Chapter 16 Short-Term Business Financing CHAPTER PREVIEW A firm’s current assets need to be financed. Many firms finance their short-term assets with short-term financing sources. The amount of short-term financing a firm uses is a strategic decision as it has risk and return implications. Using short-term funds to finance both current and fixed assets is a high-risk, high potential return strategy. The use of long-term funds to finance both current and fixed assets is a low-risk, low potential return strategy. Most students may think the only short-term financing sources available to firms are trade credit (accounts payable) and bank loans. But there are many different kinds of bank-lending arrangements, and firms have other financing sources they can use besides suppliers and banks. This chapter reviews these sources and also shows students how to compute the effective cost of a financing source. LEARNING OBJECTIVES • Identify and describe strategies for financing working capital. • Identify and briefly explain the factors that affect short-term financing requirements. • Identify the types of unsecured loans made by commercial banks to business borrowers. • Describe the use of accounts receivable, inventory, and other sources of security for bank loans. • Explain the characteristics, terms, and costs of trade credit. • Explain the role of commercial finance companies in providing short-term business financing. • Briefly describe how factors function as a source of short-term business financing. • Describe how the Small Business Administration aids businesses in meeting short-term borrowing needs. • Describe how and why commercial paper is used as a source of short-term financing by large corporations. CHAPTER OUTLINE I. STRATEGIES FOR FINANCING WORKING CAPITAL A. Maturity Matching Approach B. Aggressive Approach C. Conservative Approach II. FACTORS AFFECTING SHORT-TERM FINANCING A. Operating Characteristics 1. Mix of current and fixed assets 2. Size and age of firm 3. Growth and profitability 4. Seasonal Variation 5. Sales Trend 6. Cyclical Variations B. Other Influences in Short-Term Financing III. PROVIDERS OF SHORT-TERM FINANCING A. Commercial Bank Lending 1. Bank Lines of Credit 2. Computing Interest Rates 3. Revolving Credit Agreements 4. Small Business Administration B. Trade Credit From Suppliers 1. Terms for Trade Credit 2. Cost of Trade Credit C. Commercial Finance Companies D. Commercial Paper IV. ADDITIONAL VARIETIES OF SHORT-TERM FINANCING A. Accounts Receivable Financing B. Inventory Loans C. Loans Secured by Stocks and Bonds D. Other Forms of Security for Bank Loans 1. Life Insurance Loans 2. Comaker Loans 3. Acceptances V. THE COST OF SHORT-TERM FINANCING VI. SUMMARY LECTURE NOTES I. STRATEGIES FOR FINANCING WORKING CAPITAL Net working capital is the difference between a firm’s current assets and current liabilities. It also reflects a firm’s strategic decision regarding its mix of short-term and long-term financing. Positive net working capital represents the amount of a firm’s current assets that are financed by long-term financing sources such as bonds and stocks. Negative net working capital shows the amount of fixed assets that are financed by short-term financing sources. Current assets can be divided into two categories: permanent and temporary. Permanent current assets do not represent specific inventory, receivables, or dollar bills that sit around and collect dust. Permanent current assets refer to the safety, buffer, or minimum levels of cash, receivables, and inventory that remain within the going concern. Temporary current assets refer to fluctuations above these levels, for example inventory build-up in anticipation of seasonal sales. A maturity-matching financing strategy finances long-term category assets (fixed assets and permanent current assets) with long-term financing sources; temporary current assets are financed with short-term sources. Figure 16.4 shows this strategy along with the aggressive strategy and conservative strategy. Discussion can focus on the risk/return implications of each. Figure 16.5 show different financing strategies across several firms. Of related interest is the text’s discussion of firms in financial difficulty. In some situations, a firm’s going-concern value is in doubt because of bad financing decisions, such as using an overly aggressive short-term financing mix. At times, business problems have other causes, such as the well-known dot-com debacle in 2000-2001. The problems of Enron and other energy trading firms in 2001-2002 may appear to have financial roots, but are really problems involving ethics. (Use Discussion Questions 1, 2, 3 and 5 here.) II. FACTORS AFFECTING SHORT-TERM FINANCING Firms will not blindly choose an aggressive, conservative, or maturity matching ST/LT financing mix. This decision will be guided by several influences, such as 1. Industry and company factors (proportion of current to fixed assets, size and age of a firm [life cycle] and growth prospects) 2. Seasonal sales variation 3. Sales trends and “lumpy” long-term financing 4. Business cycle needs 5. Cost (short-term financing is usually cheaper than long-term financing) 6. Flexibility (short-term is usually more flexible) 7. Ease of future financing 8. Desirability of having good bank relationships 9. Greater volatility of short-term rates relative to long-term rates Figure 16.6 is useful for illustrating the different levels of short-term financing, relative to total assets, for a number of firms in different industries. (Use Discussion Question 4 here.) III. PROVIDERS OF SHORT-TERM FINANCING A. Commercial Bank Lending The typical loan made by a bank to a business is on an unsecured basis. A line of credit is the loan limit a bank establishes for each of its business customers. Once the line is granted, the firm usually contacts the bank when it wishes to draw on the line. The bank reviews the firm’s financial condition at least once a year, so renewal of a credit line is not automatic. Additionally, most lines require the firm to have a “clean up” period during which no borrowings are outstanding against the line. This way the bank ensures the funds are truly needed