CHAPTER 16
QUESTIONS
16-1
This statement is false. A firm cannot ordinarily control its accruals because payrolls and the
timing of wage payments are set by economic forces and by industry custom, while tax-payment
dates are established by law.
16-2
Yes. Trade credit and accruals generally increase automatically as sales increase, and vice versa.
16-3
Yes. If a firm is able to buy on credit at all, if the credit terms include a discount for early
payment, and if the firm pays during the discount period, it has obtained “free” trade credit.
However, taking additional trade credit by paying after the discount period can be quite costly.
16-4
Larger firms have greater access to the financial markets than smaller firms, because they can
sell stocks and bonds. Smaller firms are, therefore, forced to rely on bank loans to a greater
extent. In addition, larger firms typically are older and, thus, have had more time to build up
retained earnings and other internal sources of funds than new, smaller firms.
16-5
Commercial paper refers to promissory notes of large, financially strong corporations. These
notes have maturities that generally vary from two to six months, with a maximum maturity of
nine months (270 days). In March 2004, the rate on commercial paper was about 3.0 percent
below the prime lending rate. The prime rate was 4 percent and the rate was 1 percent for 30-day
commercial paper. Normally, the rates on commercial paper are about 1 percent to 2 percent
below the prime rate. Mamma and Pappa Gus could not use the commercial paper market.
16-6
a.
Approximately 4½ to 5½ percent, under normal circumstances.
b.
A firm might be limited in the amount of commercial paper that dealers are willing to sell,
or it might wish to establish relations with a bank. Furthermore, commercial paper
maturities vary from two to six months, and a firm might desire longer-term debt.
16-7
Automobile dealerships, appliance and electronics stores, and other firms that sell high-priced
products and extend credit to purchasers have a tendency to factor their receivables.
16-8
Overall, or on average, the group of borrowers that is required to “put up” collateral pays a
higher effective rate of interest, because they are considered riskier borrowers than those who
can borrow on an unsecured basis. However, for an individual borrower, secured loans generally
are cheaper than unsecured loans, because, for a given risk (the individual borrower), security
reduces the risk of default.
16-9
Any factor the decreases the amount of a loan that can actually be used by the firm will increase
the cost of debt. As a result, if a firm has little or no checking balances and its loan agreement
requires a compensating balance, this requirement will have to be satisfied from the loan
proceeds, which will increase the cost of the loan. On the other hand, if the firm normally
maintains checking balances that are greater than or equal to the compensating balance
requirement, then this requirement will not affect the cost of the loan.
16-10
“Good” collateral is inventory that is easily liquidated and has a life that is longer then the length
of the loan.
16-11
Because a factor generally performs all of the functions associated with credit—that is, credit
checking, determining credit limits, and so forth—a small firm that cannot afford a credit
department probably would benefit more from factoring that from pledging receivables. In fact
1
Chapter 16
any firm that cannot afford to perform credit analysis or cannot hire good credit personnel would
be wise to factor rather than pledge receivables.
16-12
rEAR considers the effects of interest compounding, whereas APR does not.
___________________________________________________________________
PROBLEMS
16-1
16-2
a.
 1   360 
APR =   × 
 = 0.7273 = 72.73%
 99   20 − 15 
b.
 2   360 
APR =   × 
 = 0.1469 = 14.69%
 98   60 − 10 
c.
 3   360 
APR =   × 
 = 0.3181 = 31.81%
 97   45 − 10 
d.
 2   360 
APR =   × 
 = 0.2099 = 20.99%
 98   45 − 10 
e.
 2   360 
APR =   × 
 = 0.2939 = 29.39%
 98   40 − 15 
a.
 3   360 
APR =   × 
 = 0.4454 = 44.54%
 97   45 − 20 
Because the firm still takes the discount on Day 20, 20 is used as the discount period in
calculating the cost of nonfree trade credit.
16-3
b.
Paying after the discount period, but still taking the discount gives the firm more credit
than it would receive if it paid within 15 days.
a.
Effective rate = 12%.
b.
Effective rate =
0.09($50,000)
= 0.1125 = 11.25%
$50,000(1 − 0.20)
c.
Effective rate =
0.0875($50,000)
= 0.1148 = 11.48%
$50,000(1 − 0.0875 − 0.15)
d.
APR =
0.08($50,000)
$4,000
=
= 0.16 = 16.0%
$50,000 / 2
$25,000
2
Chapter 16
To calculate the exact effective rate:
Interest = $50,000 x 0.08 = $4,000; Monthly payments = $50,000/12 = $4,167
0
1
r=?
-50,000
4,167
2
3
4,167
…
4,167
11
4,167
12
4,167
4,000 = Interest pmt
8,167
Financial calculator: CF0 = -50,000; CF1 = 4,167, Nj = 11; CF2 = 8,167; IRR = 1.133%.
Monthly rate = 1.133%.
Effective annual rate = (1.01133)12 - 1.0 = 0.1448 = 14.48%
Alternative b has the lowest effective interest rate.
16-4
Sales per day =
$4,500,000
= $12,500
360
Discount sales = 0.5($12,500) = $6,250.
A/R attributable to discount customers = $6,250(10) = $62,500
A/R attributable to nondiscount customers:
Total A/R
Discount customers’ A/R
Nondiscount customers’ A/R
$437,500
62,500
$375,000
$375,000
DSO of non discount customers = 6,250 = 60 days
Alternatively,
DSO = $437,500/$12,500 = 35 days
35 = 0.5(10) + 0.5(DSONon-discount)
DSONondiscount = 30/0.5 = 60 days.
Thus, although nondiscount customers are supposed to pay within 40 days, they are actually
paying, on average, in 60 days.
Cost of trade credit to nondiscount customers equals the rate of return to Howe:
3
Chapter 16
 2   360 
APR =   × 
 = 0.1469 = 14.69%
 98   60 − 10 
rEAR = Effective rate = (1 + 2/98)7.2 - 1.0 = 15.65%.
16-5
Accounts payable:
 0.03  360 
Approx . cost = 

