Chapter 16
Current Liabilities Management
Instructor’s Resources
Overview
This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability,
and risk in managing the firm’s current liability accounts. The management of current liabilities requires
choosing appropriate levels of financing and involves tradeoffs between risk and profitability. This chapter also
reviews sources of secured and unsecured short-term financing, including the role of international loans.
Spontaneous sources, such as accounts payable and accruals, are differentiated from negotiated bank sources, such
as lines of credit. The cash discount offered on accounts payable and the cost of forgoing such discounts are
described. Secured sources include bank and commercial finance company loans, backed by collaterals such as
inventory or accounts receivable. Whether borrowing funds as a manager or for their own personal use, effective
management of current liabilities is essential, making Chapter 16 relevant at the professional and personal levels.
Suggested Answer to Opener-in-Review Question
In the chapter opener you learned about FastPay, a company that lends to online ad publishers based on
advertising receivables. Suppose that you are running a business that relies on online ad revenues. Typically
it takes 60 days to collect from your customers and convert receivables into cash. FastPay offers you
$150,000 in cash in exchange for the right to collect $155,000 in receivables from a particular customer. You
have a bank line of credit that allows you to borrow on a short-term basis at an annual interest rate of 7%.
Should you borrow on the credit line or accept the offer from FastPay?
In the FastPay arrangement, you are essentially borrowing $150,000 and paying back $155,000 (the principal plus
Answers to Review Questions
1. The two major sources of spontaneous short-term nancing (nancing that arises from the normal operang cycle) are
2. There is no coststated or unstatedassociated with taking a cash discount; there is a cost of giving up a cash discount.
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3. Stretching accounts payable is the process of delaying the payment of accounts payable for as long as possible without
4. The prime rate of interest, which is the lowest rate charged on business loans to the best business borrowers, is usually
5. The eecve interest rate is the actual rate of interest paid for the period. The calculaon of this rate depends on
6. A single-payment note is an unsecured loan from a commercial bank. It usually has a short maturity30 to 90 daysand
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10. Internaonal transacons di1er from domesc ones because they involve payments made or received in a foreign
currency. This results in addional foreign costs and also exposes the company to foreign exchange risk.
11. Lenders view secured and unsecured short–term loans as having the same degree of risk. The benet of the collateral
12. The interest rate charged on secured short–term loans is typically higher than the interest rate on unsecured short-term
13. a. A pledge of accounts receivable is the use of a rm’s receivables to secure a short-term loan. The lender evaluates
the quality of the accounts receivable, selects acceptable accounts, and les a lien on the collateral. ACer the
b. Factoring accounts receivable is the outright sale to the factor or other financial institution. The factor
14. a. Floang inventory liens are made by lenders and secured by a claim on general inventory consisng of a diversied
b. Trust receipt inventory loans are often made by manufacturers’ financing subsidiaries to their customers.
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c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged collateral.
Suggested Answer to Focus on Ethics Box: Accruals Management
Why might financial managers still be tempted to manage earnings when a clawback is legitimate
possibility?
If financial managers are unlikely to get caught and punished, the expected (positive) payoff from their actions
Suggested Answer to Focus on Practice Box: The Ebb and Flow of
Commercial Paper
What factors would contribute to an expansion of the commercial paper market? What factors would cause
a contraction in the commercial paper market?
Commercial paper is issued based on the full faith and credit of the company issuing the paper. That is why only
Answers to Warm-Up Exercises
E16-1. Cash discount and the simplified formula
Answer: Payment required if taking the cash discount $25,000 0.97 $24,250
E16-2. Managing accruals
E16-3. Effective annual interest rate
Answer: Discount loan
Interest paid at maturity
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E16-4. Effective annual interest rate
E16-5. Commercial paper interest rate
Solutions to Problems
P16-1. Payment dates
LG 1; Basic
P16-2. Cost of giving up cash discount
LG 1; Basic
P16-3. Credit terms
LG 1; Basic
b. 45 days
c.
CD 365
Cost of giving up cash discount 100% CD N
= ´
–
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1% 365
Cost of giving up cash discount 100% 1% 30
Cost of giving up cash discount 0.0101 12.17 0.1229 12.29%
= ´
–
= ´ = =
2% 365
Cost of giving up cash discount 98% (49 10)
Cost of giving up cash discount 0.0204 9.359 0.1909 19.09%
= ´ –
= ´ = =
Cost of giving up cash discount = [0.02 / (0.1 – 0.02)] = 0.0204 × 17.38 = 0.3545 = 35.46%
2% 365
Cost of giving up cash discount
100% 2% 21
= ´
–
Cost of giving up discount 20.204 17.38 0.3546 35.46%= ´ = =
1% 365
Cost of giving up cash discount 100% 1% (79 10)
Cost of giving up cash discount 0.0101 5.2899 0.0534 5.34%
= ´
– –
= ´ = =
d. For the first three purchases the firm would be better off to borrow the funds and take the discount.
P16-4. Cash discount versus loan
LG 1; Basic
P16-5. Personal finance: Borrow or pay cash for an asset
LG 2; Intermediate
a. Calculate the down payment on the loan
b. Calculate the monthly payment on the loan
c. Cash price of dining room set
This is the marginal amount of money needed
$ 3,000
d. Earnings on savings
5.20%
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e. Opportunity cost
$ 267
f. Cost of the financing alternative (24 $117.25)
$ 2,814
P16-6. Cash discount decisions
LG 1, 2; Intermediate
a. Approximate cost of giving up discount from each supplier:
b. The firm should take the discounts offered by suppliers J, K, and M because passing those up means
c. The new implicit interest rate for supplier M would be: 3% × (365 / 110) = 9.95%
P16-7. Changing payment cycle
LG 2; Basic
P16-8. Spontaneous sources of funds, accruals
LG 2; Intermediate
P16-9. Cost of bank loan
LG 3; Intermediate
P16-10. Personal finance: Unsecured sources of short-term loans
LG 3; Challenge
a. Fixed-rate loan
b. Variable-rate loan
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P16-11. Effective annual rate
LG 3; Basic
P16-12. Compensating balances and effective annual rates
LG 3; Intermediate
a. Compensating balance requirement $800,000 borrowed 15%
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b. If Weathers became a regular customer of State Bank and kept its normal deposits at the bank, then
P16-14. Integrative—comparison of loan terms
LG 3; Challenge
b. Effective annual interest rate
[$2,000,000 (0.08 0.028) (0.005 $2,000,000)] 14.125%
($2,000,000 0.80)
´ + + ´ =
´
c. The revolving credit account seems better because the cost of the two arrangements is the same; with
a revolving loan arrangement, the loan is committed.
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