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16.3 Secured sources of short-term loans
1) A floating inventory lien is a lender's claim on the borrower's general inventory as collateral for a
secured loan.
2) Secured short-term financing has specific assets pledged as collateral.
3) The security agreement is an agreement between the borrower and the lender that specifies the
collateral held against a secured loan.
4) Fixed assets are the most desirable short-term-loan collateral since they normally have a longer life, or
duration, than the term of the loan.
5) Lenders recognize that holding collateral can reduce losses if the borrower defaults, but the presence of
collateral has no impact on the risk of default.
6) Commercial finance companies are lending institutions that make only unsecured loans-both short-
term and long-term—to businesses.
7) Commercial finance companies usually charge a higher interest on secured short-term loans than
commercial banks because the finance companies generally ends up with higher-risk borrowers.
8) The interest rate charged on secured short-term loans is always equal to the rate on unsecured short-
term loans.
9) The outright sale of accounts receivable at a discount in order to obtain funds is called pledging
accounts receivable.
10) One advantage of factoring accounts receivable is the ability it gives a firm to turn accounts receivable
immediately into cash without having to worry about repayment.
11) The higher cost of unsecured as opposed to secured borrowing is due to the greater risk of default.
12) Factoring accounts receivable is not a form of secured short-term borrowing. It entails the sale of
accounts receivable at a discount to obtain the required short-term funds.
13) Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer
whose account has been pledged as collateral is not notified.
14) Pledges of accounts receivable are never made on a notification basis because the lender does not trust
the borrower to collect the pledged account receivable and remit these payments as they are received.
15) Nonrecourse basis is the basis on which accounts receivable once sold to a factor, the factor accepts all
the credit risks on the purchased accounts.
16) The percentage advanced by a lender constitutes the principal of a secured loan and varies according
to the type and liquidity of the collateral.
17) The pledging cost of accounts receivable is normally 1 to 4 percent above the prime rate.
18) In pledging accounts receivable, the percentage advanced against the adjusted collateral is
determined by the borrower based on its overall evaluation on the quality of the acceptable receivables
and the expected cost of the liquidation.
19) Factoring accounts receivable is relatively an inexpensive source of unsecured short-term funds.
20) Factoring accounts receivable is relatively an expensive source of unsecured short-term funds.
21) Factoring accounts receivable is relatively an inexpensive source of unsecured short-term funds that
allows firms to turn accounts receivable immediately into cash.
22) Factoring accounts receivable is relatively an expensive source of secured short-term funds that
allows firms to turn accounts receivable immediately into cash.
23) Collateral is typically required for a ________.
A) secured short-term loan
B) line of credit
C) short-term, self-liquidating loan
D) single-payment note
24) An appropriate collateral for a secured short-term loan is ________.
A) fixed assets
B) accounts receivables
C) common stock in a privately-held corporation
D) bank over-draft
25) Financing that matures in one year or less and has specific assets pledged as collateral is called
________.
A) unsecured long-term financing
B) unsecured short-term financing
C) secured short-term financing
D) secured long-term financing
26) Lenders of secured short-term funds prefer collateral ________.
A) as it reduces the risk of default
B) that are illiquid assets
C) to reduce the losses if the borrower defaults
D) so that they can charge a higher interest rate
27) ________ involves the sale of accounts receivable.
A) Trust receipt loan
B) Factoring
C) Field warehouse arrangement
D) Pledging of accounts receivable
28) A ________ agreement normally states the exact conditions and procedures for the purchase of an
account.
A) factoring
B) pledging accounts receivable
C) revolving credit
D) line of credit
29) The stated cost of a pledge of accounts receivable is normally ________ above the prime rate.
A) 6 to 8 percent
B) 1 to 4 percent
C) 4 to 9 percent
D) 6 to 10 percent
30) Which of the following is a disadvantage of factoring?
A) ensures an uneven pattern of cash flows
B) eliminates credit and collection departments
C) turns accounts receivable into cash quickly
D) highly expensive source of short-term financing
31) Which of the following creates a secured short-term loan with accounts receivable?
A) lines of credit
B) commercial paper
C) pledge of accounts receivable
D) factoring of accounts receivable
32) The primary source of secured short-term loans to businesses are ________.
A) commercial banks and commercial finance companies
B) lines of credit and revolving lines of credit
C) commercial paper dealers and investment bankers
D) life insurance companies and government securities brokers
33) Pledges of accounts receivable are made on ________ basis, respectively.
A) a nonrecourse and a notification
B) a nonnotification and a notification
C) a notification and a recourse
D) a notification and a nonrecourse
34) Which of the following is an advantage of factoring?
A) accounts receivable immediately turned into cash
B) addition of credit and collection departments
C) less costly form of secured short-term loans
D) improves current ratio
35) Lenders recognize that by having an interest in collateral they can reduce losses if the borrowing firm
defaults, ________.
A) and the presence of collateral reduces the risk of default
B) but the presence of collateral has no impact on the risk of default
C) therefore lenders prefer to lend to customers from whom they are able to demand collateral
D) therefore lenders will impose a higher interest rate on unsecured long-term borrowing
36) Aunt Tilly's Feeds, Inc. is considering obtaining funding through advances against receivables. Total
annual credit sales are $600,000, terms are net 30 days, and payment is made on an average of 30 days.
Western National Bank will advance funds under a pledging arrangement for 13 percent annual interest.
On average, 75 percent of credit sales will be accepted as collateral. Commodity Finance offers factoring
on a nonrecourse basis for a 1 percent factoring commission, charging 1.5 percent per month on advances
and requiring a 15 percent factor's reserve. Under this plan, the firm would factor all accounts and close
its credit and collections department, saving $10,000 per year.
(a) What is the effective interest rate and the average amount of funds available under pledging and
under factoring?
(b) Which plan do you recommend? Why?
37) A trust receipt inventory loan is an arrangement in which the lender receives control of the pledged
inventory collateral, which is stored by a designated agent.
38) Inventory is more attractive than accounts receivable as a short-term collateral since it normally has a
market value greater than its book value, which is used to establish its value as collateral.
39) A floating inventory lien is most attractive when the firm has a stable level of inventory that consists
of a diversified group of relatively inexpensive merchandise.
40) Under the floating inventory lien, the borrower is free to sell the merchandise and is expected to remit
the amount lent against each item, along with accrued interest, to the lender immediately after the sale.
The lender then releases the lien on the appropriate item.
41) Appropriate collateral for a loan secured under a floating inventory lien is ________.
A) cars
B) granite slabs
C) air conditioners
D) paper clips
42) Appropriate collateral for a loan secured under a trust receipt inventory loan is ________.
A) drill bits
B) pencils
C) vehicles
D) bolts
43) A terminal warehouse is ________.
A) a warehouse located beyond city limits for storing the merchandise
B) a warehouse on the borrower's premises to store the merchandise
C) a central warehouse storing the merchandise of various customers
D) a warehouse located near the lender's home for storing the merchandise
44) A field warehouse is ________.
A) a warehouse outside the metropolitan area
B) a warehouse on the borrower's premises
C) a central warehouse storing the merchandise of several businesses
D) a warehouse located near the lender
45) Discuss and contrast the three types of loans discussed in the text that use inventory as collateral:
floating inventory liens, trust receipt inventory loans, and warehouse receipt loans.