for short-term purposes. The bank may require the firm to maintain a compensating balance in return for the line of credit. Should the firm’s financial condition worsen, the bank can cancel the line of credit. A revolving credit agreement is a more formal arrangement between the bank and the firm. In return for a fee paid for any unused credit on the revolver, the bank guarantees the revolving line will be available to the firm during a specified time frame. The prime rate is the interest rate a bank charges its best customers. But the effective annual cost of borrowing can be affected by how the interest is computed and whether the loan is discounted or has a compensating balance requirement. If the loan is discounted or has a compensating balance requirement, the firm may have to borrow more than it needs in order to obtain sufficient usable funds (Equations 16.2 and 16.3). The Small Business Administration (SBA) was created in 1953 by the federal government to provide financial assistance to small firms that cannot obtain loans from private sources on reasonable terms. The SBA assists in the financing of small firms in the following three ways: 1. It may make direct loans to businesses. 2. It may participate jointly with private banks in extending loans to businesses. 3. It may agree to guarantee a bank loan. (Use Discussion Questions 6 through 10 and 19 here.) B. Trade Credit from Suppliers Trade credit is credit extended by one business firm to another and represents the most important form of short-term business financing. When trade credit terms provide for no discount for early payment, there is no explicit cost for such financing. But when a discount is offered for early payment, the cost of not taking the discount can be quite high, as examples using the approximate effective cost formula (Equation 16.4) will show. Firms should compare the cost of trade credit with the cost of bank loans, which could be used to take advantage of cash discount opportunities. (Use Discussion Questions 14 and 15 here.) C. Commercial Finance Companies A commercial finance company is an organization without a bank charter that advances funds to business concerns by 1. Discounting accounts receivable 2. Making loans secured by chattel mortgages on equipment 3. Financing deferred-payment sales of commercial and industrial equipment Some are also involved in inventory financing. Commercial finance companies obtain funds to lend from their equity base by issuing bonds and commercial paper and by borrowing from banks. The cost of loans from commercial finance companies is generally higher than the cost of comparable loans from commercial banks. Thus, firms first turn to commercial banks for short-term funds. However, due to high risk and/or rapid growth, some firms have to take more costly commercial finance company loans. (Use Discussion Question 16 here.) D. Commercial Paper Commercial paper refers to short-term unsecured notes issued by large U.S. corporations of high credit quality. Commercial paper may either be sold directly by the issuers or be sold to commercial paper dealers or houses, who resell the paper to others. The most important reason that large firms issue commercial paper is that the cost is generally less than regular bank rates. At the same time, the yield on commercial paper is above that of T-bills. Thus, there is both an incentive for businesses to issue commercial paper and for investors to purchase it. The Euro CP market is growing in popularity among issuers. Commercial paper is sold on a discount basis, so the net proceeds will be less than the paper’s face amount. This discount and the fees associated with issuing it must be considered when computing the paper’s effective annual cost. (Use Discussion Questions 20 through 22 here.) IV. ADDITIONAL VARIETIES OF SHORT-TERM FINANCING If the firm (a) is perceived to be too risky for an unsecured loan or (b) has needs that exceed its credit line, it may pledge its receivables in return for financing. Pledging allows the firm to obtain a short-term loan by using receivables as collateral. Before entering into such an agreement, the bank will review the 1. Collection experience of the firm 2. Characteristics of the receivables 3. Type of goods sold by the firm and its return rate on defective goods Banks charge a fee when receivables are pledged to compensate them for the time and effort in reviewing receivables accounts. A factor purchases accounts receivable from firms, thereby assuming risks of nonpayment. Under maturity factoring, the firm selling the accounts receives funds on the normal due date of the receivables. With advance factoring, the factor pays the firm for its receivables before the normal due date. Using a factor eliminates the need for a credit department. The factor becomes the firm’s credit department. All credit sales must be approved by the factor. Customers whose accounts are sold to the factor are notified that their payments are to be sent directly to the factor, not to the selling firm. Financially weak firms that are unable to secure financing through customary channels use factors. In addition, financially strong firms that are experiencing rapid growth in credit sales sometimes use factors to shift some of the credit department responsibilities to the factors. Inventory can also be used to secure short-term loans. The amount lent depends upon the type of inventory, its condition, and the degree of control the lender can exercise over the inventory. Possible borrowing arrangements include 1. Blanket inventory lien 2. Trust receipt 3. Warehouse receipt 4. Field warehouse Other sources of security or collateral for small business loans include stocks and bonds owned by the business owner; loans against a life insurance policy; loans signed by the owner as a co maker (making the owner, rather than the firm, ultimately responsible for repaying the loan); and bankers’ acceptances (as discussed in Chapter 16 and Chapter 18). (Use Discussion Question 11, 12, 17, 18 and 13 here.) V. THE COST OF SHORT-TERM FINANCING A five-step process can help students determine the amount to be borrowed, the interest and fees to be paid, the net proceeds of the loan, and the periodic financing cost, which should then be annualized. The cost of bank lines of credit, revolving, pledged, factored, and other loans can be determined using this process. End-of-chapter problems give students much practice with this process. DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by net working capital? Briefly describe the financing implications when net working capital is positive. Net working capital is defined as current assets minus current liabilities. When positive, it shows the dollar amount of current assets that are financed by long-term financing sources. 