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. 8-6. 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. 8-9. 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. Chapter 8 Problems 1. Cash discount (LO1) Compute the cost of not taking the following cash discounts. a. 2/10, net 40. b. 2/15, net 30. c. 2/10, net 45. d. 3/10, net 90. 8-1. Solution: a. b. c. d. 2. Cash discount decision (LO1) Regis Clothiers can borrow from its bank at 17 percent to take a cash discount. The terms of the cash discount are 3/19, net 45. 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. The cost of not taking the cash discount is greater than the cost of the loan (42.82 percent vs. 17 percent). The firm should borrow the money and take the cash discount. 3. Cash discount decision (LO1) Simmons Corp. can borrow from its bank at 17 percent to take a cash discount. The terms of the cash discount are 1.5/10, net 45. 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. The cost of not taking the cash discount is less than the cost of the loan (15.64 percent vs. 17 percent). The firm should not borrow the money to take the cash discount. 4. Effective rate of interest (LO2) Your bank will lend you $4,000 for 45 days at a cost of $50 interest. What is your effective rate of interest? 8-4. Solution: 5. Effective rate of interest (LO2) A pawnshop will lend $2,500 for 45 days at a cost of $35 interest. What is the effective rate of interest? 8-5. Solution: 6. Effective rate on discounted loan (LO2) Sol Pine borrows $5,000 for one year at 13 percent interest. What is the effective rate of interest if the loan is discounted? 8-6. Solution: Sol Pine 7. Effective rate on discounted loan (LO2) Mary Ott is going to borrow $10,400 for 120 days and pay $150 interest. What is the effective rate of interest if the loan is discounted? 8-7. Solution: Mary Ott 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 11 percent and LIBOR 1.5 percent less. Also assume there will be a $45 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: Dr. Ruth Prime rate loan (11%) LIBOR rate loan LIBOR is cheaper than prime (10.40 percent vs. 11 percent). 9. Foreign borrowing (LO2) Gulliver Travel Agencies thinks interest rates in Europe are low. The firm borrows euros at 9 percent for one year. During this time period the dollar falls 14 percent against the euro. What is the effective interest rate on the loan for one year? (Consider the 14 percent fall in the value of the dollar as well as the interest payment.) 8-9. Solution: Gulliver Travel Agencies 9% Interest 14% Decline in the dollar (increased cost in euros) 23% Total effective cost 10. Dollar cost of a loan (LO2) Talmud Book Company borrows $24,900 for 60 days at 12 percent interest. What is the dollar cost of the loan? 8-10. Solution: Talmud Book Company 11. Net credit position (LO1) McGriff Dog Food Company normally takes 27 days to pay for average daily credit purchases of $9,530. Its average daily sales are $10,680, and it collects accounts in 32 days. a. What is its net credit position? That is, compute its accounts receivable and accounts payable and subtract the latter from the former. b. If the firm extends its average payment period from 27 days to 37 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 b. Accounts receivable will remain at $341,760 Accounts payable = $9,530 × 37 = 352,610 Net credit position ($ 10,850) The firm has improved its cash flow position. Instead of extending $84,450 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $10,850 in credit. 12. Compensating balances (LO2) Maxim Air Filters Inc. plans to borrow $300,000 for one year. Northeast National Bank will lend the money at 10 percent interest and requires a compensating balance of 20 percent. What is the effective rate of interest? 8-12. Solution: Maxim Air Filters Inc. Effective rate of interest with 20% compensating balance = or 13. Compensating balances (LO2) Digital Access Inc. needs $400,000 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 9 percent on the total amount borrowed, what is the effective rate on the $400,000 actually being used? 8-13. Solution: Digital Access Inc. a. b. 14. Compensating balances and installment loans (LO2) Carey Company is borrowing $200,000 for one year at 12 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. What is the effective rate of interest? What would the effective rate be if Carey were required to make 12 equal 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: Carey Company Effective rate of interest with 20% compensating balance = Installment loan with compensating balance 15. Compensating balances with idle cash balances (LO2) Randall Corporation plans to borrow $233,000 for one year at 20 percent from the Waco State Bank. There is a 21 percent compensating balance requirement. Randall Corporation keeps minimum transaction balances of $17,500 in the normal course of business. This idle cash counts toward meeting the compensating balance requirement. What is the effective rate of interest? 8-15. Solution: Randall Corporation Effective rate of interest = 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 $23,600 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 $2,280 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 = Required compensating balance Minimum balance on deposit Additional funds needed at bank 17. Effective rate under different terms (LO2) Your company plans to borrow $13 million for 12 months, and your banker gives you a stated rate of 24 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 24 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 b. Discounted interest c. An installment loan with 12 payments d. Discounted interest with a 5% compensating balance 18. Effective rate under different terms (LO2) If you borrow $5,300 at $400 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. $400/$5,300 = 7.55% Use formula 8-6 for b, c, and d. Rate on installment loan = b. (2 × 2 × $400)/(3 × $5,300) = $1,600/$15,900 = 10.06% c. (2 × 4 × $400)/(5 × $5,300) = $3,200/$26,500 = 12.08% d. (2 × 12 × $400)/(13 × $5,300) = $9,600/$68,900 = 13.93% 19. Effective rate under different terms (LO2) Zerox Copying Company plans to borrow $172,000. New Jersey National Bank will lend the money at one-half percentage point over the prime rate at the time of 17½ percent (18 percent total) and requires a compensating balance of 21 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: Zerox Copying Company Effective rates of interest with compensating balance First determine interest 17½% (prime rate) + ½% = 18% 18% $172,000 $30,960 Then determine the rate Effective rate of interest with compensating balance and four quarterly payments. 