WESLEYAN UNIVERSITY-PHILIPPINES
COLLEGE OF BUSINESS AND ACCOUNTANCY
STRATEGIC COST MANAGEMENT
MODULE 4
Short-Term Financing
Factors Considered in Selecting the Source of Short-Term Financing
1. Cost of credit
2. Availability of credit in the amount needed and for the period of time when financing is required
3. Influence of the use of particular credit source on the cost and availability of other sources of
financing
4. Additional covenants of the loans that are unique to the sources mentioned previously
Cost of Credit
Cost of
Trade Credit
=
Discount %
1-Discount %
Effective Annual
=
Rate(Simple)
Effective Annual
Rate(Simple)
x
360
Payable Def Period - Disc. Period
Interest
Principal
= (1 +
Interest%
Compounding Periods
)
xCompounding Periods
-
1
-
1
Effective Annual
Interest
=
Rate(Discount)
Amount Received
Effective Annual
Rate(Discount)
Interest Php
Proceeds
= (1 +
)
xCompounding Periods
Effective Annual
Interest
=
Rate(SI w/ CB)
Principal - Compensating Balance
Effective Annual
Interest
=
Rate(DI w/ CB)
Principal - Compensating Balance - Interest
Cost of
Commercial Paper
=
Interest + Issue Cost
360
x
Face Value - Interest - Interest Cost
Days to Maturity
Sources of Short-Term Funds
Unsecured Credit
1. Accruals – difference in payment period
2. Trade credit – spontaneous source (regular activity), most flexible, high cost
3. Bank loans – nonspontaneous
4. Line of credit
5. Commercial papers – unsecured short-term promissory note sold in the money market by highly
credit-worthy firms
Secured Credit
1. Pledging of Receivables
2. Factoring of accounts receivable
3. Inventory loans w/
a. Floating or blanket lien
b. Chattel mortgage
c. Field warehouse financing agreement
d. Terminal warehouse receipt
Exercises:
1. Accruals are ‘free” in the sense that no interest must be paid on these funds
a. True
b. False
2. The effect of compensating balances is to decrease commercial paper is correct?
a. True
b. False
3. Which of the ff. statements concerning commercial paper is correct?
a. Commercial paper is secured debt of large financially strong firms.
b. Maturities of commercial paper generally exceed 9 months.
c. Commercial paper interest rates are typically 1.25 to 1.50 percentage points above the stated
prime rate.
d. None of the above statements is correct.
4. A firm buys on terms 2/10, net 30, but generally does not pay until 40 days after the invoice date.
Its purchases total P1,080,000 per year. How much “non-free” trade credit does the firm use on
average each year?
a. P120,000
b. P90,000
c. P60,000
d. P30,000
5. Refer to the previous number. What is the approximate cost of the “non-free” trade credit?
a. 16.2%
b. 19.4%
c. 21.9%
d. 24.5%
6. You plan to borrow P10,000 from your bank, which offers to lend you the money at a 10%
nominal or stated rate on a 1-year-loan. What is the effective interest rate if the loan is a discount
loan?
a. 11.1%
b. 13.3%
c. 15.0%
d. 20.0%
7. what is the effective interest rate if the loan is a discount loan with a 15% compensating balance?
a. 11.1%
b. 13.3%
c. 15.0%
d. 20.0%
8. Under the terms of the previous question, how much would you have to borrow to have the use of
P10,000?
a. 10,000
b. 11,111
c. 12,000
d. 13,333
9. If a firm had been extending trade credit on a 2/10, net 30 basis, what change would be expected
on the balance sheet of its customers if the firm went to a net cash 30 policy?
a. Increased payables
b. Increased payables and increased bank loans
c. Increased receivables
d. Decreased receivables and increased bank loans
10. Given that each of the ff short-term sources Is available, which source of financing is likely to
have the highest cost for a small business?
a. Trade credit
b. Commercial bank loan
c. Factoring
d. Advances by owners
11. The net effect of a compensating balance requirement on a loan from the viewpoint of the
borrower is
a. The effective borrowing costs will be lower than if the compensating balance were not
required
b. The effective borrowing costs will be higher than if the compensating balance were not
required
c. The compensating balance has no effect on financing costs
d. The compensating balance will seldom be used if the loan maturity is less than 5 years.
