the payment of accounts payable for as long as possible without damaging the firm’s credit rating. Stretching payments reduces the implicit cost of giving up a cash discount. 4. The prime rate of interest, which is the lowest rate charged on business loans to the best business borrowers, is usually used by the lender as a base rate to which a premium is added by the lender, depending upon the risk of the borrower, in order to determine the rate charged. A floating-rate loan has its interest tied to the prime rate. The rate of interest is established at an increment above the prime rate and floats at that increment above prime over the term of the note. 5. The effective interest rate is the actual rate of interest paid for the period. The calculation of this rate depends on whether interest is paid at maturity or in advance (deducted from the loan so that the borrower receives less than the requested amount). When interest is paid at maturity, the effective interest rate is equal to: Interest Amount borrowed

The effective interest rate when interest is paid in advance—a discount loan—is calculated as follows: Interest Amount borrowed − Interest

Paying interest in advance raises the effective rate above the stated rate, much like annuity due values exceed ordinary annuity values. 6. A single-payment note is an unsecured loan from a commercial bank. It usually has a short maturity⎯30 to 90 days⎯and the interest rate is normally tied in some way to the prime rate of interest. The interest rate on these notes may be fixed or floating. The effective annual interest rate when the note is rolled over throughout the year on the same terms is calculated on a compound basis as follows, using Equation 4.24 in the text. m

r  reff =  1 +  − 1 m  

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7. A line of credit is an agreement between a commercial bank and a business that states the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time. a. In a line of credit agreement, a bank may retain the right to revoke the line if any major changes occur in the firm’s financial condition or operations. b. To ensure that the borrower will be a good customer, frequently a line of credit will require the borrower to maintain compensating balances in a demand deposit. In some cases, fees in lieu of balances may be negotiated. c. To ensure that money lent under the credit agreement is actually being used to finance seasonal needs, banks require that the borrower have a zero loan balance for a certain number of days per year. This is called the annual cleanup period. 8. A revolving credit agreement is a guaranteed line of credit. Under a line of credit agreement, a firm is not guaranteed that the bank will have funds available to lend upon demand, while under the more formal revolving credit agreement the availability of funds is guaranteed. Since the lender under the revolving credit agreement guarantees the availability of funds, the borrower must pay a commitment fee, a fee levied against the average unused portion of the line. 9. Commercial paper (CP), which is a short-term, unsecured promissory note, can be sold by large, creditworthy firms in order to raise funds. Commercial paper is merely the IOU of a financially sound firm. The maturity of commercial paper is generally from 3 to 270 days and is normally issued in multiples of $100,000 or more. The interest rate on commercial paper is usually 1% to 2% below the prime rate and is a less costly source of short-term funds than bank loans. Commercial paper is purchased by corporations, life insurance companies, pension funds, banks, and other financial institutions and investors. Commercial paper may be sold directly by the issuing firm to a purchaser or may be sold through a middleman known as a commercial paper house, which charges a fee to the issuer for its marketing efforts. 10. International transactions differ from domestic ones because they involve payments made or received in a foreign currency. This results in additional foreign costs and also exposes the company to foreign exchange risk. A letter of credit is a letter written by a company’s bank to a foreign supplier that effectively guarantees payment of an invoiced amount, assuming that all the specified terms are met. Netting occurs when a company’s subsidiaries or divisions located in different countries have transactions that result in intracompany receivables and payables. Rather than pay the gross amount of both the receivables and payables, paying the net amount due⎯which is lower⎯allows the parent to reduce foreign exchange fees and other transaction costs. 11. Lenders view secured and unsecured short-term loans as having the same degree of risk. The benefit of the collateral for a secured loan is only beneficial if the firm goes into bankruptcy. The risk associated with going bankrupt and defaulting on a loan does not change due to being secured or unsecured. However, the risk of loss is less on a secured loan. 12. The interest rate charged on secured short-term loans is typically higher than the interest rate on unsecured short-term loans. Typically, companies that require secured loans may not qualify for unsecured debt, and they are perceived as higher-risk borrowers by lenders. The presence of collateral does not change the risk of default; it provides a means to reduce losses if the borrower defaults. In general, lenders require security for less creditworthy, higher-risk borrowers. Since the negotiation and administration of these loans is more troublesome for the lender, the lender normally requires certain fees to be paid by the secured borrower. The higher rates on these secured short-term loans are attributable to the greater risk of default and the increased loan administration costs of these loans over the unsecured short-term loan. © 2012 Pearson Education, Inc. Publishing as Prentice Hall