2. What is meant by “permanent” current assets? How do “temporary” current assets differ from permanent current assets? Permanent current assets refer to the safety or buffer or minimum levels of cash, receivables, and inventory that remain within the going concern. Temporary current assets refer to fluctuations above these levels, for example inventory build-up in anticipation of seasonal sales. 3. Explain the strategies businesses can use to finance their assets with short-term and long-term funds. A maturity-matching financing strategy finances long-term category assets (fixed assets and permanent current assets) with long-term financing sources; temporary current assets are financed with short-term sources. An aggressive strategy uses short-term financing to finance all current assets (and sometimes some fixed assets); a conservative strategy uses long-term financing to finance fixed assets, permanent current assets, and some of the temporary current assets. 4. What influences affect the nature of the demand for short-term versus long-term funds? The short-term/long-term financing mix decision will be guided by several influences, such as: a. Industry and company factors (proportion of current to fixed assets, size and age of a firm [life cycle] and growth prospects) b. Seasonal sales variation c. Sales trends and “lumpy” long-term financing d. Business cycle needs e. Cost (short-term financing is usually cheaper than long-term financing) f. Flexibility (short-term is usually more flexible) g. Ease of future financing h. Desirability of having good bank relationships i. Greater volatility of short-term rates relative to long-term rates 5. Explain how a conservative approach to financing a firm’s assets is a low risk/low expected return strategy whereas an aggressive approach to financing is a high risk/high expected return strategy. From the typically upward-sloping yield curve, we know that (generally) short-term securities have lower yields than long-term securities. From the borrower’s perspective, that means the cost of paying short-term financing charges (short-term interest rates) will be less than the cost of paying long-term financing charges (long-term interest rates and equity holders’ required rates of return). Compared to a conservative plan which relies more on long-term financing, an aggressive financing plan using relatively more short-term financing will generally have lower financing costs and will, all else being equal, be more profitable. As it comes due, short-term debt is replaced by new short-term debt (called “rolling over”). But with the expectation of higher return comes higher risk. Short-term interest rates are more volatile than long-term rates, and in periods of tight money or in periods of inflation jitters, short-term rates can rise quickly, sharply increasing the cost of using short-term money. Sources of short-term credit may also disappear. In such a “credit crunch,” banks may not have enough funds to lend to satisfy demand, and investors may not be willing to purchase the firm’s short-term debt. A conservative financing plan has a higher financing cost, but with a lower risk of not being able to borrow when short-term funds are needed. 6. Prepare a list of advantages and disadvantages of short-term bank borrowing relative to other short-term financing sources. Advantages include maintaining a bank relationship; firms with good relationships are more likely to obtain loans during times when funds are tight. Another advantage is the flexibility of dealing with a local banker who can work with the firm in times of cash flow difficulties. Bank borrowing rates are usually less than those from pledging or factoring receivables, using inventory as collateral, or from using commercial finance companies. Disadvantages include: the need to maintain compensating balances; the fact that a line of credit can be removed at the bank’s option; and the fact that commercial paper offers lower rates for large corporations than the bank’s prime rate. 7. What is meant by an unsecured loan? Are these loans an important form of bank lending? Unsecured loans have neither collateral nor security. Bank loans to businesses are usually on an unsecured basis. 8. Explain what a bank line of credit is. A line of credit is a loan limit a bank establishes for each of its business customers. Once the line is granted, the firm usually contacts the bank when it wishes to draw down the line. The bank reviews the firm’s financial condition at least once a year, so renewal of a credit line is not automatic. Additionally, most lines require the firm to have a “clean-up” period during which no borrowings are outstanding against the line. 9. Explain how discounting and compensating balances affect the effective cost of financing. Both generally have the effect of increasing the amount of the loan so the firm can obtain the usable funds it needs. As such, the firm pays interest on a larger loan amount than the funds it actually receives. Discounting and compensating balances both increase the effective cost of financing. The one exception is if the firm already has sufficient funds in a noninterest bearing account to fulfill its compensating balance needs. 10. Describe the revolving credit agreement and compare it with the bank line of credit. The revolving credit agreement establishes a maximum loan volume during a given period of time, but under the terms of the agreement, the bank must make good its commitment to extend credit up to the loan limit. The customer pays a standby fee throughout the period of the revolving credit agreement in addition to paying interest while loans are outstanding. A line of credit can be revoked at any time by the bank; a firm pays interest only on the amount of the funds it borrows. 