MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 17 SHORT- TERM CREDIT FOR FINANCING CURRENT ASSETS

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. he prime rate is the rate that a bank charges its most creditworth! customers. he average customer can e"pect to pa! one or two percent #or more$ above prime. he stated interest rate is the percentage rate unad%usted for time or method of repa!ment. he effective interest rate is the true rate and considers all these variables. & ' percent stated rate for (0 da!s provides a 20 percent effective rate. he financial manager should recogni)e the effective rate as the true cost of borrowing. he effective rate is also referred to as the &*+ #&nnual *ercentage +ate$.

3.

,. -ommercial paper can be either purchased or issued b! a corporation. o the e"tent one corporation purchases another corporation.s commercial paper as a short/term investment, it is a current asset. -onversel!, if a corporation issues its own commercial paper, it is a current liabilit!. '. *ledging accounts receivable means receivables are used as collateral for a loan0 factoring account receivables means the! are sold outright to a finance compan!. 6. hree t!pes of lender control used in inventor! financing are a. 1lanket inventor! lien/general claim against inventor! or collateral. 2o specific items are marked or designated. b. rust receipt/borrower holds the inventor! in trust for the lender. 3ach item is marked and has a serial number. 4hen the inventor! is sold, the trust receipt is canceled and the funds go into the lender.s account. 17-1

Cha t!" 17

Short-term Credit for Financing Current Assets

c. 4arehousing the inventor! is ph!sicall! identified, segregated, and stored under the direction of an independent warehouse compan! that controls the movement of the goods. If done on the premises of the warehousing firm, it is termed public warehousing. &n alternate arrangement is field warehousing whereb! the same procedures are conducted on the borrower.s propert!. II. Multiple Choice 1. 2. 3. ,. '. 6. 6. 8. (. 10. 11. 12. 13. 1,. 1'. & 1 5 1 5 & 5 1 5 & & 1 1 16. 16. 18. 1(. 20. 21. 22. 23. 2,. 2'. 26. 26. 28. 2(. 30. 5 & 1 1 5 1 & 5 5 5 5 5 31. 32. 33. 3,. 3'. 36. 36. 38. 3(. ,0. ,1. ,2. ,3. ,,. ,'. 5 & & & 5 5 1 5 5 5 ,6. 5 ,6. &

Supporting computations: ,. *1,080,000 7 360 8 *3,000 in purchases per da!. !picall!, there will be *3,000 #,0$ 8 *120,000 of accounts pa!able on the books at an! given time. 9f this, *3,000 #10$ is :free; credit, while *3,000 #30$ 8 *(0,000 is :non/free; credit.

'. &ppro". cost 8 8

5iscount < 100 / 5iscount < 2< 100< / 2< "

360 " 5a!s credit is 5iscount outstanding period 2 (8 " 360 30

360 ,0 / 10 8

17-2

Short-term Credit for Financing Current Assets

Cha t!" 17

82,.'< 6. 8 *10,000 1 0.1' 0.10 3ffective rate on the discount loan 8 8 Interest 8 0.1111 8 11.11< ?ace value Interest

-redit terms are 2710, net ,0, but dela!ing pa!ments 30 additional da!s is #*2,,00,000$ #0.10$ the e=uivalent of 2710, net 60. &ssuming no penalt!, the appro"imate cost *2,,00,000 #*2,,00,000$ #0.10$ is as follows> &ppro". cost 8 8 *2,0,000 5iscount < 360 *2,160,000 " 5a!s credit is 5iscount 100 / 5iscount < outstanding period 2< 360 2 360 " 8 " 100< / 2< 60 / 10 (8 60

812.2,< herefore, the loan cost is 1.13 percentage points less than trade credit. 6. 8 8 11.1< *1,000 7 *',000 8 20.0< 8 13.3< *1,000 *(,000 8

8. &ppro"imate effective rate 8 (. 8 3ffective rate 10.

