A B C D E F G H I

1 Ch 23 Mini Case 3/16/2001

2 Ch 23 Mini Case 3/23/2001
3 Chapter 23. Mini Case for Short-Term Financing
4
5 Bats and Balls (B&B) Inc., a baseball equipment manufacturer, is a small company with seasonal sales. Each year before the
6 baseball season, B&B purchases inventory which is financed through a combination of trade credit and short-term bank
7 loans. At the end of the season, B&B uses sales revenues to repay its short-term obligations. The company is always looking
8 for ways to become more profitable, and senior management has asked one of its employees, Ann Taylor, to review the
company's current asset financing policies. Putting together her report, Ann is trying to answer each of the following
9
questions:
10
11
12 a. B&B tries to match the maturity of its assets and liabilities. Describe how B&B could adopt either a more aggressive or
13 more conservative financing policy.
14
15 Aggressive: Uses short-term (temporary) capital to finance some permanent assets.
16 Conservative: Uses long-term (permanent) capital to finance some temporary assets.
17
18 b. What are the advantages and disadvantages of using short-term credit as a source of financing?
19
20 Short-term debt is riskier than long-term debt for the borrower.
21 Short-term rates may rise.
22 May have trouble rolling debt over.
23 Advantages of short-term debt.
24 Typically lower cost.
25 Can get funds relatively quickly with low transactions costs.
26 Can repay without penalty.
27
28 c. Is it likely that B&B could make significantly greater use of accruals?
29
30 Accruals are free in the sense that no explicit interest is charged. However, firms have little control over accrual levels,
31 which are influenced more by industry custom, economic factors, and tax laws than by managerial actions.
32
33 d. Assume that B&B buys on terms of 1/10, net 30, but that it can get away with paying on the 40th day if it chooses not to
34 take discounts. Also, assume that it purchases $3 million of components per year, net of discounts. How much free trade
35 credit can the company get, how much costly trade credit can it get, and what is the percentage cost of the costly credit?
36 Should B&B take discounts?
37
38 Company buys goods worth $3,000,000. That’s the cash price.
39 They must pay $30,303 more over the year if they forego the discount.
40 Think of the extra $30,303 as a financing cost similar to the interest on a loan.
41
42 Net daily purchases = $3,000,000/360
43 Net daily purchases = $8,333
44
45 Payables level if discount is taken:
46 Payables = $8,333 x 10
47 Payables = $83,333
48
49 Payables level if don’t take discount:
50 Payables = $8,333 x 40
51 Payables = $333,333
52
53 Credit Breakdown
54 Total trade credit = $333,333

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 A B C D E F G H I
55 Free trade credit = $83,333
56 Costly trade credit = $250,000
57
58 Nominal cost of costly trade credit:
59
60 Firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $250,000 in extra trade credit, so
61
62 k(nom) = $30,303 / $250,000
63 k(nom) = 12.12%
64
65 But the $30,303 in lost discounts is paid all during the year, not just at year-end, so the EAR is higher.
66
67 Discount % 360
k(nom) = X
68 1 - Discount % Days taken - Discount period
69
70 1 360
k(nom) = X
71 99 30
72
73 k(nom) = 12.12%
74
75 Effective Annual Rate
76
77 Periodic rate = 0.01 / 0.99
78 Periodic rate = 1.01%
79
80 Periods per year = 360 / ( 40 - 10 )
81 Periods per year = 12
82
83 EAR = (1 + Periodic rate)n - 1.0
84 EAR = 12.82%
85
86
87 e. What is commercial paper? Would it be feasible for B&B to finance with commercial paper?
88
89 Commercial paper (CP) are short term notes issued by large, strong companies. B&B could not issue CP; the company is too
90 small. CP trades in the market at rates just above the T-bill rate. CP is bought by banks and other companies, then held as
91 marketable securities for liquidity purposes.
92
93 f. Suppose B&B decided to raise an additional $100,000 as a 1-year loan from its bank, for which it was quoted a rate of 8
94 percent. What is the effective annual cost rate assuming (1) simple interest, (2) discount interest, (3) discount interest with a
95 10 percent compensating balance, and (4) add-on interest on a 12-month installment loan? For the first three of these
96 assumptions, would it matter if the loan were for 90 days, but renewable, rather than for a year?
97
98 ( 1 ) Simple interest
99
100 Interest = 0.08 X $100,000
101 Interest = $8,000
102
103 On a simple interest loan of one year, k(nom) = EAR
104 k(nom) = EAR = $8,000/$100,000
105 k(nom) = 8%
106
107 f interest were paid quarterly: 12 Note: Change shaded cell to see affect of paying interest quarterly or daily
108 instead of monthly (the shaded cell equals the number of interest payments)

