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105
© Pearson Education Limited 2008
Short-Term Financing
Creditors have better memories than debtors, and
creditors are a superstitious sect—great observers of set
days and times.
BENJAMIN FRANKLIN
Chapter 11: Short-Term Financing
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© Pearson Education Limited 2008
ANSWERS TO QUESTIONS
1. Trade credit from suppliers is spontaneous because there is no formal negotiation for the
2. The reasons trade credit from suppliers is used to finance temporary working capital are as
follows:
a. Firms may be erroneously calculating the cost of this financing for, say, 60 days
3. Stretching payables creates problems for suppliers, since their ability to forecast cash flows
is substantially impaired. The more uncertain the cash projections, the higher the level of
4. The firm could expect its liquidity to be improved. The cost to the firm’s customers of not
taking cash discounts has risen drastically (from 9.3% to 37.2%). Thus, customers will tend
5. There is far less ability to change the amount of financing provided by accrued expenses
6. The rate on commercial paper is lower than the prime rate, since the high quality borrower,
who is able to issue commercial paper, can get the prime rate at the bank. Lenders can buy
7. The commercial paper market is not available to all firms. Also, the market is very
8. For the most part, commercial paper is restricted to large, high quality industrial companies,
9. While both represent money market, short-term instruments, a bankers’ acceptance has a
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
10. A line of credit is an informal lending arrangement, usually for one year, where the bank
expresses a willingness to lend up to some specified amount of funds at an interest rate
related to the prime rate or to the bank’s cost of funds. A revolving credit agreement is a
11. Because interest is subtracted from the amount advanced, a discount note has a higher
12. The quality of the borrower and its cash flow ability to service debt, largely determine
13. The percentage advanced depends on the marketability of the collateral, the synchronization
14. The analysis should be on the basis of costs and benefits. Typically, the factoring
arrangement will be more costly as a method of financing. However, the sale of receivables
16. a. Industries whose products are relatively standard, easily disposed of, and physically
b. Smaller, undercapitalized firms, frequently resort to accounts receivable assignment or
c. Due to capital market restrictions, international companies may seek to raise funds
d. Trust receipt loans are used frequently in the automotive industry, because it relieves
Chapter 11: Short-Term Financing
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17. In determining an appropriate composition of short-term financing, such things as the
relative cost of funds, the availability of different types of financing, whether or not the type
SOLUTIONS TO PROBLEMS
1. a. Mr. Blunder is confusing the percentage cost of using funds for five days with the cost
c. Assuming the firm has made the decision not to take the cash discount, it makes no
2.
Alt. #1: Discount in $ or Alt. #2: Discount as %
a. ($5/$495) (365/10) = 36.9% (1/99) (365/10) = 36.9%
3. No. Assume credit terms of “2/10, net 30.” For a $100 invoice, the annual interest cost
would be:
For a $500 invoice, the annual cost would be the same:
4.
Alt. #1: Discount in $ or Alt. #2: Discount as %
a. ($5/$495) (365/20) = 18.4% (1/99) (365/20) = 18.4%
• The major advantage of stretching is the substantial reduction effected in annual interest
cost.
• The major disadvantages of stretching are the cost of the cash discount foregone and the
possible deterioration in credit rating.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
5. a. ($5,000,000) (0.60) (0.10) = $300,000 in interest
b. $310,000 in annual dollar cost 10.33%
c. With 20 percent utilization we have:
The annual dollar cost goes down, while the annual percentage cost goes up as less of
the total revolving credit agreement is utilized. Declining interest costs, rising
commitment fees, and declining useable funds combine to produce this result.
6. a. ($100,000 × 0.08) in interest = 11.1%
($100,000 $8,000 $10,000) in useable funds −−
b. ($100,000 × 0.09) in interest =11.1%
Alternative (c) is best because it has the lowest effective interest cost.
7. a.
Interest cost ($200,000 × 0.10)(90/365) = $ 4,932
8. Factoring costs (monthly):
Purchase of receivables
Chapter 11: Short-Term Financing
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Banking financing costs (monthly):
Interest (0.15 / 12) ($100,000) = $1,250
The firm should continue its factoring arrangement -- it is cheaper.
9. Differential interest cost (Finance company minus Bank) = 7.5% – 2.5% = 5%.
Quarterly differential = 5% / 4 = 1.25%.
Interest cost savings:
Quarter Inventories Inventories × 1.25%
1 $1,600,000 $ 20,000
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1.
a. 1/10, net/30 (1/99) (365/20) = 18.4%
b. 2/10, net/30 (2/98) (365/20) = 37.2%
2. Annualized costs are as follows:
a. Trade credit: (3 / 97) (365 / 20) = 56.47%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
The bank financing is approximately 3.4 percent more expensive than the commercial
paper; therefore, commercial paper should be issued.
3. Annualized costs are as follows:
a. Trade credit: If discounts are not taken, up to $97,000 (i.e., 97% × $50,000 per month ×
b. Bank loan: Assuming that the compensating balance would not otherwise be
maintained, the cost would be
c. Factoring: Factor fee for the year would be 2% × ($150,000 × 12) = $36,000. The
Bank borrowing would thus be the cheapest source of funds.
4.
a. 12% of 80 percent of $400,000 for 6 months $19,200
b. $400,000 × 20% × 1/2 year $40,000
c. 10 of 70 percent of $400,000 for 6 months $14,000