*10,000 #0.10$ *10,000 *10,000 #0.10$ 8 *13,333, 17-3

Cha t!" 17

Short-term Credit for Financing Current Assets

since 0.1' #*13,333$ 8 *2,000 is re=uired for the compensating balance, and 0.10 #*13,333$ 8 *1,333 is10< re=uired for the immediate interest pa!ment. 3ffective rate 1 0.1' 0.10 21. he effective rate is e=ual to net interest e"pense divided b! proceeds received not proceeds borrowed. *10 million @ *12',000 8 *200 million *12',000 *10 million 2,. 8 26. Interest *roceeds 8 120,000 #0.06 " 100,000$ 8 1,000,000 100,000 8 .0('( 8.66< 1 180 7 360 8 12.66<

#*1,000,000 (80,000 @ 1,200$ " , 1,000,000 20,000 1,200 III. Problems Interest .06 PRO#LEM 1 $CAMATCHILE SALES *roceeds A1.00 #.(3$ COMPANY% .20B .06 .63 he discounted interest cost of the commercial paper issue is calculated as follows> Interest e"pense 8 .10 " *200 million " 180 7 360 8 *10 million

he effective cost of credit can now be calculated as follows> +& 3 8 "

17-4

Short-term Credit for Financing Current Assets

Cha t!" 17

,6<

PRO#LEM & $'AN MFG( CO(% a. Interest for two months 8 8 8 8 .1, " " *'00,000 *11,666 *'00,000 #.2 " *'00,000 @ *11,666$ *383,333

+& 3 8 " 2 Interest for two 12 months 8 .0300,3 " 6 8 .18026, or 18.026< 2ote that Can would actuall! have to borrow more than the needed *'00,000 in order to cover the compensating balance re=uirement. Dowever, as we demonstrated earlier, the effective cost of credit will not be affected b! ad%usting the loan amount for interest e"pense changes accordingl!. b. proceeds heEoan estimation of the cost of forgoing trade discounts is generall! =uite #for *'00,000 loan$ straightforward0 however, in this case the firm actuall! stretches its trade credit for purchases made during Cul! *11,666 12 be!ond the due date b! an additional 30 da!s. If it is able to do this *388,333 2 without penalt!, then the firm effectivel! forgoes a 3 percent discount for not pa!ing within 1' da!s and does not pa! for an additional ,' da!s #60 da!s less the discount period of 1' da!s$. hus, for the Cul! trade credit, Can.s cost is calculated as follows> +& 3 8 #.03 7 .(6$ " #360 7 ,'$ 8 2,.6,<

Dowever, for the &ugust trade credit the firm actuall! pa!s at the end of the credit period #the 30th da!$, so that the cost of trade credit becomes +& 3 8 c. 8 .12 " 17-5 " *'00,000 #.03 7 .(6$ " #360 7 1'$ 8 6,.22<

Cha t!" 17

Short-term Credit for Financing Current Assets

8 *ledging fee

*10,000 1 1

8 .00' " *200,000 *6'0,000 .1, " 8 *3,6'0 *200,000 .1, " *200,000 .2 " *200,000 "

+& 3 8

8 .026' " 6 8 .16', or 16.'< PRO#LEM ) $'ELO MFG( COMPANY% a. +& 3 8 8 .18, or 18< b. +& 3 8 *10,000 @ *3,6'0 *'00,000 " 360 ?inal due date/ 5iscount period 12 2"

8 .20, or 20< c. +& 3 8 .18 " *200,000 8 .21212, or 21.212< *200,000 1 1 "

&lternative #a$ offers the lower/cost service of financing, although it carries the highest stated rate of interest. he reason for this, of course, its that there is no compensating balance re=uirement nor is interest discounted for this alternative. .16 " *200,000 1 1 *200,000 .20 " *200,000 PRO#LEM * $+I,I CORPORATION% 17-6

Short-term Credit for Financing Current Assets

Cha t!" 17

2< (8<

360 " 10$ #60

"