 = (0.03093)(4.5) = 0.1392 = 13.92%.
 0.97  90 - 10 
rEAR cost = (1.03093)4.5 ─ 1.0 = 14.69%.
Notes payable:
rEAR =
0.12
0.12
=
= 0.1364 = 13.64% .
1 - 0.12 0.88
The bank loan is better.
16-6
(a)
Simple interest: rEAR = 12%.
(b)
3-months: (1 + 0.115/4)4 - 1 = 0.120055 = 12.01%
(c)
Add-on:
Repayment amount = Funds needed (1 + rd)
PMT = Loan/12
Assume borrowed $100. (It doesn’t matter what the amount is.) Then, repayment amount
= 100(1.06) = 106. PMT = 106/12 = 8.8333.
12
100 =
8.8333
∑ (1+ r
t =1
d
t
)
Enter N = 12, PV = -100, PMT = 8.8333, and press I to get I = 0.9080% = rd.
rEAR = (1.009080)12 – 1.0 = 0.1146 = 11.46%
(d)
Trade credit: If the cash discount is not taken, the firm gets 60 - 15 = 45 days of credit at a
cost of 1/99 = 1.0101%. There are 360/45 = 8 periods, so the effective cost rate is:
rEAR = (1 + 1/99)8 - 1 = (1.0101)8 - 1 = 0.0837 = 8.37%.
Thus, the least expensive type of credit for Meyer is trade credit with an effective cost of 8.37
percent.
Average
16-7
a.
accounts =
payable
$3,600,000
× 10 = $10,000 × 10 = $100,000
360 days
4
Chapter 16
b.
There is no cost of trade credit at this point. The firm is using “free” trade credit.
Average payable = $3,600,000 × 30 = $10,000 × 30 = $300,000
(net of discounts)
360 days
c.
Approximate cost = (2/98)(360/20) = 36.73%,
or $73,469/($300,000 - $100,000) = 36.73%.
Effective cost = rEAR = (1 + 2/98)18 - 1 = 43.86%.
d.
Approximate = 2 × 360 = 24.49%
cost
98 (40 - 10)
Effective rate = rEAR = (1 + 2/98)12 - 1 = 27.43%.
16-8
a.
Cost of = Principal× 0.13 = 0.13 = 0.1494 = 14.94%
bank loan Principal(1 - 0.13) 0.87
Terms: 2/10, net 30. But the firm plans delaying payments 35 additional days, which is
the equivalent of 2/10, net 65.
Effective rate = (1 + 2/98)(360/55) - 1.0 = 14.14%.
Comparing interest costs, the Gallinger Corporation might be tempted to expand its
payables rather than obtain financing from a bank. (For reason see solution to part b.)
16-9
b.
The interest rate comparison favors trade credit. But, Gallinger Corporation should take
into account how its trade creditors would look upon a 35-day delay in making payments.
Gallinger would become a “slow pay” account, and in times when suppliers were
operating at full capacity, Gallinger would be given poor service and also would be forced
to pay on time.
a.
Alternative 1—Discount loan:
Effectiv e rate Alt 1 =
Interest
Loan amount - Interest
=
$450,000(0.0925)
$450,000 − $450,000(0.0925)
=
$41,625
= 0.1019 = 10.19%
$408,375
5
Chapter 16
Alternative 2—Simple interest loan:
Effectiv e rate Alt 2 =
Interest
Amount needed for 
Loan amount -  compensati
ng balance 

=
$450,000(0.10)
$450,000 − [$450,000(0.15) − $50,000]
=
$45,000
$45,000
=
= 0.1040 = 10.40%
$450,000 − $17,500 $432,500
Alternative 3—Revolving line of credit:
Effectiv e rate Alt 3 =
Interest + Commitment fee
Loan amount
=
$450,000(0.0925) + ($1,000,000 − $450,000)(0.0025)
$450,000
=
$43,000
= 0.0956 = 9.56%
$450,000
Because the length of the loan is one year, the APR and effective cost are the same.
Alternative 3, the revolving line of credit would be preferred because it has the lowest
effective cost.
b.
Alternative 1—Discount loan:
Amount of usable funds needed
Loan
=
Amount Alt 1
1- r
SIMPLE
=
$450,000
$450,000
=
= $495,868
1 − 0.0925
0.9075
The interest for this loan would be $495,868(0.0925) = $45,868, so the amount of usable
funds would be $495,868 - $45,868 = $450,000
Alternative 2—Simple interest with a compensating balance:
Amount of usable funds needed - Checking balance
Loan
Amount Alt 2 =
1 - CB%
=
$450,000 − $50,000 $400,000
=
= $470,588
1 − 0.15
0.85
The compensating balance for this loan would be $470,588(0.15) = $70,588. Only
$20,588 of the compensating balance requirement needs to be taken from the loan
proceeds, because the $50,000 checking balance can be used to satisfy the rest. So the
amount of usable funds would be $470,588 - $20,588 = $450,000.
6
Chapter 16
Alternative 3—Revolving line of credit:
Nothing needs to be deducted from the amount of the line of credit drawn down, so the
amount that needs to be borrowed is $450,000.
16-10
a.
The quarterly interest rate is equal to 11.25%/4 = 2.8125%.
Effective annual rate = (1 + 0.028125)4 ─ 1
= 1.117336 ─ 1 = 0.117336 = 11.73%.
b.
0.0225
Quarterly =
= 2.89%
rate
1.0 - 0.0225 - 0.20
Effective annual rate = (1 + 0.0289)4 ─ 1
= (1.0289)4 ─ 1 = 0.1209 = 12.09%.
c.
Interest = $1.5 million x 0.0225 = $33,750
Approximate = $33,750 × 4 = 4.5% × 4 = 18.0%
rate
 $1,500,000 