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13. a. A pledge of accounts receivable is the use of a firm’s receivables to secure a short-term loan. The lender evaluates the quality of the accounts receivable, selects acceptable accounts, and files a lien on the collateral. After the selection of accounts, the lender determines the percentage advanced against receivables. Typically ranging from 50% to 90% of the face value of the acceptable receivables, this amount becomes the principal on the loan. Pledging receivables usually costs 2% to 5% above the prime rate due to the nature of the borrower and additional administrative costs. Commercial banks offer this type of financing. b. Factoring accounts receivable is the outright sale to the factor or other financial institution. The factor sets the conditions of the sale in a factoring agreement. Normally factoring is done on a nonrecourse basis (the factor accepts all credit risks), and the customer is usually notified that the account receivable has been sold. Factoring can typically cost from 3% to 7% above the prime rate, including commissions and interest. This type of financing is handled by specialized financial institutions called factors; some commercial banks and commercial finance companies factor receivables. While the cost is high, the advantages include immediate conversion of receivables into cash and also the known pattern of cash flows. 14. a.

Floating inventory liens are made by lenders and secured by a claim on general inventory consisting of a diversified and low-cost group of merchandise. Generally less than 50% of the book value of the average inventory is advanced. The interest charge on a floating lien is typically 3% to 5% above the prime rate. b. Trust receipt inventory loans are often made by manufacturers’ financing subsidiaries to their customers. Under this arrangement, merchandise is typically expensive (automotive, industrial and consumer-durable equipment, for example) and remains in the hands of the borrower. The lender advances 80% to 100% of the cost of the salable inventory. The borrower is free to sell the merchandise and is trusted to remit the loan amount plus accrued interest to the lender immediately. The interest charge is generally 2% or more above the prime rate. c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged collateral. The inventory may be retained by the borrower in the firm’s warehouse with security administered by a field warehousing company, or it may be stored in a terminal warehouse located in the geographic vicinity of the borrower. Generally, less than 75% to 90% of the collateral’s value is advanced to the borrower at an interest rate from 4% to 8% above the prime rate.

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Suggested Answer to Focus on Practice Box: The Ebb and Flow of Commercial Paper

What factors would contribute to an expansion of the commercial paper market? What factors would cause a contraction in the commercial paper market? Commercial paper is issued based on the full faith and credit of the company issuing the paper. That is why only the larger corporations are able to issue commercial paper. In a business downturn, the credit rating of even the largest corporations may slip, leading to a decrease in the amount of commercial paper issued. As the chapter reports, in October 2008, as the financial crisis grew worse, the commercial paper market dried up and the U.S. Federal Reserve created a means to fund short-term needs directly from it. Also, a decrease in sales can lead to a decrease in the amount of short-term money needed, hence a decrease in commercial paper. Finally, when interest rates are low, corporations can access the funds they need from banks, which pushes down the volume of commercial paper. All of these factors work in reverse to create an increase in commercial paper volume. Improving business cycles, increases in business sales, and rising interest rates all can contribute to the increased issuance of commercial paper.

