Chapter 08: Sources of Short-Term Financing

Chapter 8 Sources of Short-Term Financing

Discussion Questions
8-1. Under what circumstances would it be advisable to borrow money to take a cash discount? 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. 8-2. Discuss the relative use of credit between large and small firms. Which group is generally in the net creditor position, and why? Larger firms tend to be in a net creditor position because they have the financial resources to be suppliers to credit. The smaller firm must look to the larger manufacturer or wholesaler to help carry the firms financing requirements. 8-3. How have new banking laws influenced competition? New banking laws allowed more competition and gave banks the right to expand across state lines to create larger, more competitive markets. They also increased bank mergers. 8-4. What is the prime interest rate? How does the average bank customer fare in regard to the prime interest rate? 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. 8-5. What does LIBOR mean? Is LIBOR normally higher or lower than the U.S. prime interest rate? LIBOR stands for London Interbank Offered Rate. As indicated in Figure 8-1, it is consistently below the prime rate.

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8-6.

What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporate borrowers? The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are actually made available to the borrower. A $125,000 loan with a $25,000 compensating balance requirement means only $100,000 is being provided on a net basis. This benefit to the lender need not be a disadvantage to the borrower. The borrower may, in turn, receive a lower quoted interest rate and certain gratuitous services because of the compensating balance requirement.

8-7.

Commercial paper may show up on corporate balance sheets as either a current asset or a current liability. Explain this statement. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporations 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.

8-8.

What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage? In comparison to bank borrowing, commercial paper can generally be issued at below the prime rate. Furthermore, there are no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank. Finally, there is a certain degree of prestige associated with the issuance of commercial paper. The drawback is that commercial paper may be an uncertain source of funds. When money gets tight or confidence in the commercial paper market diminishes, funds may not be available. There is no loyalty factor such as that which exists between a bank and its best borrowers.

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8-9.

What is the difference between pledging accounts receivable and factoring accounts receivable? Pledging accounts receivable means receivables are used as collateral for a loan; factoring account receivables means they are sold outright to a finance company.

8-10.

What is an asset-backed public offering? A public offering is backed by an asset (accounts receivable) as collateral. Essentially a firm sells its receivables into the securities markets.

8-11.

Briefly discuss three types of lender control used in inventory financing. Three types of lender control used in inventory financing are: 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 lenders 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 borrowers property.

8-12.

What is meant by hedging in the financial futures market to offset interest rate risks? Hedging means to engage in a transaction that partially or fully reduces a prior risk exposure. In selling a financial futures contract, if interest rates go up, one is able to buy back the contract at a profit. This will help to offset the higher interest charges to a corporation or other business entity.

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Chapter 8

Problems
2. Cash discount decision (LO1) Regis Clothiers can borrow from its bank at 11 percent to take a cash discount. The terms of the cash discount are 2/15, net 60. Should the firm borrow the funds?

8-2.

Solution: Regis Clothiers First, compute the cost of not taking the cash discount and compare this figure to the cost of the loan.

Cost of not Discount% 360 taking a cash = 100% Disc.% final due date discount period discount 2% 360 98% 60 15

2.04% 8 16.32%
The cost of not taking the cash discount is greater than the cost of the loan (16.32% vs. 11%). The firm should borrow the money and take the cash discount.
3. Cash discount decision (LO1) Simmons Corp. can borrow from its bank at 12 percent to take a cash discount. The terms of the cash discount are 1.5/10, net 60. Should the firm borrow the funds?

8-3.

Solution:

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Chapter 08: Sources of Short-Term Financing

Simmons Corporation First, compute the cost of not taking the cash discount and compare this figure to the cost of the loan.

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Chapter 08: Sources of Short-Term Financing

Cost of not Discount% 360 taking a cash = 100% Disc.% final due date discount period discount 1.5% 360 98.5% 60 10

1.52% 7.2 10.94%

The cost of not taking the cash discount is less than the cost of the loan (10.94% vs. 12%). The firm should not borrow the money to take the cash discount.
4. Effective rate of interest (LO2) Your bank will lend you $2,000 for 45 days at a cost of $25 interest. What is your effective rate of interest?

8-4.

Solution:

Effective rate =

Interest Days in the year (360) Principal Days loan is outstanding $25 360 $2,000 45 1.25% 8 10%

5.

Effective rate of interest (LO2) A pawn shop will lend $100 for 10 days at a cost of $5 interest. What is the effective rate of interest?

8-5.