16-11
a.
2


Bankston can take the discounts, in which case it will have ($500,000/60)(10) = $83,333
in accounts payable. In this case, it would have to obtain $500,000 ─ $83,333 = $416,667
from the bank. (The $416,667 understates the amount of the bank loan because of
compensating balances and the interest discount.) Alternatively, if Bankston pays in 30
days, it will have ($500,000/60)(30) = $250,000 in accounts payable. To reach this
position, it will have to receive $500,000 ─ $250,000 = $250,000 of usable funds from the
bank.
(1)
The cost of the nonfree trade credit is:
Approximate cost = (1/99)(360/20) = 18.18%.
Effective cost = (1 + 1/99)18 - 1.0 = 19.83%.
(2)
The effective cost of the bank loan is found as follows:
Effective rate =
=
Simple rate
(1 − Simple rate − CB)
0.15
= .02308 = 23.08%
(1 − 0.15 − 0.20)
Because the cost of nonfree trade credit is less than the cost of the bank loan,
Bankston should forego discounts and reduce its payables only to $250,000.
7
Chapter 16
b.
Bankston will need $250,000. To obtain the use of this amount of money, it will have to
borrow $384,615, which is determined using Equation 16-5:
$250,000
$250,000
Loan
Amount = (1 − 0.15 − 0.2) = 0.65 = $384,615
Check:
Usable funds = $384,615 ─ Interest ─ 20%(Compensating balance)
= $384,615 ─ 0.15($384,615) ─ 0.2($384,615)
= $384,615 ─ $57,692 ─ $76,923 = $250,000
Effective interest rate =
16-12
a.
1.
Line of credit:
Commitment fee
Interest
Total
2.
$57,692
= 0.2308 = 23.08%
$250,000
= (0.005)($2,000,000)(11/12)
= (0.11)(1/12)($2,000,000)
= $ 9,167
= 18,333
$27,500
Trade discount:
 0.02   360 
APR = 
×
 = 0.2449 = 24.49%
 0.98   40 − 10 
Total cost
3.
= $40,817
30-day commercial paper:
Interest
Transaction fee
4.
= [0.2449($2,000,000)]/12
= (0.095)($2,000,000)(1/12)
= (0.005)($2,000,000)
= $15,833
= 10,000
$25,833
60-day commercial paper:
Interest
Transaction fee
= (0.09)($2,000,000)(2/12)
= (0.005)($2,000,000)
= $30,000
= 10,000
Marketable securities interest received
= (0.094)($2,000,000)(1/12)
= (15,667)
Transactions cost, marketable securities
= (0.004)($2,000,000)
=
8
8,000
$40,000
$32,333
The 30-day commercial paper has the lowest dollar cost.
b.
16-13
a.
Chapter 16
The lowest cost of financing is not necessarily the best. The use of 30-day commercial
paper is the cheapest; however, sometimes the commercial paper market is tight and funds
are not available. This market also is impersonal. A banking arrangement might provide
financial counseling and a long-run relationship in which the bank performs almost as a
“partner and counselor” to the firm. Note also that while the use of 60-day commercial
paper is more expensive than the use of 30-day paper, it provides more flexibility in the
event the money is needed for more than 30 days. However, the line-of-credit provides
even more flexibility than the 60-day commercial paper and at a lower cost.
$500,000
Accounts receivable =
= $515,464
needed to factor
1 − ( 0.12 + 0.02)
12
b.
Monthly costs:
Commission
Interest
= $515,464 x 0.02
=
= $515,464 x (0.12/12) =
Monthly savings:
Credit expense
Bad debt losses = $515,464 x 0.025
=
=
$10,309
5,155
$15,464
$ 3,500
12,887
$16,387
The factoring arrangement will result in a savings of $16,387 ─ $15,464 = $923 per
month, or $923 x 12 = $11,076 per year.
c.
$750,000
Accounts receivable =
= $773,196
needed to factor
1 − ( 0.1212 + 0.02 )
Monthly costs:
Commission
Interest
= $773,196(0.02)
=
= $773,196(0.12/12) =
Monthly savings:
Credit expense
Bad debt losses = $773,196(0.025)
=
=
$15,464
7,732
$23,196
$ 3,500
19,330
$22,830
No, Cooley would lose $366 a month, or $4,392 a year, under this arrangement.
9
Chapter 16
16-14
a.
Month
July
August
September
October
November
December
Total
Borrowings*
$ 550,000
1,300,000
1,500,000
1,250,000
900,000
300,000
Interest
Charges**
$ 4,125
9,750
11,250
9,375
6,750
2,250
$43,500
Unused line
of credit
$ 950,000
200,000
0
250,000
600,000
1,200,000
Commitment
Fee***
$ 792
167
0
208
500
1,000
$2,667
*
Includes $300,000 commitment fee.
** Monthly interest rate = 9%/12 = 0.75%.
*** Monthly commitment fee = 1%/12 = 0.0833%.
Total cost = $43,500 + $2,667 = $46,167
b.
Month
July
August
September
October
November
December
Total
Borrowings
$ 250,000
1,000,000
1,200,000
950,000
600,000
0
Interest
Charge*
$ 1,667
6,667
8,000
6,333
4,000
0
$26,667
* Monthly interest rate = 8%/12 = 0.67%.
c.
Interest charges
Flat fee
1% of $1,200,000
Total cost
$26,667
2,000
12,000
$40,667
Line of credit
Field warehousing
