Chapter 8
Sources of Short-Term Financing
Discussion Questions
8-1. Under what circumstances would it be advisable to borrow money to take a
cash discount?
It is advisable to borrow in order to take a cash discount when the cost of
borrowing is less than the cost of foregoing the discount. If it cost us
8-2. Discuss the relative use of credit between large and small firms. Which group
is generally in the net creditor position, and why?
Larger firms tend to be in a net creditor position because they have the
8-3. How have new banking laws influenced competition?
New banking laws allowed more competition and gave banks the right to
8-4. What is the prime interest rate? How does the average bank customer fare
in regard to the prime interest rate?
The prime rate is the rate that a bank charges its most creditworthy customers.
8-5. What does LIBOR mean? Is LIBOR normally higher or lower than the
U.S. prime interest rate?
8-6. What advantages do compensating balances have for banks? Are the
advantages to banks necessarily disadvantages to corporate borrowers?
The use of a compensating balance or minimum required account balance
allows the banker to generate a higher return on a loan because not all funds
are actually made available to the borrower. A $125,000 loan with a $25,000
8-7. Commercial paper may show up on corporate balance sheets as either
a current asset or a current liability. Explain this statement.
Commercial paper can be either purchased or issued by a corporation.
8-8. What are the advantages of commercial paper in comparison with bank
borrowing at the prime rate? What is a disadvantage?
In comparison to bank borrowing, commercial paper can generally be issued
at below the prime rate. Furthermore, there are no compensating balance
The drawback is that commercial paper may be an uncertain source of funds.
8-9. What is the difference between pledging accounts receivable and factoring
accounts receivable?
Pledging accounts receivable means receivables are used as collateral for a
8-10. What is an asset-backed public offering?
A public offering is backed by an asset (accounts receivable) as collateral.
8-11. Briefly discuss three types of lender control used in inventory financing.
Three types of lender control used in inventory financing are:
a. Blanket inventory—Lien-general claim against inventory or collateral.
b. Trust receipt—Borrower holds the inventory in trust for the lender. Each
c. Warehousing—The inventory is physically identified, segregated, and
stored under the direction of an independent warehouse company that controls
8-12. What is meant by hedging in the financial futures market to offset interest rate
risks?
Hedging means to engage in a transaction that partially or fully reduces a prior
Chapter 8
Problems
1. Cash discount (LO1) Compute the cost of not taking the following cash discounts.
a. 2/10, net 40.
b. 2/15, net 30.
c. 2/10, net 45.
d. 3/10, net 90.
8-1. Solution:
Cost of not Discount % 360
taking a cash =100% Disc.% Final due date
discount Discount period
´
– –
Cost of not Discount% 360
taking a cash =100% Disc.% Final due date Discount period
discount
3% 360
97% 45 19
3.09% 13.85 42.80%
´
– –
= ´ –
= ´ =
The cost of not taking the cash discount is greater than the cost of
3. Cash discount decision (LO1) Simmons Corp. can borrow from its bank at 17 percent to
take a cash discount. The terms of the cash discount are 1.5/10, net 45. Should the firm
borrow the funds?
8-3. Solution:
Simmons Corporation
First, compute the cost of not taking the cash discount and
compare this figure to the cost of the loan.
Cost of not Discount% 360
taking a cash =100% Disc.% Final due date Discount period
discount
1.5% 360
98.5% 45 10
1.52% 10.29 15.64%
´
– –
= ´ –
= ´ =
The cost of not taking the cash discount is less than the cost of the loan
4. Effective rate of interest (LO2) Your bank will lend you $4,000 for 45 days at a cost of
$50 interest. What is your effective rate of interest?
8-4. Solution:
Interest Days in the year (360)
Effective rate = Principal Days loan is outstanding
$50 360
$4, 000 45
1.25% 8 10%
5. Effective rate of interest (LO2) A pawnshop will lend $2,500 for 45 days at a cost of $35
interest. What is the effective rate of interest?