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Suggested Answer to Focus on Ethics Box: Accruals Management

Why might financial managers still be tempted to manage earnings when a clawback is legitimate possibility? If financial managers are unlikely to get caught and punished, the expected (positive) payoff from their actions might tempt them to manage earnings. Financial managers also might engage in earnings management if the superior performance it allows them to report leads to positive career outcomes (e.g., promotions, advancement). In such a case, the possibility of a clawback might be viewed as a small price to pay when the manager leverages their actions into a higher paying, more prestigious position.

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Answers to Warm-Up Exercises

E16-1. Cash discount and the simplified formula Answer: Payment required if taking the cash discount = $25,000 × 0.97 = $24,250 Cost of giving up the cash discount = 3% × (365 ÷ 15) = 73% E16-2. Managing accruals Answer: Savings = 25 × 60 × $12.50 × 0.10 = $1,875 E16-3. Effective annual interest rate Answer: Discount loan Effective annual interest = ($15,000 × 0.08) ÷ [$15,000 − ($15,000 × 0.08)] = $1,200 ÷ $13,800 = 8.70% Interest paid at maturity Effective annual interest = ($15,000 × 0.09) ÷ $15,000 = 9.0% Jasmine Scents should take the discount loan since it has the better interest rate. Note, however, that if the firm actually needs the use of $15,000, it will need to borrow more than $15,000 under the discount loan option. Specifically, the company will need to borrow $15,000 ÷ (1.00 − 0.08) = $16,304.35 since only 92% of the loan ($15,000) will be received and available for use. E16-4. Effective annual interest rate Answer: Effective annual interest rate = ($125,000 × 0.10) ÷ ($125,000 − $10,000) = 10.87% E16-5. Commercial paper interest rate Answer: Interest = $300,000 − $298,000 = $2,000 Effective 120-day rate = $2,000 ÷ $298,000 = 0.67%

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Solutions to Problems

P16-1. Payment dates LG 1; Basic a. December 25 b. December 30 c. January 9 d. January 29 P16-2. Cost of giving up cash discount LG 1; Basic a. (0.02 ÷ 0.98) × (365 ÷ 20) b. (0.01 ÷ 0.99) × (365 ÷ 20) c. (0.02 ÷ 0.98) × (365 ÷ 35) d. (0.03 ÷ 0.97) × (365 ÷ 35) e. (0.01 ÷ 0.99) × (365 ÷ 50) f. (0.03 ÷ 0.97) × (365 ÷ 20) g. (0.04 ÷ 0.96) × (365 ÷ 170)

= 37.24% = 18.43% = 21.28% = 32.25% = 7.37% = 56.44% = 8.95%

P16-3. Credit terms LG 1; Basic a. 1/15 net 45 date of invoice 2/10 net 30 EOM 2/7 net 28 date of invoice 1/10 net 60 EOM b. 45 days 49 days 28 days 79 days c.

CD 365 × 100% − CD N 1% 365 × Cost of giving up cash discount = 100% − 1% 30 Cost of giving up cash discount = 0.0101 × 12.17 = 0.1229 = 12.29%

Cost of giving up cash discount =

2% 365 × 98% (49 − 10) Cost of giving up cash discount = 0.0204 × 9.359 = 0.1909 = 19.09% Cost of giving up cash discount =

2% 365 × 100% − 2% 21 Cost of giving up cash discount = 0.0204 × 17.38 = 0.3646 = 36.46% Cost of giving up cash discount =

Cost of giving up cash discount =

2% 365 × 100% − 2% 21

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Cost of giving up discount = 20.204 × 17.38 = 0.3546 = 35.46% 1% 365 × 100% − 1% (79 − 10) Cost of giving up cash discount = 0.0101 × 5.2899 = 0.0534 = 5.34% Cost of giving up cash discount =

d. For the first three purchases the firm would be better off to borrow the funds and take the discount. The annual cost of not taking the discount is less than the firm’s 8% cost of capital in the last case. P16-4. Cash discount versus loan LG 1; Basic Cost of giving up cash discount = (0.03 ÷ 0.97) × (365 ÷ 35) = 32.25% Since the cost of giving up the discount is higher than the cost of borrowing for a short-term loan, Erica is correct; her boss is incorrect. P16-5. Personal finance: Borrow or pay cash for an asset LG 2; Intermediate a.

b.

c.

d.

e.

f.

