Chapter 08: Sources of Short-Term Financing
8-24. Solution:
Neveready Flashlights, Inc.
a.
$10,400 360
Effective rate of interest = $340,000 55
3.06% 6.55 20.04%
´
= ´ =
b.
( )
3% 360
Cost of lost discount = 97% 72 17
3.09% 6.55 20.24%
´–
= ´ =
c. Yes, because the cost of borrowing is less than the cost of
losing the discount.
d.
( ) ( )
Amount
$340,000 $340, 000 $340,000 $425,000 needed to be
1 C 1 .20 .80 borrowed
= = =
– –
8-24. (Continued)
e.
$13,000 360
Effective interest rate = $425,000 $85,000 55
$13,000 6.55 3.82% 6.55
$340,000
25.02%
´
–
= ´ = ´
=
No, do not borrow with a compensating balance of 20 percent
Chapter 08: Sources of Short-Term Financing
25. Bank loan to take cash discount (LO1 and 2) Harper Engine Company needs $631,000
to take a cash discount of 2.5/20, net 75. A banker will lend the money for 55 days at an
interest cost of $13,300.
a. What is the effective rate on the bank loan?
b. How much would it cost (in percentage terms) if Harper did not take the cash
discount, but paid the bill in 75 days instead of 20 days?
c. Should Harper borrow the money to take the discount?
d. If another banker requires a 10 percent compensating balance, how much must
Harper borrow to end up with $631,000?
e. What would be the effective interest rate in part d if the interest charge for 55 days
were $10,100? Should Harper borrow with the 10 percent compensating balance?
(There are no funds to count against the compensating balance requirement.)
8-25. Solution:
Harper Engine Company
a.
$13,300 360
Effective rate of interest = 631,000 55
2.11% 6.55 13.82%
´
= ´ =
b.
( )
2.50% 360
Cost of lost discount = 97.50% 75 20
360
2.56% 55
2.56% 6.55 16.77%
´–
= ´
= ´ =
c. Yes, because the cost of borrowing is less than the cost of
d.
( ) ( )
Amount
$631,000 $631,000 $631,000 $701,111 needed to be
1 C 1 .10 .90 borrowed
= = =
– –
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Chapter 08: Sources of Short-Term Financing
e.
$10,100 360
Effective interest rate = $701,111 70,111 55
$10,100 6.55
$631,000
1.60% 6.55 10.48%
´
–
= ´ =
= ´ =
Yes, because the cost of borrowing is less than the cost of
losing the discount.
26. Competing terms from banks (LO2) Summit Record Company is negotiating with two
banks for a $151,000 loan. Fidelity Bank requires a 28 percent compensating balance, discounts
the loan, and wants to be paid back in four quarterly payments. Southwest Bank requires a 14
percent compensating balance, does not discount the loan, but wants to be paid back in 12
monthly installments. The stated rate for both banks is 10 percent. Compensating balances will
be subtracted from the $151,000 in determining the available funds in part a.
a. Calculate the effective interest rate for Fidelity Bank and Southwest Bank. Which
loan should Summit accept?
b. Recompute the effective cost of interest, assuming that Summit ordinarily maintains
$42,280 at each bank in deposits that will serve as compensating balances.
c. Does your choice of banks change if the assumption in part b is correct?
8-26. Solution:
Summit Record Company
a. Fidelity Bank
Southwest Bank
( ) ( )
Effective interest rate
2 12 $15,100
=$151, 000 $21,140 12 1
´ ´
– ´ +
Chapter 08: Sources of Short-Term Financing
8-26. (Continued)
b. The numerators stay the same as in part (a) but the
Fidelity Bank
Effective interest rate = $120,800/($151,000 $15,100) 5
= $120,800/$679,500=17.78%
– ´
Southwest Bank
Effective interest rate = $362,400/($151,000 13)
= $362,400/$1,963,000 = 18.46%
´
c. Yes. If compensating balances are maintained at both banks
27. Accounts receivable financing (LO1) Charming Paper Company sells to the 12 accounts
listed here.
Account
Receivable Balance
Outstanding
Average Age of
the Account over the
Last Year
A……………………………… $ 60,800 22
B……………………………… 168,000 43
C……………………………… 78,300 19
D……………………………… 24,300 55
E……………………………… 58,900 42
F……………………………… 238,000 39
G……………………………… 30,400 16
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of McGraw-Hill Education.
Chapter 08: Sources of Short-Term Financing
H……………………………… 374,000 72
I………………………………. 41,400 32
J………………………………. 96,500 58
K……………………………… 292,000 17
L……………………………… 67,700 37
Capital Financial Corporation will lend 90 percent against account balances that have
averaged 30 days or less; 80 percent for account balances between 31 and 40 days; and
70 percent for account balances between 41 and 45 days. Customers that take over
45 days to pay their bills are not considered acceptable accounts for a loan.
The current prime rate is 15.5 percent, and Capital charges 4.5 percent over prime to
Charming as its annual loan rate.
a. Determine the maximum loan for which Charming Paper Company could qualify.
b. Determine how much one month’s interest expense would be on the loan balance
determined in part a.
8-27. Solution:
Charming Paper Company
a. 0–30 days Amount
A $ 60,800
31–40 days Amount
F $ 238,000
41–45 days Amount
B $168,000
E 58,900
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of McGraw-Hill Education.
Chapter 08: Sources of Short-Term Financing
b. Loan balances $ 851,860
Interest, 20% annual
28. Hedging to offset risk (LO5) The treasurer for Pittsburgh Iron Works wishes to use
financial futures to hedge her interest rate exposure. She will sell five Treasury futures
contracts at $138,000 per contract. It is July and the contracts must be closed out in
December of this year. Long-term interest rates are currently 13.3 percent. If they increase
to 14.5 percent, assume the value of the contracts will go down by 5 percent. Also if
interest rates do increase by 1.2 percent, assume the firm will have additional interest
expense on its business loans and other commitments of $53,000. This expense, of course,
will be separate from the futures contracts.
a. What will be the profit or loss on the futures contract if interest rates go to 14.5
percent by December when the contract is closed out?
b. Explain why a profit or loss took place on the futures contracts.
c. After considering the hedging in part a, what is the net cost to the firm of the
increased interest expense of $53,000? What percent of this $53,000 cost did the
treasurer effectively hedge away?
d. Indicate whether there would be a profit or loss on the futures contracts if interest
rates dropped.
8-28. Solution:
Pittsburgh Iron Works
a. Sales price, December Treasury bond contract
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of McGraw-Hill Education.
Chapter 08: Sources of Short-Term Financing
b. A profit took place because the value of the bond went down
c. Increased interest cost $53,000