2.0,< " 8 8 16.32<

*300,000 *300,000 *300,000 3ffective rate of interest with a 20< compensating balance re=uirement> .80 #1 -$ #1 .20$ 8 Interest rate 7 #1 -$ 8 1,< 7 #1 .2$ 8 1,< 7 #.8$ 8 16.'< *6,8'0 360 60 up the *36',000 *6',000 he effective cost of the loan, 16.'<, is more than the cost of passing discount, 16.32<. Fiwi -orporation should continue to pa! in '' da!s and *6,8'0 pass up the discount. *300,000 INC(% PRO#LEM - $READY FLASHLIGHTS. 5iscount < -ost of not taking a a.cash 3ffective rate of interest 100< 8 5isc.< " discount 8 2< 360 (8< b. -ost of lost discount8 #'' 10$ 8 1.83< " 6 8 10.(8< "

2.0,< " 6 8 12.2,<

c. Ges, because the cost of borrowing is less than the cost of losing the discount. d. 8 8 8

*36',000 amount needed to be borrowed 8 8 8 *','00 *300,000 " 6 8 13.68< 17-7 " 360 60 2.28< " 6

e. 3ffective interest rate

Cha t!" 17

Short-term Credit for Financing Current Assets

2o, do not borrow with a compensating balance of 20 percent since the effective rate is greater than the savings from taking the cash discount. PRO#LEM / $SUMMIT RECORD COMPANY% a. Trust Bank 3ffective interest rate 8 8 *62,000 7 *3'',000 8 20.28<

Northeast Bank 3ffective interest rate 8 8 *216,000 7 *1,160,000 8 18.,6<

-hoose 2ortheast 1ank since it has the lowest effective interest rate. b. he numerators sta! the same as in part #a$ but the denominator increases to reflect the use of more mone! because compensating balances are alread! maintained at both banks. Trust Bank 2 " , " *(,000 #*100,000 *20,000 7 *(,000$ " #, 1$ 3ffective interest rate 8 *62,000 #*100,000 @ *(,000$ " ' 8 *62,000 7 *,'',000 8 1'.82< Northeast Bank 3ffective interest rate 8 8 *216,000 7 #*100,000 " 13$ *216,000 7 *1,300,000 8 16.62<

2 " 12 " *(,000 #*100,000 *10,000$ " #12 @ 1$ 17-8

Short-term Credit for Financing Current Assets

Cha t!" 17

c. Ges. If compensating balances are maintained at both banks in the normal course of business, then rust 1ank should be chosen over 2ortheast 1ank. he effective cost of its loan will be less. PRO#LEM 7 $AT#P(. INC(% a. 11.63< b. 12.0(< c. 18<

PRO#LEM 0 $FAMILIA. INC(% a. -ost of commercial paper 8

-ost of commercial paper in the first =uarter -ost of issuing commercial paper> Interest #*,,000,000 " .066' " H$ *lacement fee #*,,000,000 " .0012'$ ?irst =uarter cost ?unds available for use> ?unds raised Eess> -ompensating balance Eess> Interest and placement 2et funds available in first =uarter 8 * * 66,'00 ',000 82,'00

*,,000,000 *,00,000 82,'00 ,82,'00 *3,'16,'00 * 82,'00 *3,'16,'00 8 2.3,'< 66,'00

-ost of commercial paper in the first =uarter

-osts incurred b! using commercial paper 2et funds available from commercial paper -ost of issuing commercial paper per =uarter>

Interest #*,,000,000 " .066' " H$ ?unds available for use> ?unds raised 17-9

*,,000,000

Cha t!" 17

Short-term Credit for Financing Current Assets

Eess> -ompensating balance 2et funds available per =uarter -ost of commercial paper per =uarter

*,00,000 66,'00

,66,'00 *3,'22,'00 * 66,'00 *3,'22,'00

8 otal annual effective cost of commercial paper 3ffective cost 8 8 8 8 8

2.20<

1st =uarter cost @ 3#cost of 2nd, 3rd, ,th =trs.$ .023,' @ 3#.02200$ .023,' @ .06600 .08(,' 8.('<