Solution:
Interest Days in the year (360) Principal Days loan is outstanding $5 360 $5 360 5.0% 36 180% $100 10 $100 10

Effective rate of interest =

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6.

Effective rate on discounted loan (LO2) Sol Pine is going to borrow $3,000 for one year at 8 percent interest. What is the effective rate of interest if the loan is discounted?

8-6.

Solution: Sol Pine Effective rate on a = Interest Days per year (360) discounted loan Princ. Int. Days loan is outstanding $240 360 $240 1 $3,000 $240 360 $2,760 8.70%

7.

Effective rate on discounted loan (LO2) Mary Ott is going to borrow $5,000 for 90 days and pay $140 interest. What is the effective rate of interest if the loan is discounted?

8-7.

Solution: Mary Ott Effective rate on a = Interest Days per year (360) discounted loan Princ. Int. Days loan is outstanding $140 360 $140 4 $5,000 $140 90 $4,860 2.88% 4 11.52%

8.

Prime vs. LIBOR (LO2) Dr. Ruth is going to borrow $5,000 to help write a book. The loan is for one year and the money can either be borrowed at the prime rate or the LIBOR rate. Assume the prime rate is 6 percent and LIBOR 1.5 percent less. Also assume there will be a $40 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR). Which loan has the lower effective interest cost?

8-8.

Solution:

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Chapter 08: Sources of Short-Term Financing

Dr. Ruth Prime Rate Loan (6%) LIBOR Rate Loan

Effective rate =

Interest Days per year (360) Principal Days loan is outstanding

Effective interest = (4.5% $5,000)+$40=$225+$40=$265 $265 360 5.3% 1 5.3% $5,000 360

LIBOR is cheaper than prime (5.3% vs. 6%).

9. Foreign borrowing (LO2) Gulliver Travel Agencies thinks interest rates in Europe are low. The firm borrows euros at 5 percent for one year. During this time period the dollar falls 10 percent against the euro. What is the effective interest rate on the loan for one year? (Consider the 10 percent fall in the value of the dollar as well as the interest payment.)

8-9.

Solution: Gulliver Travel Agencies 5% interest 10% decline in the dollar (increased cost in euros) 15% total effective cost

10.

Dollar cost of a loan (LO2) Talmud Book Company borrows $16,000 for 30 days at 9 percent interest. What is the dollar cost of the loan?

Dollar cost of loan = Amount borrowed Interest rate

Days loan is outstanding Days in the year 360

8-10. Solution:

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Talmud Book Company

Dollar cost of loan =

Amount borrowed Interest rate

Days loan is outstanding Days per year (360)

30 360 1 $16,000 9% 12 $16,000 .75% $120 $16,000 9%

11. Net credit position (LO1) McGriff Dog Food Company normally takes 20 days to pay for average daily credit purchases of $9,000. Its average daily sales are $10,000, and it collects accounts in 25 days. a. What is its net credit position? That is, compute its accounts receivable and accounts payable and subtract the latter from the former.
Accounts receivable = Average daily credit sales Average collection period Accounts payable = Average daily credit purchases Average payment period

b. If the firm extends its average payment period from 20 days to 32 days (and all else remains the same), what is the firm's new net credit position? Has it improved its cash flow?

8-11. Solution: McGriff Dog Food Company a. Net credit position = Accounts Receivable Accounts payable

average Accounts receivable = average daily credit sales collection period $250,000 $10,000 25days

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average Accounts payable = average daily credit purchases payment period $180,000 $9,000 20
Net Credit Position $250,000 $180,000 $70,000

b. Accounts Receivable will remain at $250,000 Accounts Payable = $9,000 32 = 288,000 Net Credit Position ($ 38,000) The firm has improved its cash flow position. Instead of extending $70,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $38,000 in credit.
12. Compensating balances (LO2) Logan Drilling Corp. plans to borrow $200,000 for one year. Northern National Bank will lend the money at 10 percent interest and require a compensating balance of 20 percent. What is the effective rate of interest?

8-12. Solution: Logan Drilling Company Effective rate of interest with 20% compensating balance =
Interest rate 10% 10% 12.5% 1 C 1 .2 .8

or

Interest Days of the Year (360) Principal Compensating balance Days loan is outstanding $20,000 360 $20,000 1 12.5% $200,000 $40,000 360 $160,000

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13.

Compensating balances (LO2) Computer Graphics Company needs $250,000 in funds for a project. a. b. With a compensating balance requirement of 20 percent, how much will the firm need to borrow? Given your answer to part a and a stated interest rate of 10 percent on the total amount borrowed, what is the effective rate on the $250,000 actually being used?