20. Installment loan for multiyears (LO2) Lewis and Clark Camping Supplies Inc. is borrowing $51,000 from Western State Bank. The total interest is $15,700. 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 = 21. Cash discount under special circumstance (LO2) Mr. Hugh Warner is a very cautious businessman. His supplier offers trade credit terms of 3/15, net 85. Mr. Warner never takes the discount offered, but he pays his suppliers in 75 days rather than the 85 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 In this problem, Mr. Warner has the use of funds for 60 extra days (75 – 15), instead of 70 extra days allowed by the credit terms (85 – 15). Mr. Warner’s suppliers are offering terms of 3/15, net 85. Mr. Warner is effectively accepting terms of 3/15, net 75. If he took the full 85 days to pay, his cost of not taking the discount would be 15.89 percent. 22. Bank loan to take cash discount (LO1 and 2) The Reynolds Corporation buys from its suppliers on terms of 3/17, net 45. Reynolds has not been utilizing the discounts offered and has been taking 45 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 16 percent. The bank requires a 27 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: Reynolds Corporation Effective rate of interest with a 27 percent compensating balance requirement: = Interest rate/(1 – C) = 16%/(1 – .27) = 16%/(.73) = 21.92% The effective cost of the loan, 21.92 percent, is less than the cost of passing up the discount, 39.74 percent. Reynolds Corporation should borrow funds from the bank and pay the invoice early in order to take advantage of the discount. 23. Bank loan to take cash discount (LO1 and 2) The Reynolds Corporation buys from its suppliers on terms of 3/17, net 45. Reynolds has not been utilizing the discounts offered and has been taking 45 days to pay its bills. Mr. Duke, Vice President of Reynolds Corporation, 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 16 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? 8-23. Solution: Reynolds Corporation Effective rate of interest with a 20 percent compensating balance requirement: The answer now changes. The effective cost of the loan, 20.00 percent, is less than the cost of passing up the discount, 39.74 percent. Reynolds Corporation should borrow the funds and pay early to take the discount. 24. Bank loan to take cash discount (LO1 and 2) Neveready Flashlights Inc. needs $340,000 to take a cash discount of 3/17, net 72. A banker will loan the money for 55 days at an interest cost of $10,400. 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 72 days instead of 17 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 $340,000? e. What would be the effective interest rate in part d if the interest charge for 55 days were $13,000? Should the firm borrow with the 20 percent compensating balance? (The firm has no funds to count against the compensating balance requirement.) 8-24. Solution: Neveready Flashlights, Inc. a. b. c. Yes, because the cost of borrowing is less than the cost of losing the discount. d. 8-24. (Continued) e. 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 and 2) Harper Engine Company needs $631,000 to take a cash discount of 2.5/20, net 75. A banker will loan the money for 55 days at an interest cost of $13,300. 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 75 days instead of 20 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 $631,000? e. What would be the effective interest rate in part d if the interest charge for 55 days were $10,100? Should Harper borrow with the 10 percent compensating balance? (There are no funds to count against the compensating balance requirement.) 8-25. Solution: Harper Engine Company a. b. c. Yes, because the cost of borrowing is less than the cost of losing the discount. d. e. Yes, because the cost of borrowing is less than the cost of losing the discount. 26. Competing terms from banks (LO2) Summit Record Company is negotiating with two banks for a $151,000 loan. Fidelity Bank requires a 28 percent compensating balance, discounts the loan, and wants to be paid back in four quarterly payments. Southwest Bank requires a 14 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 10 percent. Compensating balances will be subtracted from the $151,000 in determining the available funds in part a. a. Calculate the effective interest rate for Fidelity Bank and Southwest Bank. Which loan should Summit accept? b. Recompute the effective cost of interest, assuming that Summit ordinarily maintains $42,280 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 Southwest Bank Choose Southwest Bank since it has the lowest effective interest rate. 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 Southwest Bank 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. 27. Accounts receivable financing (LO1) Charmin Paper Company sells to the 12 accounts listed next. Account Receivable Balance Outstanding Average Age of the Account over the Last Year A $ 60,800 22 B 168,000 43 C 78,300 19 D 24,300 55 E 58,900 42 F 238,000 39 G 30,400 16 H 374,000 72 I 41,400 32 J 96,500 58 K 292,000 17 L 67,700 37 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 15.5 percent, and Capital charges 4.5 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 $ 60,800 C 78,300 G 30,400 K 292,000 Total 461,500 Loan % 90% Loan $415,350 31–40 days Amount F $ 238,000 I 41,400 L 67,700 Total $ 347,100 Loan% 80% Loan $ 277,680 41–45 days Amount B $168,000 E 58,900 Total $226,900 Loan % 70% Loan $158,830 Maximum Loan = $415,350 + $277,680 + $158,830 = $851,860 b. Loan balances $ 851,860 Interest, 20% annual (15.5% prime 4.5%) (1.67%) 1.67% per month One month’s interest $ 14,226.06 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 $138,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 13.3 percent. If they increase to 14.5 percent, assume the value of the contracts will go down by 5 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 $53,000. 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 14.5 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 $53,000? What percent of this $53,000 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) $138,000 Purchase price, December Treasury bond contract (5% price decline) .95 × $138,000 = 131,100 Gain per contract $ 6,900 Number of contracts 5 Profit on futures contracts $ 34,500 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 $53,000 Profit from hedging 34,500 Net cost $18,500 The net cost is 34.91 percent. This means 65.09 percent 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. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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