11. When might a business seek accounts receivable financing? Accounts receivable may be pledged as collateral for short-term business loans when a business does not qualify for an unsecured loan or its line of credit is inadequate to meet its short-term financial requirements. 12. What safeguards may a bank establish to protect itself when it lends on the basis of a customer’s receivables pledged as collateral for a loan? The banks will accept for pledging only those receivables that are current and have every prospect of being paid by the customer. The bank can audit the firm’s books to see if it is honoring the terms of the agreement. 13. When a business firm uses its inventory as collateral for a bank loan, how is the problem of storing and guarding the inventory accomplished for the bank? The inventory can be moved into a bonded and licensed warehouse. If the items are large or difficult to store, a field warehouse may be established. 14. What is meant by trade credit? Briefly describe some of the possible terms for trade credit. Trade credit is accounts receivable and notes receivable taken by business sellers of goods and services from their customers. Terms of trade credit include end of month (E.O.M.); middle of month (M.O.M.); and receipt of goods (R.O.G.). Terms of 2/10 net 30 mean a 2- percent discount may be taken if payment is made within 10 days; otherwise full payment is due within 30 days. 15. What are the primary reasons for using trade credit for short-term financing? Convenience; it permits goods to be sold with a simultaneous transfer of funds, allowing the goods to be used and examined for defects before payment. Firms in a financially weak condition will find trade credit to be more readily available than bank credit. 16. Under what circumstances would a business secure its financing through a commercial finance company? A firm may use a commercial finance company if it is unable to qualify for a bank loan or if the firm needs more funds than a bank is willing to lend at the current time. 17. Describe how a factor differs from a commercial finance company in terms of accounts-receivable financing. A factor purchases accounts receivable outright and assumes all credit risks. In contrast, a commercial finance company traditionally accepts accounts receivable as collateral for a loan. 18. Why would a business use the services of a factor? Factoring may be used because other forms of financing are unavailable. Factoring is attractive to some firms as the factor becomes the firm’s credit and collection department, approving and financing receivables, thus eliminating the overhead expenses of such departments. 19. How does the Small Business Administration provide financing to businesses? The Small Business Administration (SBA) provides financing to firms unable to obtain loans through private channels on reasonable terms. Assistance is provided in three ways: a) it may make direct loans to businesses; b) it may participate jointly with private banks in extending loans to businesses; c) it may agree to guarantee a bank loan. 20. What is commercial paper and how important is it as a source of financing? Commercial paper is short-term unsecured notes issued by large U.S. corporations of high credit quality. The most important reason that large firms issue commercial paper is that the cost is generally less than regular bank rates. In addition, compensating balances are avoided and very large amounts can be borrowed. 21. Is commercial paper a reliable source of financing? Why or why not? As a short-term source of financing, the interest rate on commercial paper will rise sharply should short-term interest rates rate. This may happen if inflation is expected to rise or if a liquidity crisis affects the economy. If an issuer begins to have—or is perceived to have—liquidity problems, investors may not be willing to purchase its new issues of paper. The firm will have to find other financing sources to pay off the retiring paper. 22. How is changing technology changing the methods of raising short-term funds? For inventory financing, digital writing and recording devices, such as digital cameras, allow for storage of important inventory information for asset-backed loans. Excess inventory or assets can be sold to raise funds on business auction web sites. Several on-line systems for issuing commercial paper (portals which match buyers and issuers) have been developed to reduce the fees of issuing paper. Of course, internet searches make the task of finding our financing sources easier. PROBLEMS AND ANSWERS 1. A supplier is offering your firm a cash discount of 2 percent if purchases are paid for within 10 days; otherwise the bill is due at the end of 60 days. Would you recommend borrowing from a bank at an 18 percent annual interest rate in order to take advantage of the cash discount offer? Explain your answer. % Discount 365 days Effective Cost = × 100% – % Discount Credit period – Discount days 2 365 = × = 14.90% 100 – 2 60 – 10 It is cheaper to use the trade credit (14.90%) than to borrow from a bank to take the credit discount (18%). 2. Assume that you have been offered cash discounts on merchandise that can be purchased from either of two suppliers. Supplier A offers trade credit terms of 3/20, net/70, while Supplier B offers 4/15, net/80. What is the approximate effective cost of missing the cash discounts from each supplier? If you could not take advantage of either cash discount offer, which supplier would you select? % Discount 365 days Supplier A’s Effective Cost = × 100% – % Discount Credit period – Discount days 3 365 = × = 22.56% 100 – 3 70 – 20 4 365 Supplier B’s effective cost = × = 23.33% 100 – 4 80 – 15 Select Supplier A because they have the lower effective financing cost. 3. Obtain a current issue of the Federal Reserve Bulletin, or review of copy from the Fed’s Web site (www.federalreserve.gov) or the St. Louis Fed’s Web site (www.stlouisfed.org), and determine the changes in the prime rate that have occurred since the end of 1998. Comment on any trends in the data. Library assignment 4. Compute the effective cost of not taking the cash discount under the following trade credit terms: a. 2/10 net 40 2 365 × = 24.83% 100 – 2 40 – 10 b. 2/10 net 50 2 365 × = 18.62% 100 – 2 50 – 10 c. 3/10 net 50 3 365 × = 28.22% 100 – 3 50 – 10 d. 2/20 net 40 2 365 × = 37.24% 100 – 2 40 – 20 5. What conclusions can you make about credit terms from reviewing your answers to Problem 4? Effective cost falls when there is a larger difference between the end of the credit period and the end of the discount period (a, b); effective cost rises as the discount percentage rises (b, c); effective cost rises as the difference between the end of the credit period and the end of the discount period falls (a, d). 