Difference
$46,167
40,667
$ 5,500
San Joaquin should choose the field warehousing arrangement because it costs $5,500 less
than the line of credit.
10
INTEGRATIVE PROBLEM
Chapter 16
15-16 C. CHARLES SMITH RECENTLY WAS HIRED AS PRESIDENT OF DELLVOE
OFFICE EQUIPMENT INC., A SMALL MANUFACTURER OF METAL OFFICE
EQUIPMENT. AS HIS ASSISTANT, YOU HAVE BEEN ASKED TO REVIEW
THE COMPANY’S SHORT-TERM FINANCING POLICIES AND TO PREPARE
A REPORT FOR SMITH AND THE BOARD OF DIRECTORS. TO HELP YOU
GET STARTED, SMITH HAS PREPARED SOME QUESTIONS THAT, WHEN
ANSWERED, WILL GIVE HIM A BETTER IDEA OF THE COMPANY’S
SHORT-TERM FINANCING POLICIES.
A.
WHAT IS SHORT-TERM CREDIT, AND WHAT ARE THE FOUR MAJOR
SOURCES OF THIS CREDIT?
ANSWER: Short-term credit is any liability originally scheduled for payment within one year. The four
major sources of short-term credit are: accruals, accounts payable, commercial bank loans, and
commercial paper.
B. IS THERE A COST TO ACCRUALS, AND DO FIRMS HAVE MUCH CONTROL
OVER THEM?
ANSWER: Accruals increase automatically as a firm’s operations expand. They consist of accrued wages
and accrued taxes. Accruals are “free” in the sense that no explicit interest is paid on funds raised through
accruals. A firm cannot ordinarily control its accruals because the timing of wage payments is set by
economic forces and industry custom, whereas tax payment dates are established by law.
C. WHAT IS TRADE CREDIT?
ANSWER: Trade credit is a spontaneous source of financing in the sense that it arises from ordinary
business transactions. Trade credit is the largest single category of short-term debt, representing about 40
percent of the current liabilities of the average nonfinancial corporation. This percentage is somewhat
larger for small firms because they often do not qualify for financing from other sources, and therefore,
rely heavily on trade credit.
11
Chapter 16
D. LIKE MOST SMALL COMPANIES, DELLVOE HAS TWO PRIMARY SOURCES
OF SHORT-TERM DEBT: TRADE CREDIT AND BANK LOANS. ONE SUPPLIER,
WHICH SUPPLIES DELLVOE WITH $50,000 OF MATERIALS A YEAR, OFFERS
DELLVOE TERMS OF 2/10, NET 50.
(1) WHAT ARE DELLVOE’S NET DAILY PURCHASES FROM THIS
SUPPLIER?
ANSWER: If Dellvoe’s gross purchases are $50,000 annually, then, with a 2 percent discount, its net
purchases are 0.98 ($50,000) = $49,000. If we assume a 360-day year, then net daily purchases are
$49,000/360 = $136.11.
D. (2)
WHAT IS THE AVERAGE LEVEL OF DELLVOE’S ACCOUNTS PAYABLE
TO THIS SUPPLIER IF THE DISCOUNT IS TAKEN? WHAT IS THE
AVERAGE LEVEL IF THE DISCOUNT IS NOT TAKEN? WHAT ARE THE
AMOUNTS OF FREE CREDIT AND COSTLY CREDIT UNDER BOTH
DISCOUNT POLICIES?
ANSWER: If the discount is taken, then Dellvoe must pay this supplier on Day 11 for purchases made on
Day 1, on Day 12 for purchases made on Day 2, and so on. Thus, in a steady state, Dellvoe will on
average have 10 days’ worth of purchases in payables, so,
Payables = 10($136.11) = $1,361.11.
If the discount is not taken, then Dellvoe will wait 50 days before paying, so
Payables = 50($136.11) = $6,805.56.
Therefore:
Trade credit if discounts are not taken: $6,805.56 = total trade credit
Trade credit if discounts are taken: 1,361.11 = free trade credit
Difference: $5,444.45 = costly trade credit
Here we see that Dellvoe gets $1,361.11 of free credit—it can wait 10 days and still take the discount. If
the firm forgoes the discount then it can get $6,805.56 in credit. The difference, $6,805.56 ─ $1,361.11 =
$5,444.45, is the amount of costly trade credit.
D. (3)
WHAT IS THE APR OF THE COSTLY TRADE CREDIT? WHAT IS ITS rEAR?
ANSWER: To get $5,444.45 of costly trade credit Dellvoe must give up 0.02 ($50,000) = $1,000 in lost
discounts annually. Because the forgone discounts pay for $5,444.45 of credit, the APR is 18.37 percent:
APR =
$1,000
= 0.1837 ≈ 18.4%
$5,444.45
Following is a formula that can be used to find the approximate cost rate of costly trade credit:
12
Chapter 16
Cost of forgoing
Discount %
360
=
×
a cash discount 1 − Discount % Payment date - Discount date
=
2 360
×
= 0.020408 × 9 = 0.1837 = 18.37%
98 40
Note that (1) the formula gives the same cost rate as was calculated earlier, (2) the first term is the
periodic cost of the credit (Dellvoe spends $2 to get the use of $98), and (3) the second term is the
number of “savings periods” per year (Dellvoe delays payment for 50 ─ 10 = 40 days, and there are
360/40 = 9 40-day periods in a year.)
The effective annual rate is 19.94%:
m
9
D iscount % 

