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CHAPTER 27—PROVIDING AND OBTAINING CREDIT
TRUE/FALSE
1. The credit period is the amount of time it takes to do a credit search on a potential customer.
2. Credit standards refer to the financial strength and importance of a potential customer to the firm
required in order to qualify for credit.
3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing
business.
4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket
expenses.
5. Cash discounts are mostly used to get new customers in the door since existing customers almost
always use the delayed payment terms.
6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from
additional sales with the lost revenues from the discount.
7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are
paying more slowly.
8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying
more slowly, because it is unaffected by seasonal changes in sales.
9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount
of time customers take to pay remains unchanged.
10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are,
on average, paying more slowly, because it is unaffected by seasonal changes in sales.
11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount
of remaining receivables from each month in that quarter by that month's sales.
MULTIPLE CHOICE
1. A firm's credit policy consists of which of the following items?
a.
Credit period, cash discounts, credit standards, collection policy.
b.
Credit period, cash discounts, receivables monitoring, collection policy.
c.
Cash discounts, credit standards, receivables monitoring, collection policy.
d.
Credit period, receivables monitoring, credit standards, collection policy.
e.
Credit period, cash discounts, credit standards, receivables monitoring.
2. Which of the following is not correct?
a.
A more aggressive collection policy will reduce bad debt expenses, but may also decrease
sales.
b.
Collection policy usually has little impact on sales since collecting past-due accounts
occurs only after the customer has already purchased.
c.
Typically a firm will turn over an account to a collection agency only after it has tried
several times on its own to collect the account.
d.
A lax collection policy will frequently lead to an increase in accounts receivable.
e.
Collection policy is how a firm goes about collecting past-due accounts.
3. Which of the following is not correct for a firm with seasonal sales and customers who all pay
promptly at the end of 30 days?
a.
The quarterly uncollected balances schedule will be the same in each quarter.
b.
The level of accounts receivable will be constant from month to month.
c.
The ratio of accounts receivable to sales will vary from month to month.
d.
The level of accounts receivable at the end of each quarter will be the same.
e.
DSO will vary from month to month.
4. Which of the following statements is most correct?
a.
It is possible for a firm to overstate profits by offering very lenient credit terms which
encourage additional sales to financially "weak" firms. A major disadvantage of such a
policy is that it is likely to increase uncollectible accounts.
b.
A firm with excess production capacity and relatively low variable costs would not be
inclined to extend more liberal credit terms to its customers than a firm with similar costs
that is operating close to capacity.
c.
Firms use seasonal dating primarily to decrease their DSO.
d.
Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the
original sale took place on February 1st, the customer can take the discount up until March
15th, but must pay the net invoice amount by April 1st.
e.
If credit sales as a percentage of a firm's total sales increases, and the volume of credit
sales also increases, then the firm's accounts receivable will automatically increase.
5. Which one of the following aspects of banks is considered most relevant to businesses when choosing
a bank?
a.
Competitive cost of services provided.
b.
Size of the bank's deposits.
c.
Experience of personnel.
d.
Loyalty and willingness to assume lending risks.
e.
Convenience of location.
6. Refer to Exhibit 27.1. How large are your brother's monthly payments?
a.
$6,250
b.
$7,000
c.
$7,500
d.
$5,250
e.
$6,875
7. Refer to Exhibit 27.1. What is the nominal annual add-on interest rate on this loan?
a.
10.00%
b.
16.47%
c.
18.83%
d.
20.00%
e.
24.00%
8. Suppose that you're planning a vacation and borrow $2,000 from a bank for one year at a stated annual
interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank
requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What
effective annual interest rate are you being charged?
a.
14.00%
b.
8.57%
c.
16.28%
d.
21.21%
e.
28.00%
9. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after
it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly
continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11
percent discount interest loan with a 20 percent compensating balance four times annually. What is the
effective annual interest rate of these discount loans?
a.
11.00%
b.
15.94%
c.
11.46%
d.
13.75%
e.
12.72%
10. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent "add-on", one-year installment
loan, payable in four equal quarterly payments. What is the effective annual rate of interest?
a.
9.50%
b.
10.19%
c.
15.99%
d.
16.98%
e.
20.38%
11. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-
month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual
rate (EAR) of this loan?
a.
16.22%
b.
17.97%
c.
17.48%
d.
18.67%
e.
18.00%
12. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request
for a $75,000, 1-year loan.
