978-0134476308 Chapter 15

Chapter 15

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 15 relevant at the professional and personal levels.

 Answers to Review Questions

1. The two major sources of spontaneous short-term financing (financing that arises from the normal operating

cycle) are accounts payable and accruals. Both of these sources are spontaneous because they increase and

2. There is no cost⎯stated or unstated⎯associated with taking a cash discount; there is a cost of giving up a

cash discount. By giving up a cash discount, the purchaser pays the full price for merchandise but can make

3. Stretching accounts payable is the process of delaying the payment of accounts payable for as long as

4. The prime rate of interest is a rate charged on business loans to creditworthy business borrowers. It is usually

used by lenders as a base rate. Lenders add a premium to that base rate that depends on the borrower’s credit

11. Lenders view secured and unsecured short-term loans as having the same degree of default risk. The benefit

12. The interest rate charged on secured short-term loans is typically higher than the interest rate on unsecured

short-term loans. Typically, companies that require secured loans may not qualify for unsecured debt, and

13. a. A pledge of accounts receivable is the use of a firm’s receivables to secure a short-term loan. The lender

evaluates the quality of the accounts receivable, selects acceptable accounts, and files a lien on the

collateral. After the selection of accounts, the lender determines the percentage advanced against

receivables. Typically ranging from 50% to 90% of the face value of the acceptable receivables, this

14. a. Floating inventory liens are made by lenders and secured by a claim on general inventory consisting of a

diversified and low-cost group of merchandise. Generally less than 50% of the book value of the average

inventory is advanced. The interest charge on a floating lien is typically 3% to 5% above the prime rate.

b. Trust receipt inventory loans are often made by manufacturers’ financing subsidiaries to their customers.

Under this arrangement, merchandise is typically expensive (automotive, industrial and consumer-

durable equipment, for example) and remains in the hands of the borrower. The lender advances 80% to

100% of the cost of the salable inventory. The borrower is free to sell the merchandise and is trusted to

remit the loan amount plus accrued interest to the lender immediately. The interest charge is generally

2% or more above the prime rate.

c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged

collateral. The inventory may be retained by the borrower in the firm’s warehouse with security

administered by a field warehousing company, or it may be stored in a terminal warehouse located in the

geographic vicinity of the borrower. Generally, less than 75% to 90% of the collateral’s value is

advanced to the borrower at an interest rate from 4% to 8% above the prime rate.

324 Zutter/Smart • Principles of Managerial Finance Brief, Eighth Edition

 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?

E15-1. Cash discount and the simplified formula

E15-2. Managing accruals

E15-3. Effective annual interest rate

E15-4. Effective annual interest rate

E15-5. Commercial paper interest rate

P15-1. Payment dates

LG 1; Basic

P15-2. Cost of giving up cash discount

LG 1; Basic

a. (0.02 ÷ 0.98) × (365 ÷ 20) = 37.24%

P15-3. Credit terms

LG 1; Basic

a. 1/15 net 45 date of invoice

2/10 net 30 EOM

2/7 net 28 date of invoice

P15-4. Cash discount versus loan

LG 1; Basic

P15-5. Personal finance: Borrow or pay cash for an asset

LG 2; Intermediate

a. Calculate the down payment on the loan

Loan principal

$ 14,500

N

$780.48)

e. Opportunity cost

N

et initial cash outlay

$ 780.48

$ 11,100

P15-6. Cash discount decisions

LG 1, 2; Intermediate

a. Approximate cost of giving up discount from each supplier:

J: 1% × (365/25) = 14.6%; or the more precise calculation is (1/99) × (365/25) = 14.75%

P15-7. Changing payment cycle

LG 2; Basic

P15-8. Spontaneous sources of funds, accruals

P15-9. Cost of bank loan

LG 3; Intermediate

P15-10. Personal finance: Unsecured sources of short-term loans

LG 3; Challenge

a. Fixed-rate loan

Interest expense = loan amount × (prime rate + percent over prime) × (loan period ÷ 365)

P15-11. Effective annual rate

LG 3; Basic

Because this is a discount loan, interest is essentially paid up front. Given that the interest rate is 6%,

P15-12. Compensating balances and effective annual rates

LG 3; Intermediate

a. Compensating balance requirement = $800,000 borrowed × 15%

= $120,000

P15-13. Compensating balance versus discount loan

LG 3; Intermediate

a. State Bank interest = $150,000 × 0.09 × 6/12 / ($150,000 – ($150,000 × 0.10)) =

$6,750 / $135,000 = 5.00 %

P15-14. Integrative—comparison of loan terms

LG 3; Challenge

P15-15. Cost of commercial paper

LG 4; Intermediate

−=

P15-16. Accounts receivable as collateral

LG 5; Intermediate

a. Acceptable accounts receivable

Customer Amount

1. Amount required: $2,500,000 short term and $1,000,000 long term

1. Amount required: $7,000,000 long term and $0 short term

1. Calculation of short-term requirements

Month

(1)

Total Funds

Requirements

(2)

Permanent

Requirements

Seasonal

Requirements

January $1,000,000 $3,000,000 $0

February 1,000,000 3,000,000 0

Monthly average: Permanent = $3,000,000

Seasonal = $1,166,667 (sum of seasonal requirements ÷ 12)

Seasonal = $1,166,667 (14,000,000 ÷ 12)

2. Cost: (10% × $1,166,667) + (14% × $3,000,000) = $536,667

b. Net working capital = current assets − current liabilities

expensive long-term financing, it is the most expensive ($980,000) and the least profitable. It is the lowest-

risk strategy, however, reserving short-term financing for emergencies. The high level of working capital also

reduces risk.

The tradeoff strategy falls between the two extremes in terms of both profitability and risk. The cost

($536,667) is higher than the aggressive strategy because the permanent funds requirement of $3,000,000 is

financed with more costly long-term funds. In five months (January, February, March, November, and

December), the company pays interest on unneeded funds. The risk is less than with the aggressive strategy;

Note: Other recommendations are possible, depending on the student’s risk preference. Of course, the student

should present sound reasons for his or her choice of strategy.

d. 1. Effective interest, line of credit:

2. Effective interest, revolving credit agreement:

Cost of borrowing:

12.92%

==

12.92%) by using the line of credit. The only negative is that if Third National lacks loanable funds, Kanton

may not be able to borrow the needed funds. Under the revolving credit agreement, funds availability would