Calculate the down payment on the loan Loan principal Down payment required Cash down payment on loan Calculate the monthly payment on the loan Present value (amount borrowed) Length of loan (months) Monthly interest rate (annual rate ÷ 12) Solve for PMT (monthly payment)

$

3,000 10% $ 300.00

$2,700.00 24 0.333% $ 117.24

Cash price of dining room set Cash rebate Cash purchase after rebate Less: Cash down payment on loan Net initial cash outlay under cash purchase option − This is the marginal amount of money needed Earnings on savings Years Net initial cash outlay Opportunity cost under the cash purchase option 2 ($2,500 x (1.052 −1) Opportunity cost Net initial cash outlay Cost of cash option

$ $ $

$ $ $

267 2,500 2,767

Cost of the financing alternative (24 × $117.25) Cost of the cash option

$ $

2,814 2,767

$

3,000 200 2,800 (300) 2,500

5.20% 2 $ 2,500 $ 267

Because it is less expensive, Bob and Carol should pay cash for the furniture. The lower cost of the cash alternative is largely the result of the $300 cash rebate.

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P16-6. Cash discount decisions LG 1, 2; Intermediate a.

c.

Supplier

b.

Cost of Forgoing Discount

Decision

J K

(0.01 ÷ 0.99) × (365 ÷ 20) = 18.43% (0.02 ÷ 0.98) × (365 ÷ 60) = 12.42%

Borrow Give up

L

(0.01 ÷ 0.99) × (365 ÷ 40) = 9.22%

Give up

M

(0.03 ÷ 0.97) × (365 ÷ 45) = 25.09%

Borrow

Prairie would have lower financing costs by giving up Ks and Ls discount since the cost of forgoing the discount is lower than the 16% cost of borrowing. Cost of giving up discount from Supplier M = (0.03 ÷ 0.97) × (365 ÷ 75) = 15.05% In this case the firm should give up the discount and pay at the end of the extended period.

P16-7. Changing payment cycle LG 2; Basic Annual savings = ($10,000,000) × (0.13) = $1,300,000 P16-8. Spontaneous sources of funds, accruals LG 2; Intermediate Annual savings = $750,000 × 0.11 = $82,500 P16-9. Cost of bank loan LG 3; Intermediate a. Interest = ($10,000 × 0.15) × (90 ÷ 365) = $369.86 b. 90-day rate = $369.85 ÷ $10,000 = 3.70% c. Effective annual rate = (1 + 0.037)4.06 − 1 = 15.89% P16-10. Personal finance: Unsecured sources of short-term loans LG 3; Challenge a. Fixed-rate loan Interest expense = loan amount × (prime rate + percent over prime) × (loan period ÷ 365) $45,000 (0.065 + 0.025) (180 ÷ 365) = $1,997.26 b. Variable-rate loan Time period Prime rate Percent over prime Applicable rate Beginning amount owed Interest expense Amount owed at end of period

First 60 days 6.5% 1.5% 8.0% $45,000 $ 591.78 $45,591.78

Days 61 to 90 7.0% 1.5% 8.5% $45,591.78 $318.52 $45,910.30

Days 91 to 180 8.0% 1.5% 9.5% $45,910.30 $1,075.43 $46,985.73

The variable rate loan, which has an interest expense of $1,985.73, is less costly.

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P16-11. Effective annual rate of interest LG 3; Basic Effective interest =

$10,000 × 0.10 = 14.29% [$10,000 × (1 − 0.10 − 0.20)]

P16-12. Compensating balances and effective annual rates LG 3; Intermediate a. Compensating balance requirement = $800,000 borrowed × 15% = $120,000 Amount of loan available for use = $800,000 − $120,000 = $680,000 Interest paid

Effective interest rate b. Additional balances required

Effective interest rate c.

