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					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 firm’s 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.




                                               8-1
Chapter 08: Sources of Short-Term Financing


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 corporation’s 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.




                                              8-2
Chapter 08: Sources of Short-Term Financing


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 lender’s 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 borrower’s 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.




                                              8-3
Chapter 08: Sources of Short-Term Financing



                                              Chapter 8


Problems

1.     Cash discount (LO1) Compute the cost of not taking the following cash discounts.
       a. 2/10, net 50.
       b. 2/15, net 40.
       c.  3/10, net 45.
       d. 3/10, net 180.

8-1.      Solution:

          Cost of not       Discount %         360
          taking a cash =              
          discount        100%  Disc.% Final due date 
                                         Discount period

          a. Cost of        2%   360
                                      2.04%  9.00 18.36%
             lost discount 98% 50  10

          b. Cost of        2%   360
                          =            2.04%  14.40  29.38%
             lost discount 98% 40  15

          c. Cost of        3%   360
                          =            3.09%  10.29  31.80%
             lost discount 97% 45  10

          d. Cost of        3%   360
                          =             3.09%  2.12  6.55%
             lost discount 97% 180  10




                                               8-4
Chapter 08: Sources of Short-Term Financing


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 =              
          discount        100%  Disc.% final due date  discount period

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




                                              8-5
Chapter 08: Sources of Short-Term Financing




          Cost of not       Discount%                  360
          taking a cash =              
          discount        100%  Disc.% final due date  discount period
                                  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:

                                  Interest    Days in the year (360)
          Effective rate =                 
                                 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)
Effective rate of interest =                     
                                       Principal Days loan is outstanding
                                         $5 360       $5 360
                                                              5.0%  36  180%
                                       $100 10 $100 10

                                              8-6
Chapter 08: Sources of Short-Term Financing




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:




                                              8-7
Chapter 08: Sources of Short-Term Financing




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

                                   Interest   Days per year (360)
           Effective rate =                 
                                  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?
                                                                 Days loan is outstanding
       Dollar cost of loan = Amount borrowed × Interest rate ×
                                                                                    
                                                                  Days in the year 360
8-10. Solution:



                                              8-8
Chapter 08: Sources of Short-Term Financing




                                    Talmud Book Company
           Dollar cost of loan =

                                                         Days loan is outstanding
           Amount borrowed  Interest rate 
                                                           Days per year (360)

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

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

             Accounts receivable = average daily     average
                                    credit sales collection period

            $250,000                         $10,000                25days

                                                8-9
Chapter 08: Sources of Short-Term Financing




             Accounts payable = average daily     average
                               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




                                              8-10
Chapter 08: Sources of Short-Term Financing


13.   Compensating balances (LO2) Computer Graphics Company needs $250,000 in funds for
      a project.
      a.    With a compensating balance requirement of 20 percent, how much will the firm
            need to borrow?
      b.    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
                                                         Amount needed
           a.    Amount to be borrowed =
                                                            1  C 
                                                         $250,000 $250,000
                                                                    
                                                          1  .20    .80
                                         $312,500
           b.     $312,500 total amount borrowed
                       10% Interest rate
                   $ 31,250 Interest


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

14.   Compensating balances and installment loans (LO2) The Dade Company is borrowing
      $300,000 for one year and paying $27,000 in interest to Miami National Bank. The bank
      requires a 20 percent compensating balance. What is the effective rate of interest? What
      would be the effective rate if the company were required to make 12 monthly payments to
      retire the loan? The principal, as used in Formula 8–6, refers to funds the firm can
      effectively utilize (Amount borrowed – Compensating balance).

8-14.       Solution:




                                              8-11
Chapter 08: Sources of Short-Term Financing




                                      The Dade Company
            Effective rate of interest with 20% compensating balance =
                          Interest             Days in the year (360)
                                             
             Principal  Compensating balance Days loan is outstanding
                    $27,000          360 $27,000
                                               1  11.25%
               $300,000  $60,000 360 $240,000


            Installment loan with compensating balance


                     2  Annual no. payments  Interest
             
                   Total no. of payments +1  Principal

                               2  12  $27,000
             
                          (12  1)  ($300,000  $60,000)


                    $648,000       $648,000
                                                             20.77%
                  13  $240,000   $3,120,000
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?




                                              8-12
Chapter 08: Sources of Short-Term Financing




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


                                              8-13
Chapter 08: Sources of Short-Term Financing




                  Required Compensating Balance  minimum balance on
                         deposit  additional funds needed at bank

17.   Effective rate under different terms (LO2) Your company plans to borrow $5 million for
      12 months, and your banker gives you a stated rate of 14 percent interest. You would like
      to know the effective rate of interest for the following types of loans. (Each of the
      following parts stands alone.)
      a. Simple 14 percent interest with a 10 percent compensating balance.
      b. Discounted interest.
      c.   An installment loan (12 payments).
      d. Discounted interest with a 5 percent compensating balance.