6. Your firm needs to raise funds for inventory expansion. a. What is the effective annual rate on a loan of $150,000 if it is discounted at a 12 percent stated annual rate and it matures in five months? 12% APR × 5/12 = 5% over five months Interest ($) = .05($150,000) = $7,500 $ received = $150,000 – $7,500 = $142,500 5-month interest rate = $7,500/$142,500 = 5.26% EAR = (1 + .0526)12/5 – 1 = 0.1309 or 13.09% b. How much must you borrow in order to obtain usable funds of $150,000? Loan request = Desired usable funds/(1 – Discount) = $150,000/(1 – .05) = $157,894.74 c. What is the effective annual rate if you borrow the funds computed in Part b? 5-month interest rate = $7,894.74/$150,000 = 5.26% EAR = (1.0526)12/5 – 1 =13.09% 7. Bank A offers loans with a 10 percent stated annual rate and a 10 percent compensating balance. You wish to obtain $250,000 in a six-month loan. a. How much must you borrow in order to obtain $250,000 in usable funds? Assume you currently do not have any funds on deposit at the bank. What is the effective annual rate on a six-month loan? For a 6-month loan, you must borrow $250,000/(1 – .10) = $277,777.78 At 10% APR, 6-month interest rate = 5% Interest ($) = .05 × $277,777.78 = $13,888.89 Periodic rate = $13,888.89/$250,000 = 5.56% EAR = (1.0556)2 – 1 = 11.42% b. How much must you borrow in order to obtain $250,000 in usable funds if you currently have $10,000 on deposit at the bank? What is the effective annual rate on a six-month loan? With a 10% compensating balance, 10% of what is borrowed ($250,000 + x ) should equal $10,000 + x : .1($250,000 + x) = $10,000 + x x = $16,666,67 You will need to borrow $250,000 + $16,666.67 = $266,666.67 Interest ($) = .05 × $266,666.67 = $13,333.33 Periodic rate = $13,333.33/$250,000 = 5.33% EAR = (1.0533)2 – 1 = 10.95% c. How much must you borrow in order to obtain $250,000 in usable funds if you currently have $30,000 on deposit at the bank? What is the effective annual rate on a six-month loan? .1 ($250,000 + x) = $30,000 + x x = $ –5,555.56 You will need to borrow $250,000 + ($ –5,555.56) = $244,444.44 Interest ($) = .05 (244,444.44) = $12,222.22 Periodic rate = $12,222.22/$244,444.44 = 5% EAR = (1.05)2 – 1 = 10.25% 8. Compute the effective annual rates of the following: a. $1 million maturing in 90 days with a stated annual rate of 6 percent. Fees are 0.02 percent of the principal. Amount of paper to be issued: $1,000,000.00 Number of days until maturity: 90 Stated annual rate on the paper: 6.00% Fees (percentage of amount issued): 0.02% The 90 day interest cost at 6.00% APR = 1.48% Amount of discount (interest cost plus fees)= 0.0150 or $15,000.00 Net proceeds of sale: $985,000.00 90 day cost: 1.5228% Effective annual rate: 6.32% b. $15 million maturing in 60 days with a stated annual rate of 7.6 percent. Fees are 0.05 percent of the principal. Amount of paper to be issued: $15,000,000.00 Number of days until maturity: 60 Stated annual rate on the paper: 7.60% Fees (percentage of amount issued): 0.05% The 60 day interest cost at 7.60% APR = 1.25% Amount of discount (interest cost plus fees)= 0.0130 or $195,000.00 Net proceeds of sale: $14,805,000.00 60 day cost: 1.3171% Effective annual rate: 8.29% c. $500,000 maturing in 180 days with a stated annual rate of 8.25 percent. Fees are 0.03 percent of the principal. Amount of paper to be issued: $ 500,000.00 Number of days until maturity: 180 Stated annual rate on the paper: 8.25% Fees (percentage of amount issued): 0.03% The 180 day interest cost at 8.25% APR = 4.07% Amount of discount (interest cost plus fees)= 0.0410 or $20,500.00 Net proceeds of sale: $479,500.00 180 day cost: 4.2753% Effective annual rate: 8.86% d. $50 million maturing in 210 days with a stated annual rate of 6.5 percent. Fees are 0.10 percent of the principal. Amount of paper to be issued: $50,000,000.00 Number of days until maturity: 210 Stated annual rate on the paper: 6.50% Fees (percentage of amount issued): 0.10% The 210 day interest cost at 6.50% APR = 3.74% Amount of discount (interest cost plus fees)= 0.0384 or $1,920,000.00 Net proceeds of sale: $48,080,000.00 210 day cost: 3.9933% Effective annual rate: 7.04% 9. Construct a spreadsheet that computes the effective annual rates on the commercial paper offerings. Inputs to the spreadsheet should include the dollar amount of paper to be issued, the number of days the paper is outstanding, the stated annual rate, and fees. All paper is sold on a discount basis. Use it to find the effective annual rates in problem 8. Solution: see problem 8. 10. Wonder Dog Leash Company is examining their accounts receivable patterns. Wonder’s customers are offered terms of 1/10 net 30. Of their receivables, $150,000 are current, $75,000 are one-month overdue, $30,000 are two-months overdue, and $20,000 are over two-months overdue. a. What proportion of Wonder’s customers pay their bills on time? The aging schedule for Wonder’s accounts receivables is Age of Account Current 0-30 days 1 month overdue 31-60 days 2 months overdue 61-90 days >2 months overdue >90 days Amount $150,000 $75,000 $30,000 $20,000 The accounts receivable total is $275,000. The proportion of current accounts is $150,000/$275,000 = 0.545 or 54.5% b. What is the effective cost of Wonder’s terms of trade credit? Discount % 365 days 1% 365 EC = ------------------------ x --------------------------- = ------------- x ----------- = 18.43% 100% - discount % net – discount period 100% -1% 30 - 10 c. What might happen to their receivables balance if they changed their terms to 1/15 net 30? To 2/10 net 30? 