 0.02 
EAR =1 +
 − 1 = 1 +
 - 1 = 0.1994 = 19.94%.
 1 - D iscount % 
 0.98 
E. IN DISCUSSING A POSSIBLE LOAN WITH THE FIRM'S BANKER, SMITH HAS
FOUND THAT THE BANK IS WILLING TO LEND DELLVOE UP TO $800,000
FOR ONE YEAR AT A 9 PERCENT SIMPLE, OR QUOTED, RATE. HOWEVER,
HE FORGOT TO ASK WHAT THE SPECIFIC TERMS WOULD BE.
(1)
ASSUME THE FIRM WILL BORROW $800,000. WHAT WOULD BE THE
EFFECTIVE INTEREST RATE IF THE LOAN WERE BASED ON SIMPLE
INTEREST? IF THE LOAN HAD BEEN AN 8 PERCENT SIMPLE
INTEREST LOAN FOR SIX MONTHS RATHER THAN FOR A YEAR,
WOULD THAT HAVE AFFECTED THE rEAR?
ANSWER: With a simple interest loan, Dellvoe gets the full use of the $800,000 for a year, and then
pays 0.09($800,000) = $72,000 in interest at the end of the term, along with the $800,000 principal
repayment. For a one-year simple interest loan, the simple rate, 9 percent, is also the effective annual
rate.
Note that if the loan had been for six months at an 8 percent rate, then Dellvoe would have had to pay
(0.08/2)($800,000) = 0.04($800,000) = $32,000 in interest after six months, plus repay the principal. In
this case the simple 4 percent rate must be converted to an annual rate, and the effective annual rate is
8.16 percent:
Effective rate = (1.04)2 ─ 1.0 = 0.0816 = 8.16%.
In general, the shorter the maturity (within a year), the higher the effective cost of a simple interest loan.
E. (2)
WHAT WOULD BE THE rEAR IF THE LOAN WERE A DISCOUNT
INTEREST LOAN? WHAT WOULD BE THE FACE AMOUNT OF A LOAN
LARGE ENOUGH TO NET THE FIRM $800,000 OF USABLE FUNDS?
ANSWER: On a discount interest loan, the bank deducts the interest from the face amount of the loan in
advance; that is, the bank “discounts” the loan. If the loan had a $800,000 face amount, then the
13
Chapter 16
0.09($800,000) = $72,000 would be deducted up front, and, hence, the borrower would have the use of
only $800,000 - $72,000 = $728,000. At the end of the year, the borrower must repay the $800,000 face
amount. Thus, the effective annual rate is 9.89 percent:
EAR =
$72,000
= 0.0989 = 9.9%
$728,000
Note that a formula also can be used for a one-year discount loan:
rEAR =
rSIMPLE
0.09
0.09
=
=
= 0.0989 = 9.9%
1 − rSIMPLE 1 − 0.09 0.91
Finally, if Dellvoe needed the use of $800,000 for the year, then the face amount of the loan must be:
Pr incipal =
Amount needed $800,000 $800,000
=
=
= $879,121
1 − rSIMPLE
1 − 0.09
0.91
Then, the bank would discount the loan by 0.09($879,121) = $79,121, and the firm would receive the
needed $800,000.
E. (3)
ASSUME NOW THAT THE TERMS CALL FOR AN INSTALLMENT (OR
ADD-ON) LOAN WITH EQUAL MONTHLY PAYMENTS. THE ADD-ON
LOAN IS FOR A PERIOD OF ONE YEAR. WHAT WOULD BE DELLVOE'S
MONTHLY PAYMENT? WHAT WOULD BE THE APPROXIMATE COST
OF THE LOAN? WHAT WOULD BE THE rEAR?
ANSWER: In an installment (add-on) loan, the interest is calculated and added to the required cash, and
then this sum is called the loan and is amortized by equal payments over the stated life. Thus, the interest
would be $800,000 x 0.09 = $72,000, the face amount would be $872,000, and each monthly payment
would be $872,000/12 = $72,667.
However, the firm would receive only $800,000, and it must begin to repay the principal after only one
month. Thus, it would get the use of $800,000 in the first month, the use of $800,000 - $72,667 =
$727,333 in the second month, and so on, for an average of $800,000/2 = $400,000 over the year.
Because the interest expense is $72,000, the approximate cost is 18 percent, or twice the stated rate:
Approximate cost =
Interest
$72,000
=
= 0.18 = 18.0%
 Principal  $400,000


2

To find the exact effective annual rate, recognize that Dellvoe has received $800,000 and must make
monthly payments of $72,667:
14
Chapter 16
1 − 1 N 
N
PMT
(1+ r ) 
PV =
= PMT 
T


r
T =1 (1 + r )


