CHAPTER 16

LG 3

P169

LG 3

P1610

Current Liabilities Management

667

Cost of bank loan Data Back-Up Systems has obtained a $10,000, 90-day bank
loan at an annual interest rate of 15%, payable at maturity. (Note: Assume a
365-day year.)
a. How much interest (in dollars) will the firm pay on the 90-day loan?
b. Find the 90-day rate on the loan.
c. Annualize your result in part b to find the effective annual rate for this loan,
assuming that it is rolled over every 90 days throughout the year under the same
terms and circumstances.

668

PART 7

Short-Term Financial Decisions

LG 3

P1614

IntegrativeComparison of loan terms Cumberland Furniture wishes to establish

a prearranged borrowing agreement with a local commercial bank. The banks terms
for a line of credit are 3.30% over the prime rate, and each year the borrowing must
be reduced to zero for a 30-day period. For an equivalent revolving credit agreement, the rate is 2.80% over prime with a commitment fee of 0.50% on the average
unused balance. With both loans, the required compensating balance is equal to
20% of the amount borrowed. (Note: Cumberland currently maintains $0 on deposit
at the bank.) The prime rate is currently 8%. Both agreements have $4 million borrowing limits. The firm expects on average to borrow $2 million during the year no
matter which loan agreement it decides to use.
a. What is the effective annual rate under the line of credit?
b. What is the effective annual rate under the revolving credit agreement? (Hint:
Compute the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of.)
c. If the firm does expect to borrow an average of half the amount available, which
arrangement would you recommend for the borrower? Explain why.

LG 4

P1615

Cost of commercial paper Commercial paper is usually sold at a discount. Fan

Corporation has just sold an issue of 90-day commercial paper with a face value of
$1 million. The firm has received initial proceeds of $978,000. (Note: Assume a
365-day year.)
a. What effective annual rate will the firm pay for financing with commercial paper,
assuming that it is rolled over every 90 days throughout the year?
b. If a brokerage fee of $9,612 was paid from the initial proceeds to an investment
banker for selling the issue, what effective annual rate will the firm pay, assuming
that the paper is rolled over every 90 days throughout the year?

LG 5

P1616

Accounts receivable as collateral Kansas City Castings (KCC) is attempting to

obtain the maximum loan possible using accounts receivable as collateral. The firm
extends net-30-day credit. The amounts that are owed KCC by its 12 credit customers, the average age of each account, and the customers average payment period
are as shown in the following table:

Personal Finance Problem

Unsecured sources of short-term loans John Savage has obtained a short-term loan
from First Carolina Bank. The loan matures in 180 days and is in the amount of
$45,000. John needs the money to cover start-up costs in a new business. He hopes
to have sufficient backing from other investors by the end of the next 6 months.
First Carolina Bank offers John two financing options for the $45,000 loan: a fixedrate loan at 2.5% above prime rate, or a variable-rate loan at 1.5% above prime.
Currently, the prime rate of interest is 6.5%, and the consensus forecasts of a
group of mortgage economists for changes in the prime rate over the next 180 days
are as follows: Sixty days from today the prime rate will rise by 0.5%; 90 days from
today the prime rate will rise another 1%; 180 days from today the prime rate will
drop by 0.5%.
Using the forecast prime rate changes, answer the following questions.
a. Calculate the total interest cost over 180 days for a fixed-rate loan.
b. Calculate the total interest cost over 180 days for a variable-rate loan.
c. Which is the lower-interest-cost loan for the next 180 days?

LG 3

P1611

Effective annual rate A financial institution made a $10,000, 1-year discount loan
at 10% interest, requiring a compensating balance equal to 20% of the face value of
the loan. Determine the effective annual rate associated with this loan. (Note:
Assume that the firm currently maintains $0 on deposit in the financial institution.)

LG 3

P1612

Compensating balances and effective annual rates Lincoln Industries has a line of
credit at Bank Two that requires it to pay 11% interest on its borrowing and to
maintain a compensating balance equal to 15% of the amount borrowed. The firm
has borrowed $800,000 during the year under the agreement. Calculate the effective
annual rate on the firms borrowing in each of the following circumstances:
a. The firm normally maintains no deposit balances at Bank Two.
b. The firm normally maintains $70,000 in deposit balances at Bank Two.
c. The firm normally maintains $150,000 in deposit balances at Bank Two.
d. Compare, contrast, and discuss your findings in parts a, b, and c.

LG 3

P1613

Compensating balance versus discount loan Weathers Catering Supply, Inc., needs
to borrow $150,000 for 6 months. State Bank has offered to lend the funds at a 9%
annual rate subject to a 10% compensating balance. (Note: Weathers currently
maintains $0 on deposit in State Bank.) Frost Finance Co. has offered to lend the
funds at a 9% annual rate with discount-loan terms. The principal of both loans
would be payable at maturity as a single sum.
a. Calculate the effective annual rate of interest on each loan.
b. What could Weathers do that would reduce the effective annual rate on the State
Bank loan?