12. Experience w/ compensating balances in corporate bank accounts reveals that
a. The use of compensating balances tend to lower the cost of borrowing
b. Banks tend to be very strict and require that compensating balances be maintained
exactly as agreed.
c. Banks tend to be flexible in administering compensating balances and, based on the
different business conditions, allow fluctuations from the required level
d. The use of compensating balances has no effect on the cost of borrowing.
13. The financing cost of the basic level of current assets by issuing commercial paper is inconsistent
with
a. The maximization of shareowner’s wealth
b. The objective of matching the maturities of assets and liabilities
c. The goal of minimizing the cost of debt financing
d. The expectation that long-term interest rates will decrease in the coming year
14. Factoring is a credit arrangement
a. Which involves the outright sale of accounts receivable to a factor\
b. Which should be used only as a last resort when all other sources of financing fail
c. In which the actors is free to request new receivables from those accounts It deems
uncollectible
d. In which the cash advances from the factor is essentially a loan secured by the eventual
collection of the receivables factored
15. Ken Company obtained a short-term bank loan for P1,000,000 at an annual interest rate 12%. As
a condition if the loan Ken is required to maintain a compensating balance of P200,000 in its
checking account. The checking account earns interest at an annual rate of 6%. Ken would
otherwise maintain only P100,000 in its checking account for transactional purposes. Ken’s
effective interest costs of the loan is
a. 12.00%
b. 14.00%
c. 13.50%
d. 12.67%
16. Leo Inc. can issue 3-month commercial paper with a face value of P1M for P980,000. Transaction
costs would be P1,200. The annualized percentage cost of the financing would be
a. 2.17%
b. 8.48%
c. 8.67%
d. 8.00%
17. Which one of the ff. is a spontaneous source of financing?
a. Notes payable
b. Long-term debt
c. Prepaid interest
d. Trade credit
18. The ALT Corp. was recently quoted terms on a commercial bank loan of 7% discounted interest
w/ a 20% compensating balance. The term of the loan is 1 year. The effective cost of borrowing is
a. 6.54%
b. 8.75%
c. 9.41%
d. 9.59%
19. The principal advantage of using commercial paper as a short-term financing instrument is that it
a. Is generally cheaper than a commercial bank loan
b. Is readily available to almost all companies
c. Offers security to the lender
d. Can be purchased without commission costs
20. The treasury analyst for G Manufacturing has estimated the cash flows for the first half of the next
year as follows:
January
February
March
April
May
June
Cash(millions)
Inflows Outflows
2
1
2
4
2
5
2
3
4
2
5
3
G has a line of credit of up to P4M on which it pays interest monthly at a rate of 1% of the amount
utilized. G is expected to have a cash balance of P2M on January 1 and no amount utilized on its
line of credit. Assuming all cash flows occur at the end of the month, approximately how much will
G pay in interest during the first half of the year?
a. 0
b. 61,000
c. 80,000
d. 132,000
The Game Supply Company has just acquired a large account and needs to increase its working capital
by P100,000. The controller of the company has identified the four sources of funds given below:
• Pay a factor to buy the company’s receivables, which average P125,000 per month and have an
average collection period of 30 days. The factor will advance up to 80% of the face value of
receivables at 10% and charge a fee of 2% on all receivables purchased. The controller
estimated that the firm would save P24,000 in collection expenses over the year. Assume the fee
and interest are no deductible in advance.
• Borrow P110,000 from a bank at 12% interest. A 9% compensating balance would be required.
•
•
Issue P110,000 of 6-month commercial paper to net P100,000. (New paper will be issued every 6
months)
Borrow P125,000 from a bank on a discount basis at 20%. No compensating balance would be
required.
Assume a 360-day year in all of your calculations.
21. The cost of alternative A is
a. 10.0%
b. 12.0%
c. 13.2%
d. 16.0%
22. The cost of alternative B is
a. 9.0%
b. 12.0%
c. 13.2%
d. 21.0%
23. The cost of alternative C is
a. 9.1%
b. 10.0%
c. 18.2%
d. 20.0%
24. The cost of alternative D is
a. 20.0%
b. 25.0%
c. 40.0%
d. 50.0%
25. M Company needs to pay a supplier’s invoice of P60,000 and wants to take a cash discount of
2/10, net 40. The firm can borrow the money for 30 days at 11% per annum with a 9%
compensating balance. Assume a 360-day year.
