978-0273713630 Chapter 11 Solution Manual

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Short-Term Financing

Creditors have better memories than debtors, and

creditors are a superstitious sect—great observers of set

days and times.

BENJAMIN FRANKLIN

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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

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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

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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.

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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

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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%

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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