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A B C D E F G H I J
Solution 12/8/2012
Chapter: 27
Problem: 11
Cash $50 Accounts payable $500
a. How large would the accounts payable balance be if Malone takes discounts? If it does not take
discounts and pays in 30 days?
Input Data
Discount, if taken 1% Days Malone has taken to make payment 60
Accounts payables =
Term of
discount
(days)
x
Purchase
s per day
=
Accounts payables if take discounts = 10 x8.33$ = 83.33$
Accounts payables if don’t take discounts = 30 x8.33$ = 250.00$
b. How large must the bank loan be if Malone takes discounts? If Malone doesn’t take discounts?
The company must go from $500 to either $83.33 or $250, so it will need this amount of cash:
Malone Feed and Supply Company buys on terms of 1/10, net 30, but it has not been paying on time–
it is a “slower payer,” and its suppliers are getting upset. Malone does not take discounts, and it has
been paying in 60 rather than the required 30 days. Assume that the accounts payable are recorded
at full cost, not net of discounts. Malone’s balance sheet (in thousands of dollars) follows:
Now, Malone’s suppliers are threatening to stop shipments unless the company begins making
prompt payments (that is, paying in 30 days or less). The firm is going to have to reduce its $500 of
accounts payable, either to an amount that is equal to 30 days purchases (if it does not take
discounts) or to 10 days purchases (if it decides to take discounts). Management has decided to
obtain the needed funds by borrowing on an additional 1-year note payable (call this a current
liability) from its bank at a rate of 15 percent, discount interest, with a 20 percent compensating
balance required. The $50,000 of cash Malone currently has is needed for transactions, so it cannot
be used as part of the compensating balance. So, the issue now facing the company is this: How
much trade credit should it use, and how large a loan should it obtain from its bank?
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Amount needed = Loan – (Interest rate on loan)(Loan) – (Compensating balance)(Loan)
Loan = Amount needed/(1- Interest rate – Comp. Balance %)
Loan if take discounts: 641.03$
Loan if don’t take discounts: 384.62$
c. What are the nominal and effective costs of nonfree trade credit? What is the effective cost of the
bank loan? Based on these costs, what should Malone do?
(1) Cost of nonfree trade credit
This cost rate would be the same for the smaller loan. Since the cost of the bank loan exceeds the
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A B C D E F G H I J
(2) Cost of the bank loan
0 (1 Year) 1
Using the RATE function, we can determine the cost of the bank loan.
Cost of bank loan = 23.08%
Malone Feed and Supply Company Balance Sheet
Cash $126.9 Accounts payable $250.0
Accounts Receivable $450.0 Notes payable 434.6
Set up a data table as shown below:
Interest
Rate
Required Loan
Compensating Balance Percentage
Terms of the bank loan are a 15 percent discount interest rate, and a 20 percent compensating
balance. This cost is the same regardless of how much the firm borrows. Assume a $250,000 loan.
We will set up a one-year timeline to analyze the cash flow relevant to this situation.
d. Assume that Malone foregoes the discount and borrows the amount needed to become current on
its payables. Construct a pro forma balance sheet based on this decision. (Hint: you will need to
include an account called “prepaid interest” under current assets.)
The operating assets will remain unchanged, but a new current asset, “Prepaid interest,” will be
e. Using interest rates in the range of 5% to 25% and compensating balances in the range of 0% to
30%, perform a sensitivity analysis that shows how the size of the bank loan would vary with
changes in the interest rate and the compensating balance percentage.
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A B C D E F G H I J
$ 400
$ 450
$ 500
Loan Sensitivity
Comp Bal = 0%