1/15 net 30 effective cost = 1% x 365 = 24.6% 100% - 1% 30 – 15 2/10 net 30 effective cost = 2% x 365 = 37.2% 100% - 2% 30 – 10 In both cases, Wonder should see quicker payment due to the increased cost of trade credit, particularly if the terms are changed to 2/10 net 30. 11. Wonder Dog Leash Company is seeking to raise cash and is in negotiation with Big Bucks finance company to pledge their receivables. BB is willing to loan funds against 75% of current (that is, not overdue) receivables at a 15% annual percentage rate (see the aging of receivables in problem 10). To pay for its evaluation of Wonder’s receivables, BB charges a 2.5 percent fee on the total balance of current receivables. a. If the average term of a loan is 30 days, what is the effective interest rate if Wonder pledges its receivables? Data Amount needed $112,500 APR 15.00% Interest charge 1.23% =15% x (30/365) Fee 2.5% Time of loan (in days) 30 Step 1: Amount to be borrowed $112,500.00 Step 2: Interest expense $1,386.99 =1.23% x $112,500 Step 3: Fees and other expenses $2,812.50 =3% x $112,500 Step 4: Net proceeds $112,500.00 Step 5: Interest + fees $4,199.49 =$1,386.99 + $2,812.50 Net proceeds $112,500.00 Financing cost 3.73% =$4,199.49/$112,500 Annualized cost 56.19% =(1+0.0373)^(365/30)-1 b. What is the effective rate if Wonder negotiates a loan of 45 days with no other changes in the loan’s terms? Data Amount needed $112,500 APR 15.00% Rate for time of loan Interest charge 1.85% =15% x (45/365) Fee 2.5% Time of loan (in days) 45 Step 1: Amount to be borrowed $112,500.00 Step 2: Interest expense $2,080.48 =$112,500 x 1.85% Step 3: Fees and other expenses $2,812.50 ==$112,500 x 2.5% Step 4: Net proceeds $112,500.00 Step 5: Interest + fees $4,892.98 =$2,080.48 + $2,812.50 Net proceeds $112,500.00 Financing cost 4.35% =$4,892.98/$112,500 Annualized cost 41.24% =(1+0.0435)^(365/45)-1 12. Michael’s Computers is evaluating proposals from two different factors who will provide receivables financing. Big Fee Factoring will finance the receivables at an APR of 8 percent, discounted, and charges a fee of 4 percent. HighRate Factoring offers an APR of 14% (nondiscounted) with fees of 2 percent. The average term of either loan is expected to be 35 days. With an average receivables balance of $250,000, which proposal should Michael’s accept? Michael’s should accept HighRate’s offer as its APR is lower than Big Fee. Big Fee Factoring Data Amount needed $250,000 APR 8.00% Interest charge 0.77% =8% x (35/365) Fee 4% Time of loan (in days) 35 days Step 1: Amount to be borrowed $251,932.63 =$250,000/(1-0.0077) Step 2: Interest expense $1,932.63 =0.77% x $251,932.63 Step 3: Fees and other expenses $10,077.31 =4% x $251,932.63 Step 4: Net proceeds $250,000.00 Step 5: Interest + fees $12,009.94 =$1,932.63 + $10,077.31 Net proceeds $250,000.00 Financing cost 4.80% =12,009.94/$250,000 Annualized cost 63.12% =(1+0.048)^(365/35)-1 HighRate Factoring Data Amount needed $250,000 APR 14.00% Interest charge 1.34% Fee 2% Time of loan (in days) 35 days Step 1: Amount to be borrowed $250,000.00 Step 2: Interest expense $3,356.16 =1.34% x $250,000 Step 3: Fees and other expenses $5,000.00 =2% x $250,000 Step 4: Net proceeds $250,000.00 Step 5: Interest + fees $8,356.16 =$3,356.16 + $5,000 Net proceeds $250,000.00 Financing cost 3.34% =$8,356.16/$250,000 Annualized cost 40.90% =(1+0.0334)^(365/35)-1 13. Michael’s Computers’ local bank offers the firm a 12-month revolving credit agreement of $500,000. The APR of the revolver is 12 percent with a commitment fee of 0.5% on the unused portion. Over the course of a year, Michael’s chief financial officer believes they will have an average balance of $280,000 on the revolving credit agreement, with a low of $50,000 and a high of $450,000. What is the annual effective cost of this proposed agreement? Total cost = 0.12 x $280,000 + 0.005 x $220,000 = $33,600 + $1,100 = $34,700 Annual effective cost = $34,700/$280,000 = 0.124 or 12.4% 14. Bank Two wants to attract Michael’s Computers, Inc. to become a customer. Their sales force contacts Michael’s and offers them line of credit financing. The credit line will be for $500,000 with a one-month “clean-up” period. The APR on borrowed funds is 11 percent. Banc Two will offer the line of credit if Michael’s opens an account and maintains an average balance of $100,000 over the next 12 months. As in problem 13, ignoring compensating balances, Michael’s CFO believes its financing needs will average $280,000 monthly over the next year with a low monthly need of $50,000 and a high need forecast of $450,000. a. Will the line of credit satisfy Michael’s needs for short-term funds? No. With an upper limit cash need forecast of $450,000 and a $100,000 compensating balance requirement Michael’s will require a revised upper-limit-cash-need forecast of $550,000. In addition, the one-month clean-up period means no borrowing against the line for one month and currently Michael’s low-end forecast is $50,000 (which rises to $150,000 considering the new compensating balance requirement). b. How much money will Michael’s draw-down from the credit line during a low use month? $100,000 (compensating balance) + $50,000 (low monthly need forecast = $150,000. The assumption is that since Michael’s is not currently a Bank Two customer that the compensating balance represents an additional commitment that Michael’s will have to keep on deposit. c. How much will Michael’s need to borrow in a month before it maximizes its use of the line of credit? $500,000 credit limit - $100,000 compensating balance = $400,000. d. What is the average cost to Michael’s of using the credit line for a year? Michael’s average monthly financing needs are $280,000; adding the compensating balance requirement, the average monthly loan will be $380,000. Interest expense is 0.11 x $380,000 = $41,800. Thus, the average cost of the line is $41,800/$280,000 (usable funds) = 0.149 or 14.93%. Another way of computing this is to realize the compensating balance, as a percentage of the monthly balance, equals $100,000/$380,000 or 26.32 percent. The effective cost of the loan to Michaels = 11%/(1-0.2632) = 14.93 percent. 