Effective interest rate

= $800,000 × 11 % = $88,000 $88,000 = = 12.94% $680,000 = $120,000 − $70,000 = $50,000 $88,000 = = 11.73% $800,000 − $50,000 = 11%

(None of the $800,000 borrowed is required to satisfy the compensating balance requirement.) d. The lowest effective interest rate occurs in situation (c), when Lincoln has $150,000 on deposit. In situations (a) and (b), the need to use a portion of the loan proceeds for compensating balances raises the borrowing cost. P16-13. Compensating balance versus discount loan LG 3; Intermediate $150,000 × 0.09 $13,500 = = 10.0% This calculation $150,000 − ($150,000 × 0.10) $135,000 assumes that Weathers does not maintain any normal account balances at State Bank. $150,000 × 0.09 × 6 /12 $6,750 Frost finance interest = = = 4.71% $150,000 − ($150,000 × 0.09 × 6 /12) $143,250 2 Effective annual rate = (1.0471) –1 = 0.0964 = 9.64% b. If Weathers became a regular customer of State Bank and kept its normal deposits at the bank, then the additional deposit required for the compensating balance would be reduced and the cost would be lowered.

a.

State Bank interest =

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P16-14. Integrative—comparison of loan terms LG 3; Challenge a. (0.08 + 0.033) ÷ 0.80 = 14.125% [$2,000,000 × (0.08 + 0.028) + (0.005 × $2,000,000)] b. Effective annual interest rate = = 14.125% ($2,000,000 × 0.80) c. The revolving credit account seems better, since the cost of the two arrangements is the same; with a revolving loan arrangement, the loan is committed. P16-15. Cost of commercial paper LG 4; Intermediate a.

Effective 90-day rate =

$1,000,000 − $978,000 = 2.25% $978,000

Effective annual rate = (1 + 0.0225)365/90 − 1 = 9.44% b. Effective 90-day rate with transaction costs: [$1,000,000 − $978,000 − $9612] ÷[ $978,000 + $9612] = $12,388 ÷ 987,612 = 1.25% Effective annual rate = (1 + 0.0125)

365/90

− 1 = 5.17%

P16-16. Accounts receivable as collateral LG 5; Intermediate a. Acceptable accounts receivable Customer

Amount

D E F H J K Total collateral

$ 8,000 50,000 12,000 46,000 22,000 62,000 $200,000

b. Adjustments: 5% returns/allowances, 80% advance percentage. Level of available funds = [$200,000 × (1 − 0.05)] × 0.80 = $152,000

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P16-17. Accounts receivable as collateral LG 5; Intermediate a. Customer A E F G H Total Collateral

Amount $20,000 2,000 12,000 27,000 19,000 $80,000

b. $80,000 × (1 − 0.1) = $72,000 c. $72,000 × (0.75) = $54,000 P16-18. Accounts receivable as collateral, cost of borrowing LG 3, 5; Challenge a. [$134,000 − ($134,000 × 0.10)] × 0.85 = $102,510 b. ($100,000 × 0.02) + ($100,000 × 0.115) = $2,000 + $11,500 = $13,500 $13,500 Interest cost = = 13.5% for 12 months $100,000 0.115   ($100,000 × 0.02) +  $100,000 ×  = $2,000 + $5,750 = $7,750 2   $7,750 Interest cost = = 7.75% for 6 months $100,000

Effective annual rate = (1 + 0.0775)2 − 1 = 16.1% 0.115   ($100,000 × 0.02) +  $100,000 ×  = $2,000 + $2,875 = $4,875 4   Interest cost =

$4,875 = 4.88% for 3 months $100,000

Effective annual rate = (1 + 0.0488)4 − 1 = 21.0%

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P16-19. Factoring LG 5; Intermediate Holder Company Factored Accounts May 30 Accounts