?amilia Inc. should choose commercial paper because the cost of bank financing #10., percent$ e"ceeds the cost of commercial paper #8.(' percent$ b! greater than 1 percent. b. he characteristics ?amilia Inc. should possess in order to deal regularl! in the commercial paper market include> 1. Dave a prestigious reputation, be financiall! strong, and have a high credit rating. 2. Dave fle"ibilit! to arrange for large amounts of funds through regular banking channels. 3. Dave a large and fre=uentl! recurring short/term or seasonal needs for funds. ,. Dave the abilit! 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 maturit!. PRO#LEM 1 $CANADA COMPANY% a. 8

he e"pected monthl! cost of bank financing is the sum of the interest cost, processing cost, bad debt e"pense, and credit department cost. he calculations are as follows> Interest .1' 7 12 " *180,000 17-10 8 * 2,2'0

Short-term Credit for Financing Current Assets

Cha t!" 17

*rocessing .02 " *180,000 7 .6' -redit department 1ad debt e"pense .016' " .6 " *(00,000 3"pected monthl! cost of bank financing b.

8 8 8

,,800 2,'00 11,02' *20,'6'

he e"pected monthl! cost of factoring is the sum of the interest cost and the factor cost. he calculations are as follows> Interest .01' " *180,000 ?actor .02' " .6 " *(00,000 3"pected monthl! cost of factoring 8 * 2,600 8 1',6'0 *18,,'0

c.

he following are possible advantages of factoring> 1. Ising a factor eliminates the need to carr! a credit department. 2. ?actoring is a fle"ible source of financing because as sales increase, the amount of readil! available financing increases. 3. ?actors speciali)e in evaluating and diversif!ing credit risks.

d.

he following are possible disadvantages of factoring> 1. he administrative costs ma! be e"cessive when invoices are numerous and relativel! small in peso amount. 2. ?actoring removes one of the most li=uid of the firm.s assets and weakens the position of creditors. It ma! mar their credit rating and increase the cost of other borrowing arrangements. 3. -ustomers could react unfavorabl! to a firm.s factoring their accounts receivable.

e. 1ased upon the calculations in *arts a and b, the factoring arrangement should be continued. he disadvantages of factoring are relativel! unimportant in this case, especiall! since -anada -ompan! has been using the factor in the past. 1efore arriving at a final decision, the other services offered b! 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 *arts a and b. he additional borrowing capacit! needed b! -anada -ompan! is irrelevant because the firm onl! needs *180,000 and the bank will loan *,62,'00 #*(00,000 " .60 " . 6'$ and the factor will lend *'66,000 #*(00,000 " .60 " .(0$.

17-11

Cha t!" 17

Short-term Credit for Financing Current Assets

PRO#LEM 12 $#ILLY MADISON CORPORATION% a. he annual percentage cost of each compan!.s credit terms is calculated as follows> -ost 8 "

he cost of each supplier must be weighted b! the proportion of the total provided b! the supplier. Annual Percentage Cost (1) .366 .2,2 / .162 Weight ( ) .30 .2' .3' .10 1.00 Weighte! A"erage Cost (1) # ( ) .110 .061 / .016 .188

Supplier ?ort -o. Cester -o. Cam -o. Jmitt K -o. otal

&verage effective annual interest rate is 18.8 percent. b. 2o, the average effective annual interest rate does not indicate whether the! should borrow funds to take advantage of the terms on a specific account. he borrowing decision should be based on the effective annual interest rate of each supplier.s credit terms. Lone! should be borrowed to pa! within the discount period onl! when the cost of borrowing is less than the effective annual interest rate of the credit terms. ?or instance, ?ort -o. has an effective annual interest rate of 36.6< and should be paid on da! 10 onl! if the cost of borrowing is less than 36.6<. c. 1. & line of credit is a loan agreement in which the borrower has, with certain specified limitations, control over the amount borrowed #up to some ma"imum$ and when the funds are repaid. 360 da!s 5iscount 1.00 M 5iscount -redit period M 5iscount period 2. Ges, a line of credit would be appropriate for 1ill! Ladison if the compan! needs to borrow short/term mone! to take advantage of the cash discounts.

17-12