8-13. Solution: Computer Graphics Company a.

Amount to be borrowed =

Amount needed 1 C $250,000 $250,000 .80 1 .20

b.

$312,500 $312,500 total amount borrowed

10% Interest rate $ 31,250 Interest

$31,250 12.5% Effective rate $250,000

15. Compensating balances with idle cash balances (LO2) Randall Corporation plans to borrow $200,000 for one year at 12 percent from the Waco State Bank. There is a 20 percent compensating balance requirement. Randall Corporation keeps minimum transaction balances of $10,000 in the normal course of business. This idle cash counts toward meeting the compensating balance requirement. What is the effective rate of interest?

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8-15.

Solution: Randall Corporation Effective rate of interest =

Interest Days in the year (360) Principal Compensating balance Days loan is outstanding $24,000 360 $24,000 14.12% $200,000 $30,000 * 360 $170,000
* $40,000 $10,000 $30,000

Required Compensating Balance minimum balance on deposit additional funds needed at bank
16. Compensating balances with idle cash balances (LO2) The treasurer for the Macon Blue Sox baseball team is seeking a $20,000 loan for one year from the 4th National Bank of Macon. The stated interest rate is 10 percent, and there is a 15 percent compensating balance requirement. The treasurer always keeps a minimum of $1,500 in the baseball team's checking accounts. These funds count toward meeting any compensating balance requirements. What will be the effective rate of interest on this loan?

8-16. Solution: Macon Blue Sox Baseball Team Effective rate of interest =

Interest Days in the year (360) Principal Compensating balance Days loan is outstanding $2,000 360 $2,000 10.81% $20,000 $1,500 * 360 $18,500
* $3,000 $1,500 $1,500

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Required Compensating Balance minimum balance on deposit additional funds needed at bank
18. Effective rate under different terms (LO2) If you borrow $4,000 at $500 interest for one year, what is your effective interest rate for the following payment plans? a. Annual payment. b. Semiannual payments. c. Quarterly payments. d. Monthly payments.

8-18. Solution: a. $500/$4,000 = 12.5% Use formula 8-6 for b, c, and d. Rate on installment loan =

2 Annual no. of payments Interest Total no. of payments + 1 Principal

b. (2 2 $500)/(3 $4,000) = $2,000/$12,000 c. (2 4 $500)/(5 $4,000) = $4,000/$20,000 = 16.67% = 20.00%

d. (2 12 $500)/(13 $4,000) = $12,000/$52,000 = 23.08%

19. Effective rate under different terms (LO2) Zerox Copying Company plans to borrow $150,000. New Jersey National Bank will lend the money at one-half percentage point over the prime rate at the time of 8 1/2 percent (9 percent total) and requires a compensating balance of 20 percent. The principal in this case will be funds that the firm can effectively use in the business. This loan is for one year. What is the effective rate of interest? What would the effective rate be if Zerox were required to make four quarterly payments to retire the loan?

8-19. Solution:

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Zerox Copying Company Effective rates of interest with compensating balance First determine interest 8% (prime rate) + % = 9% 9% $150,000 $13,500 Then determine the rate

$13,500 $13,500 1 11.25% $150,000 30,000 $120,000

Effective rate of interest with compensating balance and 4 quarterly payments.

2 4 $13,500 $108,000 18% (4 1) $120,000 $600,000

20. Installment loan for multiyears (LO2) Lewis and Clark Camping Supplies Inc. is borrowing $45,000 from Western State Bank. The total interest is $12,000. The loan will be paid by making equal monthly payments for the next three years. What is the effective rate of interest on this installment loan?

8-20. Solution: Lewis and Clark Camping Supplies Rate on installment loan =
2 Annual no. of payments Interest Total no. of payments + 1 Principal 2 12 $12,000 $288,000 17.30% 36 1 $45,000 $1,665,000

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21.

Cash discount under special circumstance (LO2) Mr. Hugh Warner is a very cautious businessman. His supplier offers trade credit terms of 3/10, net 80. Mr. Warner never takes the discount offered, but he pays his suppliers in 70 days rather than the 80 days allowed so he is sure the payments are never late. What is Mr. Warner's cost of not taking the cash discount?