Amount

Date Due

Status on May 30

Amount Remitted

Date of Remittance

A B C D E F G H

$200,000 90,000 110,000 85,000 120,000 180,000 90,000 30,000

5/30 5/30 5/30 6/15 5/30 6/15 5/15 6/30

C 5/15 U U C 5/30 C 5/27 C 5/30 U C 5/30

$196,000 88,200 107,800 83,300 117,600 176,400 88,200 29,400

5/15 5/30 5/30 5/30 5/27 5/30 5/15 5/30

The factor purchases all acceptable accounts receivable on a nonrecourse basis, so remittance is made on uncollected as well as collected accounts. P16-20. Inventory financing LG 1, 6; Challenge a.

City-Wide Bank: [$75,000 × (0.12 ÷ 12)] +(0.0025 × $100,000) = $1,000 Sun State Bank: $100,000 × (0.13 ÷ 12) = $1,083 Citizens’ Bank and Trust: [$60,000 × (0.15 ÷ 12)] + (0.005 × $60,000) = $1,050

b. City-Wide Bank is the best alternative, since it has the lowest cost. c.

Cost of giving up cash discount = (0.02 ÷ 0.98) × (365 ÷ 20) = 37.24% The effective cost of taking a loan = ($1,000 ÷ $75,000) × 12 = 16.00% Since the cost of giving up the discount (37.24%) is higher than borrowing at Citywide Bank (16%), the firm should borrow to take the discount.

P16-21. Ethics problem LG 2; Intermediate The sales tax can be calculated based on the sales data, as follows: Sales tax = [($73,000,000 − $13,000,000) ÷ 1.05] × 0.05 = $2,857,143 An alternative method is to determine the taxable sales based on the sales tax reported. Taxable sales = $2,000,000 ÷ 0.05 = $40,000,000 These calculations show a discrepancy in the financial statement provided by Rancco. The company has possibly underreported the amount of taxable income to the state and failed to pay the appropriate amount of sales tax. The other alternative is that Rancco has deliberately inflated the amount of revenues for the year in an attempt to improve the chances of getting the loan. You will want to have the company verify its calculation of sales tax due. Notice that to be able to make a valid comparison of sales taxes paid and revenues reported you must also determine the correct amount of nontaxable revenue, which is usually not directly available from the company’s financial statements. © 2012 Pearson Education, Inc. Publishing as Prentice Hall

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Case

Case studies are available on www.myfinancelab.com.

Selecting Kanton Company’s Financing Strategy and Unsecured Short-Term Borrowing Arrangement This case asks the student to evaluate the permanent and short-term funding requirements of Kanton Company, and to choose a financing strategy from among three alternatives: aggressive, conservative, and trade off. The company’s funding requirements vary considerably during the year, showing a seasonal pattern and peaking mid-year. Then the student must calculate the effective annual interest rates for two short-term borrowing alternatives and make a recommendation. a.

Strategy I—Aggressive 1. Amount required: $2,500,000 short term and $1,000,000 long term 2. Cost: (10% × $2,500,000) + (14% × $1,000,000) = $390,000 Strategy 2—Conservative 1. Amount required: $7,000,000 long term and $0 short term 2. Cost: (14% × $7,000,000) = $980,000 Strategy 3—Tradeoff 1. Calculation of short-term requirements

Month January February March April May June July August September October November December

(1) Total Funds Requirements $1,000,000 1,000,000 2,000,000 3,000,000 5,000,000 7,000,000 6,000,000 5,000,000 5,000,000 4,000,000 2,000,000 1,000,000

(2) Permanent Requirements $3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000

Seasonal Requirements $0 0 0 0 2,000,000 4,000,000 3,000,000 2,000,000 2,000,000 1,000,000 0 0

Monthly average: Permanent = $3,000,000 Seasonal = $1,166,667 (sum of seasonal requirements ÷ 12) Seasonal = $1,166,667 (14,000,000 ÷ 12) 2. Cost: (10% × $1,166,667) + (14% × $3,000,000) = $536,667 b.