Alternative 1:
7 percent discount interest, with a 10 percent compensating balance.
Alternative 2:
8 percent simple interest, with interest paid monthly.
What is the effective annual rate on the cheaper loan?
a.
8.00%
b.
7.23%
c.
7.67%
d.
8.43%
e.
8.30%
13. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank
offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment
loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent
discounted loan?
a.
10.7%
b.
12.0%
c.
12.5%
d.
13.6%
e.
14.1%
14. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its
organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11
percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be
the face value of the note?
a.
$111,000
b.
$100,000
c.
$112,360
d.
$89,000
e.
$108,840
15. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm
receives payment from its harvests sometime after shipment. Due in part to the firm's rapid growth, it
has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent
discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value
of each note?
a.
$61,856
b.
$67,531
c.
$60,000
d.
$68,182
e.
$67,423
16. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the
choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan,
payable in 4 equal quarterly payments. What is the approximate (nominal) rate of interest on the 10.19
percent add-on loan?
a.
5.10%
b.
10.19%
c.
12.00%
d.
20.38%
e.
30.57%
17. Refer to Exhibit 27.2. What would be the incremental bad losses if the change were made?
a.
$315,000
b.
$260,500
c.
−$260,500 (bad debt losses would decline)
d.
−$315,000 (Bad debt losses would decline)
e.
$0 (no change would occur)
18. Refer to Exhibit 27.2. What would be the incremental cost of carrying receivables if this change were
made?
a.
$108,750
b.
−$116,250 (carrying costs would decline)
c.
$157,900
d.
−$225,000 (carrying costs would decline)
e.
$260,500
19. Refer to Exhibit 27.2. What are the incremental pre-tax profits from this proposal?
a.
$181,250
b.
$271,750
c.
$256,250
d.
$206,500
e.
$231,250
20. Refer to Exhibit 272.3. What would be the cost to Van Doren of the discounts taken?
a.
$116,750
b.
−$108,750
c.
$155,000
d.
$225,000
e.
$260,500
21. Refer to Exhibit 27.3. What would be the incremental bad debt losses if the change were made?
a.
$130,000
b.
$250,000
c.
−$250,000 (bad debt losses would decline)
d.
−$130,000 (bad debt losses would decline)
e.
$620,000
22. Refer to Exhibit 27.3. What would be the incremental cost of carrying receivables if the change were
made?
a.
−$108,750 (carrying costs would decline)
b.
$116,250
c.
$157,900
d.
−$225,000 (carrying costs would decline)
e.
$260,000
23. Refer to Exhibit 27.3. What are the incremental pre-tax profits from this proposal?
a.
$283,750
b.
$250,500
c.
$303,250
d.
$493,750
e.
$288,250
24. Darren's Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20.
Currently, Darren takes the discount, but she believes she could extend the payment to 40 days without
any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to
support an expansion of fixed assets. This amount could be raised by making greater use of trade credit
or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest.
Additionally, the bank requires an average compensating balance of 20 percent of the loan amount.
Darren already has a commercial checking account at this bank that could be counted toward the
compensating balance, but the required compensating balance amount is twice the amount that Darren
would otherwise keep in the account. Which of the following statements is most correct?
a.
The cost of using additional trade credit is approximately 36 percent.
b.
Considering only the explicit costs, Darren should finance the expansion with the bank
loan.
c.
The cost of expanding trade credit using the approximation formula is less than the cost of
the bank loan. However, the true cost of the trade credit when compounding is considered
is greater than the cost of the bank loan.
d.
The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent
because Darren would hold a cash balance of one-half the compensating balance amount
even if the loan were not taken.
e.
If Darren had transaction balances that exceeded the compensating balance requirement,
the effective cost of the bank loan would be 12.00 percent.
25. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three
choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily
compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two
loans would require a single payment at the end of the year, the third would require 12 equal monthly
payments beginning at the end of the first month. What is the difference between the highest and
lowest effective annual rates?
a.
1.12%
b.
2.48%
c.
3.60%
d.
4.25%
e.
5.00%
26. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days.
The financial manager estimates that offering longer credit terms would (1) increase the days sales
outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2
percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old
sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent
receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its
credit period?
a.
−$20,000
b.
−$10,000
c.
$0
d.
$10,000
e.
$20,000
27. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a
12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4
equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan?
a.
9.50%
b.
10.19%
c.
15.22%
d.
16.99%
e.
22.05%