15. Montcalm Enterprises is seeking bids on short-term loans with area banks. It expects its average outstanding borrowings to equal $320,000. Which of the following terms offers Montcalm the lowest effective rate? Town Bank: revolving credit agreement for $500,000 with a 15% APR, 0.5% commitment fee on the unused portion. Village Bank: revolving credit agreement for $400,000 with a 12% APR, 1.0% commitment fee on the unused portion and a 10% compensating balance requirement based on the size of the bank’s commitment. Town Bank’s expected cost: Interest cost = .15 x $320,000 = $48,000 Fee on unused portion= 0.005 x $180,000= $900 Total expense = $48,000 + $900 = $48,900 Effective cost = $48,900/$320,000 = 15.28% Village Bank’s expected cost: Borrowing needed to obtain $320,000 in usable funds = $320,000/(1-.1) = $355,555.55 Interest cost = .12 x $355,555.55 = $42,666.67 Fee on unused portion= 0.01 x ($400,000-$355,555.55)= $444.44 Total expense = $48,000 + $900 = $43,111.11 Effective cost = $43,111.11/$320,000 usable funds = 13.47% Conclusion: Village Bank offers Montcalm a lower financing cost. 16. Beckheart is seeking financing for its inventory. Safe-proof Warehouses offers space in their facility for Beckheart’s inventory. They offer loans with a 15-percent APR equal to 60% of the inventory. Monthly fees for the usage of the warehouse are $500 plus 0.5 percent of the inventory’s value. If Beckheart has saleable inventory of $2 million, a. How much money can the firm borrow? Amount able to borrow = 0.60 x $2 million = $1,200,000 b. What is the interest cost of the loan in dollars over a year? Interest cost = 0.15 x $1,200,000 = $180,000 c. What is the total amount of fees to be paid in a year? Monthly fee = $500 + 0.005($1,200,000) = $6,500 Annual fees = 12 x $6,500 = $78,000 d. What is the effective annual rate of using Safe-proof to finance Beckheart’s inventory? Interest cost + fees = $180,000 + $78,000 = $258,000 Effective cost = $258,000/$1,200,000 = 21.5% 17. CDRW is evaluating an inventory financing arrangement with DVD Banks. CDRW estimates an average monthly inventory balance of $800,000. DVD Bank is offering a 12 percent APR loan on 75 percent of the value of the inventory. DVD’s inventory storage and evaluation fees will be 1% a month on the total value of the inventory. What is the annual effective rate of the inventory loan? Amount needed $600,000 =0.75 x $800,000 APR 12.00% Fee 12% =1%/month x 12 months Time of loan (in days) 365 Step 1: Amount to be borrowed $600,000.00 Step 2: Interest expense $72,000.00 =.12 x $600,000 Step 3: Fees and other expenses $72,000.00 =.12 x $600,000 Step 4: Net proceeds $600,000.00 Step 5: Interest + fees $144,000.00 =$72,000 + $72,000 Net proceeds $600,000.00 Financing cost 24.00% =$144,000/$600,000 Annualized cost 24.00% =(1+0.24)^(365/365)-1 18. Which of the following offer the lowest effective rate for Wolf Howl jackets? Assume Wolf Howl will need to borrow $800,000 for 180 days. a. A 14% APR bank loan Interest cost for 180 days = 0.14 x $800,000 x (180/365) = $55,232.88 Interest as a percentage of loan = $55,232.88/$800,000= 0.069 or 6.9% Annualized rate: (1.069)365/180 – 1 = 14.5% b. A 13% APR, discounted bank loan. Interest charge = 0.13 x (180/365) = 0.0641 Need to borrow: $800,000/(1-.0641) = $854,792.17 Interest cost = 0.0641 x $854,792.17 = $54,792.18 Interest as a percentage of usable funds= $54,792.18/$800,000= 0.0685 or 6.85% Annualized rate: (1.0685)365/180 – 1 = 14.38% c. 12.5% APR with fees of 1% for receivables financing. Interest cost for 180 days = 0.125 x $800,000 x (180/365) = $49,315.07 Fees = 0.01 x $800,000 = $8,000 Interest and fee as a percentage of loan = $49,315.07+ $8,000/$800,000= 0.0716 or 7.16%. Annualized rate: (1.0716)365/180 – 1 = 15.1% d. A $2 million revolving-credit agreement with an APR of 12% with a commitment fee of 0.5% on the unused balance and a 10 percent compensating balance requirement. Borrowed funds = $800,000/(1 - .1) = $888,88.89 For 180 days, the revolver will have borrowing of $888,888.89 and an unused portion of ($2 million - $888,888.89) = $1,111,111.11. For the remaining 185 days, the unused portion equals the credit limit of $2 million. Interest cost: 0.12 x $888,888.89 x (180/365) = $52,602.73 Fees when line is drawn down: 0.005 x $1,111,111.11 x (180/365) = $2,739.73 Fees when no borrowing occurs: 0.005 x $2 million x (185/365) = $5,068.49 Total interest + fees = $60,410.95 Cost of usable funds = $60,410.95/$800,000 = 0.0755 Annualized rate: (1.0755)365/180 – 1 = 15.9% Choice: option B, 13% discounted APR loan, offers Wolf Howl the lowest effective financing rate of 14.38%. 19. Visit a firm’s website and obtain historical quarterly balance sheet information from it or from its SEC EDGAR filings (www.walmart.com and www.walgreens.com may be two good sites to use). Record quarterly balance sheet data for several years in a spreadsheet. Over time, compute and graph the firm’s financing mix (for example, by computing the ratio of current liabilities to total assets) and asset mix (by computing the ratio of current assets to total assets). What happens to the firm’s financing mix and asset mix over time? Do the financing and asset mix ratios move together over time? Are any seasonal effects in the firm’s working capital position and financing evident? What conclusions can you draw about the firm’s use of short-term financing? Answer depends on firms chosen and time frame selected. 