The amount M must borrow to pay the supplier within the discount period and cover the
compensating balance is
a. P60,000
b. P65,934
c. P64,615
d. P58,800
1. The C Company is a whole same machine tool broker which has gone through a recent
expansion of its activities resulting in a doubling of its sales. The company has determined that it
needs an additional P200M in short-term funds to finance peak season sales during roughly 6
months of the year. C’s treasurer has recommended that the firm utilize a commercial paper
offering to raise the needed funds. Specifically, he has determined that a P200M offering would
require 10% interest (paid in advance) plus P125,000 placement fee. The paper would carry a 6month(180-day) maturity. What is the effective cost of credit?
2. The Jan Mfg. Co. provides specialty steel products to the oil industry. Although the firm’s
business is highly correlated with the cyclical swings in oil exploration activity, it also experiences
some currently concerned about. The firm needs P500,000 of the 2-month July-August period
each year, and as a result the company’s vice president of finance is currently considering the
following 3 sources of financing:
a. Establish a time of credit with the First national Bank. The bank has agreed to provide Jan
with their needed P500,000 carrying an interest rate of 14% with interest discounted and a
compensating balance of 20% on the loan balance. Jan does not have a bank account with
the First national Bank and would have to establish one to satisfy the compensating balance
requirement.
b. Jan can forgo its trade discounts over the 2 months of July and August when the funding will
be needed. The firm’s discount terms are 3/15 net 30, and the firm averages P500,000 in
trade credit purchases during July and August.
c. Finally, Jan could enter into a pledging arrangement with a local finance company. The
finance company has agreed to extend Jan the needed P500,000, if it pledges P750,000 in
receivables. The finance company has offered to advance the P500,000, with 12% annual
interest payable at the end of the 2-month loan term. In addition, the finance company will
charge a ½ of 1% fee based on the pledged receivables to cover the cost of processing the
company’s accounts (this fee is paid at the end of the loan period)
Analyze the cost of each of the alternative sources of credit and select the best one. Note that the
P500,000 will be needed for a 2-month period each year.
3. The treasurer of the Jelo Mfg. Company is faced with 3 alternative bank loans. The firm wishes to
select the one that minimizes its cost of credit on a P200,000 note that it plans to issue in the next
10 days. Relevant information for the 3 loan configurations is found below:
a. An 18% rate of interest with interest paid at year-end and no compensating balance
requirement.
b. A 16% rate of interest but carrying a 20% compensating balance requirement. This loan also
calls for interest to be paid at year end.
c. A 14% rate of interest that is discounted plus a 20% compensating balance requirement.
Analyze the cost of each of these alternatives. You may assume that the firm would not normally
maintain any bank balance that might be used to meet the 20% compensating balance
requirements of alternatives (b) and (c)
4. The Kiwi Corporation buys from its suppliers on terms of 2/10, net 55. Kiwi has not been utilizing
the discounts offered and has been taking 55 days to pay its bills.
Mr. Suelas, Kiwi Corporation’s vice president, has suggested that the company begin to take the
discounts offered. Mr. Suelas proposes that the company borrow from its bank at a stated rate of
14%. The bank requires a 20% compensating balance on these loans. Current account balances
would not be available to meet any of this compensating balance requirement.
Do you agree with Mr. Suelas’ proposal?
5. Ready Flashilights, Inc. needs P300,000 to take a cash discount of 2/10, net 70. A banker will
loan the money for 60 days at an interest cost of P5,500.
a. What is the effective rate on the bank loan?
b. How much would it cost (in % terms) if the firm did not take the cash discount, but paid the bill
in 70 days instead of 10 days?
c. Should the firm borrow the money to take the discount?
d. If the banker requires a 20% compensating balance, how much must the firm borrow to end
up with the P300,000?
e. What would be the effective interest rate in part D if the interest charge for 60 days were
P6,850? Should the firm borrow with the 20% compensating balance? (The firm has no funds
to count against the compensating balance requirement)
“The wicked borrows and does not repay, But the righteous shows mercy and gives.”
Psalm 37:21