Chapter 08: Sources of Short-Term Financing
8-22. Solution:
Reynolds Corporation
Discount % 360
Cost of not taking a cash =
discount 100% Disc.% Final due date
Discount period
3% 360 3.09% 12.86 39.74%
97% (45 17)
´
– –
= ´ = ´ =
–
Effective rate of interest with a 27 percent compensating balance
requirement:
= Interest rate/(1 – C)
= 16%/(1 – .27)
= 16%/(.73) = 21.92%
The effective cost of the loan, 21.92 percent, is less than the cost
of passing up the discount, 39.74 percent. Reynolds Corporation
should borrow funds from the bank and pay the invoice early in
order to take advantage of the discount.
23. Bank loan to take cash discount (LO1 and 2) The Reynolds Corporation buys from its
suppliers on terms of 3/17, net 45. Reynolds has not been utilizing the discounts offered
and has been taking 45 days to pay its bills.
Mr. Duke, Vice President of Reynolds Corporation, has suggested that the company begin
to take the discounts offered. Duke proposes that the company borrow from its bank at a
stated rate of 16 percent. The bank requires a 20 percent compensating balance on these
loans. Current account balances would not be available to meet any of this compensating
balance requirement.
Do you agree with Duke’s proposal?
8.23. Solution:
Reynolds Corporation
Chapter 08: Sources of Short-Term Financing
Discount % 360
Cost of not taking a cash =
discount 100% Disc.% Final due date
Discount period
3% 360 3.09% 12.86 39.74%
97% (45 17)
´
– –
= ´ = ´ =
–
24. Bank loan to take cash discount (LO1 and 2) Neveready Flashlights Inc. needs
$340,000 to take a cash discount of 3/17, net 72. A banker will lend the money for 55 days at an
interest cost of $10,400.
a. What is the effective rate on the bank loan?
b. How much would it cost (in percentage terms) if the firm did not take the cash
discount, but paid the bill in 72 days instead of 17 days?
c. Should the firm borrow the money to take the discount?
d. If the banker requires a 20 percent compensating balance, how much must the firm
borrow to end up with the $340,000?
e. What would be the effective interest rate in part d if the interest charge for 55 days
were $13,000? Should the firm borrow with the 20 percent compensating balance?
(The firm has no funds to count against the compensating balance requirement.)
8-24. Solution:
Neveready Flashlights, Inc.
a.
$10,400 360
Effective rate of interest = $340,000 55
3.06% 6.55 20.04%
´
= ´ =
Chapter 08: Sources of Short-Term Financing
( )
3% 360
Cost of lost discount = 97% 72 17
´–
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
since the effective rate is greater than the savings from taking
the cash discount.
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?
Chapter 08: Sources of Short-Term Financing
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
$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
losing the discount.
Amount
$631,000 $631,000 $631,000 $701,111 needed to be
= = =
Chapter 08: Sources of Short-Term Financing
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
( ) ( )
Effective interest rate
2 4 $15,100
= $151, 000 $42, 280 $15,100 4 1
$120,800 / $468,100 25.81%
´ ´
– – ´ +
= =
Southwest Bank
( ) ( )
Effective interest rate
2 12 $15,100
=$151, 000 $21,140 12 1
$362, 400 / $1, 688,180 21.47%
´ ´
– ´ +
= =
Choose Southwest Bank since it has the lowest effective
interest rate.
8-26. (Continued)
b. The numerators stay the same as in part (a) but the
denominator increases to reflect the use of more money
Chapter 08: Sources of Short-Term Financing
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
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
Chapter 08: Sources of Short-Term Financing
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
C 78,300
G 30,400
K 292,000
Total 461,500
Loan % 90%
Chapter 08: Sources of Short-Term Financing
b. Loan balances $ 851,860
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
(Sale takes place in July) $138,000
b. A profit took place because the value of the bond went down
c. Increased interest cost $53,000
Profit from hedging 34,500
Chapter 08: Sources of Short-Term Financing
d. If interest rates dropped, there would be a loss on the futures