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109 EAR = (1+Periodic rate)# of compoundings - 1
110 EAR = 8.30%
111
112 ( 2 ) Discounted interest
113
114 Interest deductible = .08 x $100,000
115 Interest deductible = $8,000
116
117 Usable funds = $100,000 - $8,000
118 Usable funds = $92,000
119
120 Solve for EAR using Excel's RATE function
121 EAR = 8.696%
122
123 Quarterly Loan
124 Periods = 1 Note: Change the periods to see the affect of shorter duration loans on EAR
125 Interest = $8,000
126 Cash received = $92,000
127 EAR = 8.696%
128
129
130 ( 3 ) Discounted interest with a 10% compensating balance
131
132 Amount needed
Face Amount of Loan =
133 1 - Nominal rate (decimal) - CB
134
135 $100,000
Face Amount of Loan =
136 1 - 0.08 - 0.1
137
138 Face Amount of Loan = $121,951
139
140 Loan Structure:
141 Loan $121,951
142 Prepaid Interest $9,756
143 Compensating Balance $12,195
144 Usable Funds $100,000
145 N= 1
146 Solve for EAR using Excel's RATE function PV = $100,000
147 EAR = 9.756% FV = $109,756
148 PMT = 0
149
150 Quarterly Loan
151 Periods = 1 Note: Change the periods to see the affect of shorter duration loans on EAR
152 Loan = $121,951
153 Interest = $9,756
154 CB = $12,195
155 Cash received = $100,000
156 Rate(Quarter) = 9.756%
157 EAR = 9.756%
158
159 ( 4 ) Add-on interest on a 12-month installment loan
160
161 Interest = $8,000
162 Face amount of loan = $108,000

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163 Monthly Payment = $9,000
164 Average loan outstanding = $50,000
165 Approximate cost = 16%
166
167 To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This
168 constitutes an ordinary annuity: (Use Excel's RATE function)
169
170 Payments 12
171 Rate per month 1.204%
172 APR = 14.45%
173 EAR = 15.45%
174
175
176 g. How large would the loan actually be in each of the cases in Part f?
177
178 ( 1 ) Simple interest
179
180 Loan = $100,000
181
182 ( 2 ) Discounted interest
183
184 Amount needed
Actual Loan Amount =
185 1 - Nominal rate (decimal)
186
187 $100,000
Actual Loan Amount = = $108,696
188 0.92
189
190 ( 3 ) Discounted interest with a 10% compensating balance
191
192 Amount needed
Actual Amount of Loan =
193 1 - Nominal rate (decimal) - CB
194
195 $100,000
Actual Amount of Loan =
196 1 - 0.08 - 0.1
197
198
Actual Amount of Loan = $121,951
199
200
201 ( 4 ) Add-on interest on a 12-month installment loan
202
203
204 Needed Funds = $100,000
205 Interest = 0.08 x $100,000
206 Interest = $8,000
207 Face amount of loan = $108,000
208
209 h. What are the pros and cons of borrowing on a secured versus an unsecured basis?
210
211 In a secured loan, the borrower pledges assets as collateral for the loan.
212 For short-term loans, the most commonly pledged assets are receivables and inventories.
213 Securities are great collateral, but generally firms needing short-term loans generally do not have securities.
214

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