Net working capital = current assets − current liabilities Aggressive = $4,000,000 − $2,500,000 = $1,500,000 Conservative = $4,000,000 − $0 = $4,000,000 Tradeoff = $4,000,000 − $1,166,667 = $2,833,333 © 2012 Pearson Education, Inc. Publishing as Prentice Hall

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The three strategies differ in terms of profitability and risk. The aggressive strategy is the most profitable⎯it has the lowest cost, $390,000⎯because it uses the largest amount of the less-expensive short-term financing. It also pays interest only on needed financing. The aggressive strategy is also the most risky, relying heavily on short-term financing, which may have more limited availability. Net working capital is lowest, also increasing risk. Because the conservative strategy funds the highest amount in any month for the whole year with more-expensive long-term financing, it is the most expensive ($980,000) and the least profitable. It is the lowest-risk strategy, however, reserving short-term financing for emergencies. The high level of working capital also reduces risk. The tradeoff strategy falls between the two extremes in terms of both profitability and risk. The cost ($536,667) is higher than the aggressive strategy because the permanent funds requirement of $3,000,000 is financed with more costly long-term funds. In five months (January, February, March, November, and December), the company pays interest on unneeded funds. The risk is less than with the aggressive strategy; some short-term borrowing capacity is preserved for emergencies. Because a portion of short-term requirements is financed with long-term funds, the firm’s ability to obtain shortterm financing is good. Mr. Mercado should consider implementing the tradeoff strategy. The wide swings in monthly funds requirements make the cost of the conservative strategy very high in comparison to the reduced risk. For the same reason, the aggressive strategy is quite risky, requiring the firm to raise short-term funds ranging from $1,000,000 to $6,000,000. If it should become difficult to arrange short-term financing, Kanton Company would be in trouble. Note: Other recommendations are possible, depending on the student’s risk preference. Of course, the student should present sound reasons for his or her choice of strategy.

d.

1. Effective interest, line of credit: Interest on borrowing: $600,000 × (7% + 2.5%) = $57,000 Interest $57,000 Effective interest = = = 11.88% Amount available for use $600,000 × 0.80 2. Effective interest, revolving credit agreement: Cost of borrowing: Interest: $600,000 × (7% + 3.0%) $60,000 Commitment Fee: $400,000 × 0.5% 2,000 Total $62,000 Interest and commitment fee Effective interest = Amount available for use $62,000 = = 12.92% $600,000 × 0.80

e.

The line of credit arrangement seems better, since its annual cost of 11.88% is less than the 12.92% cost of the revolving loan arrangement. Kanton will save about 1% in terms of annual interest cost (11.88% versus 12.92%) by using the line of credit. The only negative is that if Third National lacks loanable funds, Kanton may not be able to borrow the needed funds. Under the revolving credit agreement, funds availability would be guaranteed.

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Spreadsheet Exercise

The answer to Chapter 16’s comparison of borrowing from First American or First Citizen spreadsheet problem is located on the Instructor’s Resource Center at www.pearsonhighered.com/irc under the Instructor’s Manual.

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Group Exercise

Group exercises are available on www.myfinancelab.com. Continuing the short-term focus of the previous chapter, the groups are asked to now look at the management of its current liabilities. Students should make the connection between these short-term liabilities and sources of short-term financing. Different accounts are developed that should allow the fictitious firm to maximize and maintain profitability. The first task is the purchase of a typical type of merchandise. Scenarios for the purchase of this merchandise are designed. The wage structure of the firm is then described, as is the accruals the firm encounters. The needs of short-term financing are then discussed, as are the terms for its procurement. A secondary sourcing alternative is then chosen from the list in the text. Providing students with web sites of factoring companies (i.e., http://www.1stcommercialcredit.com, http://www.facteon.com) helps the last portion of this exercise go smoothly.