8-21. Solution: Hugh Warner

360 Cost of not taking = Discount % a cash discount 100% Disc.% Final duedate Discount period 3% 360 100% 3% (70 10)

3.09% 6 18.54%
In this problem, Mr. Warner has the use of funds for 60 extra days (70-10), instead of 70 extra days allowed by the credit terms (80-10). Mr. Warners suppliers are offering terms of 3/10, net 80. Mr. Warner is effectively accepting terms of 3/10, net 70. If he took the full 80 days to pay, his cost of not taking the discount would be 15.89%.
22. Bank loan to take cash discount (LO1 & 2) The Reynolds Corporation buys from its suppliers on terms of 2/10, net 55. Reynolds has not been utilizing the discounts offered and has been taking 55 days to pay its bills. Mr. Duke, Reynolds Corporation vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 14 percent. The bank requires a 20 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement. Do you agree with Duke's proposal?

8-22. Solution:

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Chapter 08: Sources of Short-Term Financing

Reynolds Corporation

360 Cost of not taking a cash = Discount % discount 100% Disc.% Final due date Discount period 2% 360 2.04% 8 16.32% 98% (55 10)
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%. Reynolds Corporation should continue to pay in 55 days and pass up the discount.
23. Bank loan to take cash discount (LO1 & 2) In Problem 22, if the compensating balance requirement were 10 percent instead of 20 percent, would you change your answer? Do the appropriate calculation.

8-23. Solution: Reynolds Corporation (Continued) Effective rate of interest with a 10% compensating balance requirement:

Interest rate 14% 14% 15.56% 1 C 1 .1 .9

The answer now changes. The effective cost of the loan, 15.56%, is less than the cost of passing up the discount, 16.32%. Reynolds Corporation should borrow the funds and take the discount.

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24.

Bank loan to take cash discount (LO1 & 2) Neveready Flashlights, Inc., needs $300,000 to take a cash discount of 2/10, net 70. A banker will loan the money for 60 days at an interest cost of $5,500. a. b. c. d. e. What is the effective rate on the bank loan? How much would it cost (in percentage terms) if the firm did not take the cash discount, but paid the bill in 70 days instead of 10 days? Should the firm borrow the money to take the discount? If the banker requires a 20 percent compensating balance, how much must the firm borrow to end up with the $300,000? What would be the effective interest rate in part d if the interest charge for 60 days were $6,850? Should the firm borrow with the 20 percent compensating balance? (The firm has no funds to count against the compensating balance requirement.)

8-24. Solution: Neveready Flashlights, Inc. a.

Effective rate of interest = $5,500 360 $300,000 60 1.83% 6 10.98%

b.

Cost of lost discount =

2% 360 98% 70 10

2.04% 6 12.24%

c. d.

Yes, because the cost of borrowing is less than the cost of losing the discount.

Amount $300,000 $300,000 $300,000 $375,000 needed to be 1 C 1 .20 .80 borrowed

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8-24. (Continued) e.

Effective interest rate =

$6,850 360 $375,000 $75,000 60 $6,850 6 2.28% 6 $300,000 16.8%

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.

25.

Bank loan to take cash discount (LO1 & 2) Harper Engine Company needs $600,000 to take a cash discount of 1.5/10, net 60. A banker will loan the money for 50 days at an interest cost of $12,100. a. What is the effective rate on the bank loan? b. How much would it cost (in percentage terms) if Harper did not take the cash discount, but paid the bill in 60 days instead of 10 days? c. Should Harper borrow the money to take the discount? d. If another banker requires a 10 percent compensating balance, how much must Harper borrow to end up with $600,000? e. What would be the effective interest rate in part d if the interest charge for 50 days were $8,300? Should Harper borrow with the 10 percent compensating balance? (There are no funds to count against the compensating balance requirement.)

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8-25. Solution: Harper Engine Company a.

Effective rate of interest =

$12,100 360 600,000 50 2.02% 7.2 14.54%

b.

Cost of lost discount =

1.5% 360 98.5% 60 10

360 50 1.52% 7.2 10.94% 1.52%

c. No, because the cost of borrowing is greater than the cost of losing the discount.

d.

Amount $600,000 $600,000 $600,000 $666,667 needed to be .90 1 C 1 .10 borrowed

e.

Effective interest rate =

$8,300 360 $666,667 66,667 50 $8,300 7.2 $600,000 1.38% 7.2 9.94%

Yes, because the cost of borrowing is less than the cost of losing the discount.