∑
1 − 1 N
(1+ r )
$800,000 = $72,667 

r





Inserting N = 12, PV = -800,000, PMT = 72,667, and FV = 0 in a financial calculator, we find the
monthly rate to be 1.3514%, which converts to an effective annual rate of 17.48 percent:
(1.013514)12 ─ 1.0 = 0.1748 = 17.48%.
E. (4)
NOW ASSUME THAT THE BANK CHARGES SIMPLE INTEREST, BUT IT
REQUIRES THE FIRM TO MAINTAIN A 20 PERCENT COMPENSATING
BALANCE. HOW MUCH MUST DELLVOE BORROW TO OBTAIN ITS
NEEDED $800,000 AND TO MEET THE COMPENSATING BALANCE
REQUIREMENT? WHAT IS THE rEAR ON THE LOAN?
ANSWER: Dellvoe must obtain a loan of $1,000,000:
Pr incipal =
Amount needed
$800,000 $800,000
=
=
= $1,000,000
1 − Compensating balance
1 − 0.20
0.80
Thus, 0.2($1,000,000) = $200,000 must remain at the bank as a compensating balance; so the firm only
receives $800,000, and it must pay back the $1,000,000 plus 0.09($1,000,000) = $90,000 in interest at
the end of the year. The effective annual rate on the loan is 11.25 percent:
EAR =
I nterest
$90,000
=
= 0.1125 = 11.25%
A mount available for use $800,000
Note that the following formula can also be used:
rEAR =
rSIMPLE
0.09
0.09
=
=
= 0.1125 = 11.25%
1 − Compensating balance % 1 − 0.20 0.80
15
Chapter 16
E. (5)
NOW ASSUME THAT THE BANK CHARGES DISCOUNT INTEREST OF 9
PERCENT AND ALSO REQUIRES A COMPENSATING BALANCE OF 20
PERCENT. HOW MUCH MUST DELLVOE BORROW, AND WHAT IS THE
rEAR UNDER THESE TERMS?
ANSWER: If the loan is a discount loan, and also has a compensating balance requirement, then Dellvoe
must borrow $1,126,761:
Pr incipal =
Amount needed
$800,000
$800,000
=
=
= $1,126,761
0.71
 Compensating  1 − 0.09 − 0.20

1 − rSIMPLE − 
 balance % 
To check this value, note that
face amount
less interest = 0.09($1,126,761)
less comp. Bal = 0.2($1,126,761)
usable funds
$1,126,761
101,408
225,352
$ 800,000
In this case, the effective rate is 12.68 percent:
r EAR =
I nterest
$101,408
=
= 0.1268 = 12.68%
A mount received $800,000
Again, a simple formula can be used:
rEAR =
1 − rSIMPLE
E. (6)
rSIMPLE
0.09
0.09
=
=
= 0.1268 = 12.68%
 Compensating  1 − 0.09 − 0.20 0.71

− 
 balance % 
NOW ASSUME ALL THE CONDITIONS IN PART 4—THAT IS, A 20
PERCENT COMPENSATING BALANCE AND A 9 PERCENT SIMPLE
INTEREST LOAN—BUT ASSUME ALSO THAT DELLVOE HAS $100,000
OF CASH BALANCES THAT IT NORMALLY HOLDS FOR
TRANSACTIONS PURPOSES, WHICH CAN BE USED AS PART OF THE
REQUIRED COMPENSATING BALANCE. HOW DOES THIS AFFECT (I)
THE SIZE OF THE REQUIRED LOAN AND (II) THE EFFECTIVE COST OF
THE LOAN?
ANSWER: (i) This formula can be used to determine the size of the required loan:
Pr incipal =
Amount needed − Cash on hand $800,000 − $100,000 $700,000
=
=
= $875,000
Compensating 
1 − 0.20
0.80