8-17. Solution:
          a.     Simple interest with a 10% compensating balance
                        $700,000              $700,000
                                        1              15.56%
                  $5,000,000  $500,000      $4,500,000
          b. Discounted interest
                        $700,000              $700,000
                                        1              16.28%
                  $5,000,000  $700,000      $4,300,000
          c.     An installment loan with 12 payments
                        2 12  $700,000 $16,800,000
                                                     25.85%
                        13  $5,000,000 $65,000,000
          d. Discounted interest with a 5% compensating balance
               $700,000 /  $5,000,000 – $700,000 – $250,000  
               $700,000/$4,050,000 = 17.28%




                                              8-14
Chapter 08: Sources of Short-Term Financing


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                            = 16.67%
          c. (2 × 4 × $500)/(5 × $4,000) = $4,000/$20,000                            = 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:




                                              8-15
Chapter 08: Sources of Short-Term Financing




                                    Zerox Copying Company
          Effective rates of interest with compensating balance
          First determine interest
          8½% (prime rate) + ½% = 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




                                              8-16
Chapter 08: Sources of Short-Term Financing




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
          Cost of not taking = Discount %        360
          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. Warner’s 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:




                                                8-17
Chapter 08: Sources of Short-Term Financing




                                    Reynolds Corporation
          Cost of not taking a cash = Discount %          360
          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.




                                              8-18
Chapter 08: Sources of Short-Term Financing


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.    What is the effective rate on the bank loan?
      b.    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?
      c.    Should the firm borrow the money to take the discount?
      d.    If the banker requires a 20 percent compensating balance, how much must the firm
            borrow to end up with the $300,000?
      e.    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.
                                                        $5,500 360
           a.    Effective rate of interest =                   
                                                      $300,000 60
                                                     1.83%  6  10.98%
                                                  2%    360
           b.    Cost of lost discount =             
                                                 98%  70  10 
                                               2.04%  6  12.24%
           c.    Yes, because the cost of borrowing is less than the cost of
                 losing the discount.

           d.    $300,000 $300,000 $300,000             Amount
                                            $375,000 needed to be
                  1  C   1  .20    .80            borrowed




                                              8-19
Chapter 08: Sources of Short-Term Financing




8-24. (Continued)
          e.
                                                      $6,850         360
            Effective interest rate =                              
                                                $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.)




                                                8-20
Chapter 08: Sources of Short-Term Financing



8-25. Solution:
                                  Harper Engine Company
                                                       $12,100 360
          a.     Effective rate of interest =                  
                                                       600,000 50
                                                      2.02%  7.2  14.54%

                                                       1.5%     360
          b.         Cost of lost discount =                
                                                       98.5%  60  10 
                                                               360
                                                      1.52% 
                                                                50
                                                      1.52%  7.2  10.94%

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


          d.     $600,000 $600,000 $600,000              Amount
                                             $666,667 needed to be
                  1  C    1  .10    .90            borrowed


                                                       $8,300          360
          e.      Effective interest rate =                          
                                                  $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.




                                              8-21
Chapter 08: Sources of Short-Term Financing


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.




                                              8-22
Chapter 08: Sources of Short-Term Financing



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.




                                              8-23
Chapter 08: Sources of Short-Term Financing


27. Accounts receivable financing (LO1) Charmin Paper Company sells to the 12 accounts

listed below.

                                                                             Average Age of
                                                     Receivable Balance   the Account over the
       Account                                          Outstanding            Last Year
          A....................................          $ 60,000                 28
          B ....................................          120,000                 43
          C ....................................           70,000                 10
          D....................................            20,000                 52
          E ....................................           50,000                 42
          F ....................................          220,000                 34
          G....................................            30,000                 16
          H....................................           300,000                 65
          I .....................................          40,000                 33
          J .....................................          90,000                 50
          K....................................           210,000                 14
          L ....................................           60,000                 35

          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                                                Amount
                A                                                    $ 60,000
                C                                                      70,000
                G                                                      30,000
                K                                                     210,000
                                                    Total             370,000
                                                    loan %               90%
                                                    loan             $333,000



                                                     8-24
Chapter 08: Sources of Short-Term Financing




                31-40 days                                   Amount
                  F                                        $ 220,000
                  I                                           40,000
                  L                                           60,000
                                              Total        $ 320,000
                                              loan%             80%
                                              loan         $ 256,000

                41-45 days                                   Amount
                  B                                         $120,000
                  E                                           50,000
                                              Total         $170,000
                                              loan %            70%
                                              loan          $119,000
          Maximum Loan = $333,000 + $256,000 + $119,000 = $708,000


          b. Loan balances                             $ 708,000
                Interest, 12% annual
                (8.5% Prime  3.5%)                        (1%)    1% per month
                One month’s interest                     $ 7,080




                                               8-25
Chapter 08: Sources of Short-Term Financing


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              $63,000
                Profit from hedging                   53,500
                Net cost                             $ 9,500




                                              8-26
Chapter 08: Sources of Short-Term Financing




                        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.




                                              8-27

				
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