20. Comfin Company has the following estimates on its level of current and total assets for the next two years (presented in text): a. Estimate the levels of permanent and temporary current assets for Comfin over these months. Find the average amount for fixed assets, permanent current assets, and temporary current assets in year 201X and year 201X+1. This will be a challenging, and thought-provoking problem, as there is no one way to determine the dividing line between permanent current assets and temporary current assets. One method is to graph the data series and identify a line that is tangent to the curve in one, or in two, places; the height of the line can be an estimate of permanent current assets and will show the growth in permanent current assets over time. An example of this follows. The points touching the line can be identified and a rudimentary line can be estimated (each month takes on a numerical value, with the first point of tangency being point 0, representing the y-intercept); months before it can be designated –1, -2, and so on. Months after it can be designated +1, +2, and so on. Using the coordinates of these two points, the slope of the line can be measured as difference in current asset levels________ month corresponding to second point minus zero We can use a spreadsheet to estimate each month’s level of “permanent” current asset, represented by the line, and the temporary current assets, represented by the difference between current assets and the estimate for permanent current assets. Fixed assets are computed as the difference between total and current assets. This would provide the data necessary to solve for parts b through d. A second method is simpler variation to the first, where the lowest value for current assets is identified for each of the two annual cycles and these low points are assumed to be two points representing the level of permanent current assets. These two points occur in March 201X ($199,900) and January 201X+1 ($350,000). These two points can be used to estimate a line, as described above, and the value for fixed assets, permanent current assets, and temporary current assets can be computed for each month. Still a third, and simpler, measure is a variation of the second method. Here, we treat each year separately. March 201X has the lowest value for current assets, so $199,900 is considered the value for permanent current assets during all of 201X. For the next year, $350,000 is the lowest value for current assets (in January 201X+1) so that will be considered the value for the level of permanent current assets during all of 201X+1. This method assumes during the two annual cycles that there was a “stair step” increase in the level of permanent current assets. This alternative is shown graphically below. For the remainder of this problem, we present the solution using this third measure. Year 201X Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Assets 500,000 475,000 460,000 470,000 475,000 485,000 495,000 550,000 600,000 650,000 700,000 750,000 Current Assets 250,000 220,000 199,900 204,698 204,392 208,980 213,459 262,829 307,085 351,227 395,251 439,156 Temporary Current Assets 50,100 20,100 0 4,798 4,492 9,080 13,559 62,929 107,185 151,327 195,351 239,256 Fixed Assets 250,000 255,000 260,100 265,302 270,608 276,020 281,541 287,171 292,915 298,773 304,749 310,844 Average of Current Assets 271,415 Average of Fixed Assets 279,419 Level of Permanent Current Assets 199,900 Minimum Level of Current Assets Average of Temporary Current Assets 71,515 Year 201X+1 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Assets 600,000 570,000 552,000 564,000 570,000 582,000 594,000 660,000 720,000 780,000 840,000 900,000 Current Assets 350,000 350,000 352,100 359,302 365,608 373,020 380,541 397,171 412,951 428,773 444,749 460,844 Temporary Current Assets 0 0 2,100 9,302 15,608 23,020 30,541 47,171 62,951 78,773 94,749 110,844 Fixed Assets 250,000 220,000 199,900 204,698 204,392 208,980 213,459 262,829 307,049 351,227 395,251 439,156 Average of Current Assets 389,588 Average of Fixed Assets 271,412 Level of Permanent Current Assets 350,000 Minimum Level of Current Assets Average of Temporary Current Assets 39,588 b. What average amounts of short-term and long-term financing should Comfin have during each year if it wanted to follow a maturity-matching financing strategy over time? Using the averages computed above, we have Maturity Matching financing strategy 201X 201X+1 Short term financing: 71,515 39,588 Temporary Current Assets Long term financing: 479,319 621,412 Fixed Assets + Permanent Current Assets c. What average amounts of short-term and long-term financing should Comfin have during each year if it wanted to follow an aggressive financing strategy over time? Using the averages computed in part a), we have Aggressive financing strategy 201X 201X+1 Short term financing: 271,415 389,588 Current Assets (Permanent Current Assets + Temporary Current Assets) Long term financing: 279,419 271,412 Fixed Assets d. Suppose Comfin’s cost of short-term funds is 8 percent and its cost of long-term funds in 15 percent. Use your answers in parts b) and c) to compute the cost of each strategy. Expected cost of maturity matching financing strategy 201X 201X+1 Interest rate Short term financing: $ 5,721.18 $ 3,167.06 8% Long term financing: $ 71,897.79 $93,211.76 15% Total cost $ 77,618.97 $96,378.82 Expected cost of aggressive financing strategy 201X 201X+1 Interest rate Short term financing: $ 21,713.18 $31,167.06 8% Long term financing: $ 41,912.79 $40,711.76 15% Total cost $ 63,625.97 $71,878.82 e. What are the pro and con arguments toward each strategy in terms of profitability, risk, and company liquidity? The aggressive strategy has lower costs and will therefore be more profitable. Cost advantage of aggressive over maturity matching: 201X 201X+1 Total $ 13,993.00 $ 24,500.00 $ 38,493.00 But at the risk of using more short-term financing, Greater use of short-term financing by aggressive strategy ($): 201X 201X+1 $ 199,900.00 $ 350,000.00 And as a percentage of total assets: 201X 201X+1 30.2% 53.0% which will leave the firm exposed to liquidity crises, credit crunches, and sharp increases in short-term rates. The maturity matching approach, with its greater use of long-term financing, may provide greater liquidity and access to funds in a credit crunch than if it used a large amount of short-term financing—provided its long-term financing doesn’t include excessive amounts of debt. The choice of which strategy to use depends upon sales forecasts, economic forecasts, and management’s evaluation of the risk/expected return tradeoff of these two strategies. Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288
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