8-5. Solution:
Interest Days in the year (360)
Effective rate of interest = Principal Days loan is outstanding
$35 360 1.40% 8.00 11.20%
$2,500 45
´
= ´ = ´ =
6. Effective rate on discounted loan (LO2) Sol Pine borrows $5,000 for one year at 13
percent interest. What is the effective rate of interest if the loan is discounted?
8-6. Solution:
Sol Pine
Interest Days per year (360)
Effective rate on a =
discounted loan Princ. Int. Days loan is outstanding
$650 360 $650 1
$5,000 $650 360 $4,350
14.94%
´
–
= ´ = ´
–
=
7. Effective rate on discounted loan (LO2) Mary Ott is going to borrow $10,400 for 120
days and pay $150 interest. What is the effective rate of interest if the loan is discounted?
8-7. Solution:
Mary Ott
Interest Days per year (360)
Effective rate on a =
discounted loan Princ. Int. Days loan is outstanding
$150 360 $150 3
$10, 400 $150 120 $10, 250
1.46% 3 4.38%
´
–
= ´ = ´
–
= ´ =
8. Prime vs. LIBOR (LO2) Dr. Ruth is going to borrow $5,000 to help write a book. The
loan is for one year and the money can either be borrowed at the prime rate or the LIBOR
rate. Assume the prime rate is 11 percent and LIBOR 1.5 percent less. Also assume there
will be a $45 transaction fee with LIBOR (this amount must be added to the interest cost
with LIBOR). Which loan has the lower effective interest cost?
8-8. Solution:
Dr. Ruth
Prime rate loan (11%)
LIBOR rate loan
Effective interest = (9.5% $5,000)+$45=$475+$45=$520
$520 360 10.40% 1 10.40%
$5,000 360
´
´ = ´ =
LIBOR is cheaper than prime (10.40 percent vs. 11 percent).
9. Foreign borrowing (LO2) Gulliver Travel Agencies thinks interest rates in Europe are
low. The firm borrows euros at 9 percent for one year. During this time period the dollar
falls 14 percent against the euro. What is the effective interest rate on the loan for one year?
(Consider the 14 percent fall in the value of the dollar as well as the interest payment.)
8-9. Solution:
Gulliver Travel Agencies
9% Interest
10. Dollar cost of a loan (LO2) Talmud Book Company borrows $24,900 for 60 days at 12
percent interest. What is the dollar cost of the loan?
()
Days loan is outstanding
Dollar cost of loan = Amount borrowed × Interest rate ×
Days in the year 360
8-10. Solution:
Talmud Book Company
Dollar cost of loan =
Interest Days per year (360)
Effective rate = Principal Days loan is outstanding
´
Days loan is outstanding
Amount borrowed Interest rate Days per year (360)
´ ´
60
$24,900 12% 360
1
$24,900 12% 6
$24,900 2.00% $498
= ´ ´
= ´ ´
= ´ =
11. Net credit position (LO1) McGriff Dog Food Company normally takes 27 days to pay for
average daily credit purchases of $9,530. Its average daily sales are $10,680, and it collects
accounts in 32 days.
a. What is its net credit position? That is, compute its accounts receivable and accounts
payable and subtract the latter from the former.
Accounts receivable = Average daily credit sales × Average collection period
Accounts payable = Average daily credit purchases × Average payment period
b. If the firm extends its average payment period from 27 days to 37 days (and all else
remains the same), what is the firm’s new net credit position? Has it improved its cash
flow?
8-11. Solution:
McGriff Dog Food Company
a. Net credit position = Accounts receivable – Accounts payable
Average daily Average
Accounts receivable = credit sales collection period
$341,760 $10,680 32days
´
= ´
Average daily Average
Accounts payable = credit purchases payment period
$257,310 $9,530 27
´
= ´
Net credit position $341,760 – $257,310 $84,450= =
b. Accounts receivable will remain at $341,760
The firm has improved its cash flow position. Instead of extending
12. Compensating balances (LO2) Maxim Air Filters Inc. plans to borrow $300,000 for one
year. Northeast National Bank will lend the money at 10 percent interest and requires a
compensating balance of 20 percent. What is the effective rate of interest?