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Integrative Case 7: Casa de Diseño

Integrative Case 7, Casa de Diseño, involves evaluating working capital management of a furniture manufacturer. Operating cycle, cash conversion cycle, and negotiated financing needed are determined and compared with industry practices. The student then analyzes the impact of changing the firm’s credit terms to evaluate its management of accounts receivable before making a recommendation. a.

Operating cycle (OC)

= average age of inventory + average collection period = 110 days + 75 days = 185 days

Cash conversion cycle (CCC) = OC − average payment period = 185 days − 30 days = 155 days Resources needed

=

Total annual outlays × CCC 365 days

$26,500,000 × 155 365 = $11,253,425

=

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Chapter 16

b.

c.

Industry OC

= 83 days + 75 days = 158 days

Industry CCC

= 158 days − 39 days = 119 days

Industry resources needed

=

$26,500,000 × 119 365 = $8,639,726

Casa de Diseño Negotiated financing $11,253,425 Less: Industry resources needed 8,639,726 $2,613,699 Cost of inefficiency:

d.

Current Liabilities Management

$2,613,699 × 0.15 = $392,055

1. Offering 3/10 net 60: Reduction in collection period = 75 days × (1 − 0.4) = 45 days OC

= 83 days + 45 days = 128 days

CCC

= 128 days − 39 days = 89 days

Resources needed

=

Additional savings

= $8,639,726 − $6,461,644 = $2,178,082 = $2,178,082 × 0.15 = $326,712

2. Reduction in sales:

$40,000,000 × 0.45 × 0.03 = $540,000

$26,500,000 × 89 days 365 = $6,461,644

3. Average investment in accounts receivable assuming cash discount: New average collection period ($40,000,000 × 0.80) ÷ (365 ÷ 45)

= 45 days = $3,945,205

Average investment in accounts receivable assuming no cash discount: (40,000,000 × 0.80) ÷ (365 ÷ 75) = $6,575,342 Reduction in investment in accounts receivable: $6,575,342 − $3,945,205

= $2,630,137

Annual savings: $2,630,137 × 0.15

= $ 394,521

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4. Reduction in bad debt expense: $40,000,000 × (0.02 − 0.015) 5. Cost of offering cash discount Annual savings from reduction in investment in accounts receivable Annual savings from reduction in bad debt expense Savings due to cash discount

= $ 200,000 ($ 540,000) 394,521

$

200,000 54,521

e.

Ms. Leal should bring working capital measures in line with the industry and offer the proposed cash discount.

f.

The other sources of financing available include both unsecured and secured sources. Unsecured Sources: • Short-term self-liquidating bank loans—usually used to help with seasonal needs where the loan is repaid as receivables are collected. • Single-payment bank notes—normally a short-term (30 days to 9 months) loan to be repaid on the end of the loan period. • Line of credit—a loan much like a credit card in that the borrower can draw down the money as needed and make various payments. The loan must often be paid in full at some point within each year. • Revolving credit agreement—a guaranteed amount of funds available to the borrower. The borrower usually pays a commitment fee to the bank to compensate them for having the funds available “on demand.” • Commercial paper—a 3-day to 270-day loan sold as a security to the lender. Secured Sources: • Pledging accounts receivable—a lender loans money on the basis of the creditworthiness of the borrower’s customers who bought on account. The lender advances the money to the borrower in an amount discounted from the book value of the receivables. When the borrower collects the receivables payments, the money is remitted to the lender. • Factoring accounts receivable—selling the firm’s accounts receivable to a lender at a discount to the book value of the receivables. The factor normally receives the payment directly from the customer when they make payment. • Floating inventory liens—when inventory is used as collateral for a loan. • Trust receipt inventory loans—a loan against relatively expensive and easily identifiable assets, such as automobiles. The loan is repaid when the asset is sold. • Warehouse receipt loans—when assets in a warehouse are pledged against a loan. The lender takes control of the inventory items that are normally stored in a public warehouse.

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