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26. Competing terms from banks (LO2) Summit Record Company is negotiating with two banks for a $100,000 loan. Fidelity Bank requires a 20 percent compensating balance, discounts the loan, and wants to be paid back in four quarterly payments. Southwest Bank requires a 10 percent compensating balance, does not discount the loan, but wants to be paid back in 12 monthly installments. The stated rate for both banks is 9 percent. Compensating balances will be subtracted from the $100,000 in determining the available funds in part a. a. Which loan should Summit accept? b. Recompute the effective cost of interest, assuming that Summit ordinarily maintains $20,000 at each bank in deposits that will serve as compensating balances. c. Does your choice of banks change if the assumption in part b is correct?

8-26. Solution: Summit Record Company a. Fidelity Bank Effective interest rate

2 4 $9,000 $100,000 $20,000 $9,000 4 1

$72,000 / $355,000 20.28%

Southwest Bank

Effective interest rate = 2 12 $9,000 $100,000 $10,000 12 1

$216,000 / $1,170,000 18.46%

Choose Southwest Bank since it has the lowest effective interest rate.

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8-26. (Continued) 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. Fidelity Bank

Effective interest rate= $72,000/($100,000 $9,000) 5 = $72,000/($455,000=15.82%

Southwest Bank

Effective interest rate = $216,000/($100,000 13) = $216,000/$1,300,000 = 16.62%

c. Yes. If compensating balances are maintained at both banks in the normal course of business, then Fidelity Bank should be chosen over Southwest Bank. The effective cost of its loan will be less.

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27. Accounts receivable financing (LO1) Charmin Paper Company sells to the 12 accounts listed below. Average Age of the Account over the Last Year 28 43 10 52 42 34 16 65 33 50 14 35

Account A.................................... B .................................... C .................................... D.................................... E .................................... F .................................... G.................................... H.................................... I ..................................... J ..................................... K.................................... L ....................................

Receivable Balance Outstanding $ 60,000 120,000 70,000 20,000 50,000 220,000 30,000 300,000 40,000 90,000 210,000 60,000

Capital Financial Corporation will lend 90 percent against account balances that have averaged 30 days or less; 80 percent for account balances between 31 and 40 days; and 70 percent for account balances between 41 and 45 days. Customers that take over 45 days to pay their bills are not considered acceptable accounts for a loan. The current prime rate is 8.5 percent, and Capital charges 3.5 percent over prime to Charmin as its annual loan rate. a. Determine the maximum loan for which Charmin Paper Company could qualify. b. Determine how much one month's interest expense would be on the loan balance determined in part a.

8-27. Solution: Charmin Paper Company a. 0-30 days A C G K Total loan % loan Amount $ 60,000 70,000 30,000 210,000 370,000 90% $333,000

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31-40 days F I L Total loan% loan 41-45 days B E Total loan % loan

Amount $ 220,000 40,000 60,000 $ 320,000 80% $ 256,000 Amount $120,000 50,000 $170,000 70% $119,000

Maximum Loan = $333,000 + $256,000 + $119,000 = $708,000

b. Loan balances Interest, 12% annual (8.5% Prime 3.5%) One months interest

$ 708,000 (1%) $ 7,080 1% per month

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28.

Hedging to offset risk (LO5) The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge her interest rate exposure. She will sell five Treasury futures contracts at $107,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.3 percent. If they increase to 8.5 percent, assume the value of the contracts will go down by 10 percent. Also if interest rates do increase by 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $63,000. This expense, of course, will be separate from the futures contracts. a. What will be the profit or loss on the futures contract if interest rates go to 8.5 percent by December when the contract is closed out? b. Explain why a profit or loss took place on the futures contracts. c. After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of $63,000? What percent of this $63,000 cost did the treasurer effectively hedge away? d. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.

8-28. Solution: Pittsburgh Iron Works a. Sales price, December Treasury bond contract (Sale takes place in July) $107,000 Purchase price, December Treasury bond contract (10% price decline) .9 $107,000 = 96,300 Gain per contract $ 10,700 Number of contracts 5 Profit on futures contracts $ 53,500 b. A profit took place because the value of the bond went down due to increasing rates. This meant the subsequent purchase price was less than the initial sales price. c. Increased interest cost Profit from hedging Net cost $63,000 53,500 $ 9,500

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Net Cost $9,500 15.08% Increased interest cost $63,000

The net cost is 15.08%. This means 84.92% of the increased interest cost was hedged away. d. If interest rates went down, there would be a loss on the futures contracts. The lower interest rates would lead to higher bond prices and a purchase price that exceeded the original sales price.

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