1− 

 balance % 
16
Chapter 16
Note that the total cash in the account, after the $800,000 has been spent, will be $175,000 = $100,000 +
$75,000, which is 0.2($875,000); so the compensating balance requirement will be met.
(ii) The company will get use of $800,000, and its interest charges will be 0.09($875,000) = $78,750.
Therefore, the effective cost of the loan will be:
rEAR =
$78,750
= 0.0984 = 9.84%
$800,000
Versus 11.25 percent if it had to borrow the entire amount of the compensating balance.
F. DELLVOE IS CONSIDERING USING SECURED SHORT-TERM FINANCING.
WHAT IS A SECURED LOAN? WHAT TWO TYPES OF CURRENT ASSETS CAN
BE USED TO SECURE LOANS?
ANSWER: A secured loan is one backed by collateral, often inventories or receivables.
G. WHAT ARE THE DIFFERENCES BETWEEN PLEDGING RECEIVABLES AND
FACTORING RECEIVABLES?
IS ONE TYPE GENERALLY CONSIDERED
BETTER?
ANSWER: When receivables are pledged the lender not only has a claim against the receivables but also
has recourse to the borrower. If the firm that bought the goods does not pay, the selling firm must take
the loss. Therefore, the risk of default on the pledged accounts receivable remains with the borrower. The
buyer of the goods is not ordinarily notified about the pledging of the receivables. When accounts
receivable are factored, the credit accounts are purchased by the lender, generally without recourse to the
borrower. This means that if the purchaser of the goods does not pay for them, the lender rather than the
seller of the goods takes the loss. Under factoring, the buyer of the goods typically is notified of the
transfer and is asked to make payment directly to the factor, or lending financial institution.
Neither pledging receivables nor factoring receivables is considered better than the other. The type of
receivables financing a firm uses depends on whether the firm wants to maintain its own credit
department and assume the risk of default on bad accounts. The cost of pledging receivables is less
expensive than factoring receivables. When receivables are pledged, the firm maintains its own credit
department and assumes the risk of default on bad accounts, rather than the bank (as in the case of
factoring).
H. WHAT ARE THE DIFFERENCES AMONG THE THREE FORMS OF INVENTORY
FINANCING? IS ONE TYPE GENERALLY CONSIDERED BEST?
ANSWER: The three forms of inventory financing discussed in the text are blanket liens, trust receipts,
and warehouse receipts. An inventory blanket lien gives the lending institution a lien against all of the
borrower's inventories. A trust receipt is an instrument that acknowledges goods are held in trust for the
lender. Warehouse receipt financing uses inventory as security. A public warehouse is an independent
third-party operation engaged in the business of storing goods. Sometimes a public warehouse is not
practical and in these cases, a field warehouse may be established on the borrower's premises.
We cannot say categorically that one type of inventory financing is best. The type of inventory financing
a firm uses depends on the type of inventory and each firm's own circumstances. A trust receipt is issued
for specific goods; thus, automobile dealers tend to use this type of inventory financing. On the other
17
Chapter 16
hand, warehouse receipt financing is suitable for products that are nonperishable. Warehouse financing
can be done through a public warehouse or a field warehouse. If the inventory is bulky and transportation
to and from premises is expensive, then a field warehouse is used rather than a public warehouse. Finally,
the fixed costs of field warehousing arrangements are relatively high, so this type of financing is not
suitable for a very small firm.
I.
I.
DELLVOE HAD EXPECTED A REALLY STRONG MARKET FOR OFFICE
EQUIPMENT FOR THE YEAR JUST ENDED, AND IN ANTICIPATION OF
STRONG SALES, THE FIRM INCREASED ITS INVENTORY PURCHASES.
HOWEVER, SALES FOR THE LAST QUARTER OF THE YEAR DID NOT MEET
ITS EXPECTATIONS, AND NOW DELLVOE FINDS ITSELF SHORT ON CASH.
THE FIRM EXPECTS THAT ITS CASH SHORTAGE WILL BE TEMPORARY,
ONLY LASTING THREE MONTHS. (THE INVENTORY HAS BEEN PAID FOR
AND CANNOT BE RETURNED TO SUPPLIERS.) DELLVOE HAS DECIDED TO
USE INVENTORY FINANCING TO MEET ITS SHORT-TERM CASH NEEDS. IT
ESTIMATES THAT IT WILL REQUIRE $800,000 FOR INVENTORY FINANCING
DURING THIS THREE-MONTH PERIOD. DELLVOE HAS NEGOTIATED WITH
THE BANK FOR A THREE-MONTH, $1,000,000 LINE OF CREDIT WITH TERMS
OF 10 PERCENT ANNUAL INTEREST ON THE USED PORTION, A 1 PERCENT
COMMITMENT FEE ON THE UNUSED PORTION, AND A $125,000
COMPENSATING BALANCE AT ALL TIMES.
(CONTINUED)
EXPECTED INVENTORY LEVELS TO BE FINANCED ARE AS FOLLOWS:
MONTH
JANUARY
FEBRUARY
MARCH
AMOUNT
$800,000
500,000
300,000
CALCULATE THE COST OF FUNDS FROM THIS SOURCE, INCLUDING
INTEREST CHARGES AND COMMITMENT FEES. (HINT: EACH MONTH’S
BORROWINGS WILL BE $125,000 GREATER THAN THE INVENTORY LEVEL
TO BE FINANCED BECAUSE OF THE COMPENSATING BALANCE
REQUIREMENT.)
ANSWER:
Month
January
February
March
Total
Interest
Charges*
$ 7,708
5,208
3,542
$16,458
Borrowings
$925,000
625,000
425,000
*Monthly interest rate = 10%/12 = 0.83%.
18
Commitment
Fee**
$ 63
313
479
$855
Chapter 16
**Monthly commitment fee = 1%/12 = 0.0833%.
Interest charges
Commitment fees
Total cost
$16,458
855
$17,313
Average three-month rate = Cost/(Average loan amount)
= $17,313/[($925,000 + $625,000 + $425,000)/3]
= $17,313/$658,333 = 0.0263
APR = 2.63% x 4 = 10.52%
rEAR = (1.0236)4 – 1.0 = 0.0978 = 9.78%
19
Chapter 16
16-16
Computer-Related Problem
a.
No, the monthly cost would equal $17,464 whereas the monthly savings would equal
$16,437. Cooley would lose $1,028 per month under this arrangement.
INPUT DATA:
KEY OUTPUT:
Funds needed
Commission (%)
Interest rate
$17,464
Credit pd. (month)
Reduction in exp.
Reduction in bad debt
losses (%)
$500,000
2.50%
Rec. to be factored
$517,464
10.50%
1
$3,500
Costs per month
Savings per month
Net savings per month
2.50%
Net savings per year
$16,437
($1,028)
($12,334)
MODEL-GENERATED DATA:
Accounts receivables needed to factor: $517,464
Monthly costs:
Commission
Interest
Total monthly costs
$12,937
4,528
$17,464
Monthly savings:
Credit expense
Bad debt losses
Total monthly savings
$3,500
12,937
$16,437
Net monthly savings
($1,028)
Net annual savings
($12,334)