Customer

Account
receivable

Average age
of account

Average payment
period of customer

$37,000

40 days

30 days

42,000

25

50

C
D

15,000
8,000

40
30

60
35

50,000

31

40

F
G

12,000
24,000

28
30

30
70

46,000

29

40

3,000

30

65

J
K

22,000
62,000

25
35

35
40

80,000

60

70

CHAPTER 16

Current Liabilities Management

669

670

a. If the bank will accept all accounts that can be collected in 45 days or less as
long as the customer has a history of paying within 45 days, which accounts will
be acceptable? What is the total dollar amount of accounts receivable collateral?
(Note: Accounts receivable that have an average age greater than the customers
average payment period are also excluded.)
b. In addition to the conditions in part a, the bank recognizes that 5% of credit
sales will be lost to returns and allowances. Also, the bank will lend only 80% of
the acceptable collateral (after adjusting for returns and allowances). What level
of funds would be made available through this lending source?
LG 5

P1617

PART 7

LG 5

Short-Term Financial Decisions

P1619

Accounts receivable as collateral Springer Products wishes to borrow $80,000

from a local bank using its accounts receivable to secure the loan. The banks policy
is to accept as collateral any accounts that are normally paid within 30 days of the
end of the credit period, as long as the average age of the account is not greater than
the customers average payment period. Springers accounts receivable, their average
ages, and the average payment period for each customer are shown in the following
table. The company extends terms of net 30 days.

Customer

Account
receivable

Average age
of account

Average payment
period of customer

A
B

$20,000
6,000

10 days
40

40 days
35

C
D

22,000
11,000

62
68

50
65

2,000

14

30

12,000

38

50

G
H

27,000
19,000

55
20

60
35

LG 1

LG 6

P1620

a. Calculate the dollar amount of acceptable accounts receivable collateral held by

Springer Products.
b. The bank reduces collateral by 10% for returns and allowances. What is the level
of acceptable collateral under this condition?
c. The bank will advance 75% against the firms acceptable collateral (after
adjusting for returns and allowances). What amount can Springer borrow against
these accounts?
LG 3

LG 5

P1618

Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed

the accounts receivable of Scientific Software, Inc. The bank has chosen eight
accounts totaling $134,000 that it will accept as collateral. The banks terms include
a lending rate set at prime + 3% and a 2% commission charge. The prime rate currently is 8.5%.
a. The bank will adjust the accounts by 10% for returns and allowances. It then
will lend up to 85% of the adjusted acceptable collateral. What is the maximum
amount that the bank will lend to Scientific Software?
b. What is Scientific Softwares effective annual rate of interest if it borrows
$100,000 for 12 months? For 6 months? For 3 months? (Note: Assume a 365day year and a prime rate that remains at 8.5% during the life of the loan.)

Factoring Blair Finance factors the accounts of the Holder Company. All eight factored accounts are shown in the following table, with the amount factored, the date
due, and the status on May 30. Indicate the amounts that Blair should have remitted
to Holder as of May 30 and the dates of those remittances. Assume that the factors
commission of 2% is deducted as part of determining the amount of the remittance.
Account

Amount

Date due

Status on May 30

$200,000

May 30

Collected May 15

B
C

90,000
110,000

May 30
May 30

Uncollected
Uncollected

85,000

June 15

Collected May 30

120,000

May 30

Collected May 27

180,000

June 15

Collected May 30

90,000

May 15

Uncollected

30,000

June 30

Collected May 30

Inventory financing Raymond Manufacturing faces a liquidity crisisit needs a

loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firms accounts receivable are quite low, but its inventory is considered liquid and reasonably good
collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Note: Assume a 365-day year.)
(1) City-Wide Bank will make a $100,000 trust receipt loan against the finished
goods inventory. The annual interest rate on the loan is 12% on the outstanding
loan balance plus a 0.25% administration fee levied against the $100,000 initial
loan amount. Because it will be liquidated as inventory is sold, the average
amount owed over the month is expected to be $75,000.
(2) Sun State Bank will lend $100,000 against a floating lien on the book value of
inventory for the 1-month period at an annual interest rate of 13%.
(3) Citizens Bank and Trust will lend $100,000 against a warehouse receipt on the
finished goods inventory and charge 15% annual interest on the outstanding
loan balance. A 0.5% warehousing fee will be levied against the average amount
borrowed. Because the loan will be liquidated as inventory is sold, the average
loan balance is expected to be $60,000.
a. Calculate the dollar cost of each of the proposed plans for obtaining an initial loan
amount of $100,000.
b. Which plan do you recommend? Why?
c. If the firm had made a purchase of $100,000 for which it had been given terms of
2/10 net 30, would it increase the firms profitability to give up the discount and
not borrow as recommended in part b? Why or why not?

LG 2

P1621

ETHICS PROBLEM Rancco Inc. reported total sales of $73 million last year,
including $13 million in revenue (labor, sales to tax-exempt entities) exempt from
sales tax. The company collects sales tax at a rate of 5%. In reviewing its information as part of its loan application, you notice that Ranccos sales tax payments
show a total of $2 million in payments over the same time period. What are your
conclusions regarding the financial statements that you are reviewing? How might
you verify any discrepancies?