b.
Yes, the monthly cost would equal $20,103, whereas the monthly savings would equal
$20,253. Cooley would save $149 per month under this arrangement.
INPUT DATA:
Funds needed
Commission (%)
Interest rate
$20,103
Credit pd. (month)
Reduction in exp.
Reduction in bad debt
losses (%)
KEY OUTPUT:
$650,000
2.00%
Rec. to be factored
12.00%
1
$3,500
Costs per month
Savings per month
Net savings per month
2.50%
Net savings per year
MODEL-GENERATED DATA:
Accounts receivables needed to factor: $670,103
Monthly costs:
Commission
Interest
Total monthly costs
$670,103
$13,402
6,701
$20,103
20
$20,253
$149
$1,794
Monthly savings:
Credit expense
Bad debt losses
Total monthly savings
Net monthly savings
Net annual savings
Chapter 16
$3,500
16,753
$20,253
$149
$1,794
21
ETHICAL DILEMMA
WHO HAS THE MONEY—THE DEMOCRAT OF THE REPUBLICAN?
Ethical dilemma:
There are a few of factors that should be considered here. First, Sunflower
Manufacturing has applied for a $10 million working capital loan at The Democrat Federal Bank
(known as The Democrat). But the person who is evaluating the loan application, Sheli, has
determined that the bank should lend the company only $2 million. Sheli’s analysis of
Sunflower suggests that the company doe not have the financial strength to support the higher
loan. Second, if Sunflower is not granted the loan for the requested amount, the company might
take its banking business to a competitor of The Democrat. Third, The Democrat is having
financial difficulties that might result in future layoffs. Sheli might be affected by the bank’s
layoffs if her division does not meet its quota of loans. As a result, it might be in her best interest
to grant Sunflower the loan it requested even though her analysis suggests that such an action is
not rational.
Discussion questions:
●
What is the ethical dilemma?
In this case, the ethical dilemma is whether Sheli should grant Sunflower a loan
for the amount that was requested even though she believes that the company’s existing
credit position is not strong enough for such a loan. It appears that Sheli would be
making a decision that she does not favor in an effort to help her division meet its loan
quota and perhaps to save her job with the bank. If Sheli bases her decision on her own
best interests—that is, keeping her job—at the expense of the bank, then she probably is
making an unethical decision. If, on the other hand, her decision is based on the best
interests of the bank, then her decision is justified.
●
Do you agree with Sheli or Henry concerning the importance of loyalty as a factor in
loan decisions?
To answer this question, other questions should be asked. Do you believe that
customer loyalty is an important factor when making financial decisions? If so, how
important of an input should loyalty be in such decisions?
It appears that Henry believes loyalty is a very important factor that should be
considered when making decisions about loans. Thus, Henry considers intangibles when
making loan decisions. On the other hand, it seems that Sheli would prefer to rely strictly
on her analyses to make decisions; she doesn’t seem to be keen on considering
intangibles when making such decisions. How should such factors as loyalty and
previous business relationships be incorporated into financial decisions? How important
are these factors?
Most people would agree that loyalty and previous credit history are important
factors to consider when making loan decisions. The fact that Sunflower Manufacturing
22
has been a loyal customer of The Democrat for many years must be considered when
making the decision about how much the company should be allowed to borrow. But, is
the company’s loyalty sufficient to increase the amount of the loan from the $2 million
that Sheli’s analysis indicates the company should be granted to the $10 million that
Sunflower requested? Perhaps. Because one of the most important inputs to a loan
decision is the character of the borrower, loyalty should be considered when deciding
how much to lend to Sunflower.
●
Should The Democrat lend Sunflower the $10 million was requested?
On the positive side, if The Democrat lends Sunflower the amount that was
requested, then it appears that Sheli and Henry will meet their loan quotas and their jobs
will be secure for a while. On the other hand, if Sheli is right and Sunflower’s financial
position is not sufficient to handle a $10 million loan, there is a good likelihood that the
loan will not be repaid, which would exacerbate The Democrat’s poor financial position.
In this case, both the lender and the borrower might go bankrupt.
Like any other investment, lending money is risky. In this case, Henry is
convinced that Sunflower will take its business to a competing bank if the entire $10
million loan is not granted. Because The Democrat has been losing business to
competing banks, Henry would like to find a way to lend Sunflower the money it has
requested. It appears that Sheli is amenable to lending the money to Sunflower, but her
motives might not be appropriate. At least she is willing to reconsider her initial
recommendation. Perhaps Sheli could sit down with Sunflower’s executives and “map
out” a plan that will improve the company’s financial strength and permit The Democrat
to approve the $10 million loan without further harming its own financial.
●
What would you do if you were Sheli?
Commercial lending is a very competitive business. Sheli would be wise to
thoroughly examine Sunflower’s existing financial position and project what its financial
position will be during the life of the loan. If the financial position does not warrant
granting the loan in the amount of $10 million, Sheli should determine how Sunflower
can improve its financial position so that the firm can borrow what it needs to continue
successful operations. Because Sunflower has been a loyal customer of the bank, The
Democrat should be a loyal lender. But the bank’s loyalty can only go so far—that is, the
bank should not substantially jeopardize own operations/life.
References:
“Banks Take a New Tack On Mortgage Lending,” The Wall Street Journal Online,
November 1, 2006. (http://online.wsj.com/)
Karen E. Klein, “Building Customer Relations by Listening.” BusinessWeek.com, June
1, 2007.
23