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06 Short Term Financing Management KEY
Management Accounting (Foundation University (Philippines))
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Chapter 6 Short Term Financing Management
Answer Key
I. TRUE OR FALSE STATEMENTS Black – True; Red - False
1. The use of short-term debt provides flexibility in financing since the firm is only paying interest when it is using
the borrowed funds.
2. A firm can reduce net working capital by substituting long-term financing, such as bonds, with short-term
financing, such as one-year notes payable.
3. Notes payable is a spontaneous source of financing.
4. Increasing the use of short-term debt versus long-term debt financing will increase profit.
5. Current liabilities have greater illiquidity risk due to the higher frequency that they have to be repaid or rolled
over.
6. Trade credit is a source of spontaneous financing.
7. Short-term debt is frequently less expensive because it provides the borrower more security.
8. Sources of financing repaid in six months to one year are usually categorized as long-term.
9. Major sources of secured credit include commercial banks, finance companies, and factors.
10. Inventory loans are considered an unsecured source of financing.
11. The cost of trade credit varies directly with the size of the cash discount and inversely with the length of time
between the end of the discount period and the final due date.
12. The continual practice of stretching on trade credit is potentially a very useful source of short-term credit for
the firm.
13. The effective cost to the borrower of an unsecured bank loan is increased if a compensating balance is required.
14. Minimizing working capital is accomplished by slowing down the cash conversion cycle.
15. The conventional method for financing permanent levels of accounts receivable and inventory is accounts
payable and accrued expenses.
16. A firm should take the cash discount if the firm's cost of borrowing from the bank is greater than the cost of
giving up a cash discount.
17. If a firm anticipates stretching accounts payable, its cost of giving up a cash discount is reduced.
18. The cost of giving up a cash discount on a credit purchase is the implied interest rate paid in order to delay
payment for an additional number of days
19. In giving up a cash discount, the amount of the discount that is given up is the interest being paid by a firm to
keep its money by delaying payment for a number of days.
20. A revolving credit agreement is a form of financing consisting of short-term, unsecured promissory notes issued
by firms with a high credit standing.
II. MULTIPLE CHOICE QUESTIONS Encircle the letter that corresponds to the best answer.
1.
Which of the following is a spontaneous source of financing?
a. Accrued wages
b. Preferred stock
c. Trade credit
d. Both a and c
2. Accounts receivable and inventory self-liquidate through the ______ cycle.
a. spontaneous account
b. net working capital
c. cash conversion
d. sales-to-receivables collection
3. Which of the following is considered a source of spontaneous financing?
a. Trade credit
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b. Inventories
c. Accounts payable
d. Both a and c
4. With regard to the hedging principle, which of the following assets should be financed with current liabilities?
a. Minimum level of cash required for year-round operations
b. Expansion of accounts receivable to meet seasonal demands
c. Machinery used to produce a firm’s inventory
d. Both a and b
5. Trade credit is an example of which of the following sources of financing?
a. Spontaneous
b. Temporary
c. Permanent
d. Both a and b
6. Which of the following is a spontaneous source of financing?
a. Accounts payable
b. Accounts payable and wages and salaries payable
c. Accounts payable and inventories
d. Accounts payable, wages and salaries payable, and accrued interest
7.
Which of the following types of financing offers the firm the greatest degree of flexibility?
a. Bonds
b. Preferred stock
c. Short-term lines of credit
d. Long-term notes payable
8. Which of the following actions would improve a firm’s liquidity?
a. Selling stock and reducing accounts payable
b. Selling stock to purchase equipment
c. Selling bonds and purchasing machinery
d. Both a and c
9.
As sales increase, a company needs more inventory and more employees resulting in ________.
a. more accounts payable and accruals, and therefore increasing its spontaneous liabilities.
b. less accounts payable and accruals, and therefore decreasing its spontaneous liabilities.
c. more accounts payable and accruals, and therefore decreasing its spontaneous liabilities.
d. less accounts payable and accruals, and therefore increasing its spontaneous liabilities.
10. A negative cash conversion cycle ________.
a. means that the operating cycle exceeds the average inventory period.
b. means that the average payment period exceeds the operating cycle.
c. indicates that a firm is shortening its average payment period and lengthening its average collection
period.
d. indicates that a firm is shortening its average age of inventory and average payment period.
11. If a firm decides to take the cash discount that is offered on goods purchased on credit, the firm should
a. pay as soon as possible.
b. pay on the last day of the credit period.
c. pay on or before the last day of the discount period.
d. not take the discount no matter when the firm actually pays.
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12. The effective interest rate generally is ________.
a. lower if the loan is a discount loan
b. higher if the loan is a discount loan
c. higher on a loan if interest is paid at maturity
d. not affected by whether the loan is a discount loan or a loan with interest paid at maturity
13. The cost of giving up a cash discount on a credit purchase is ________
a. the true purchase price of the goods
b. added on to the price of the goods in order to make payment quickly
c. deducted from the price of the goods in order to make payment quickly
d. the implied interest rate paid in order to delay payment for an additional number of days
14. Short-term loans that businesses obtain from banks and through commercial paper are ________.
a. negotiated and secured
b. negotiated and unsecured
c. spontaneous and secured
d. spontaneous and unsecured
15. Short-term, self-liquidating loans are intended to ________.
a. recapitalize the firm
b. provide maximum amount to the firm that it can owe to the bank
c. provide one-time loan to the borrower who needs funds for a specific purpose
d. cover seasonal peaks in financing caused by inventory and receivable buildups
III. MULTIPLE CHOICE PROBLEMS
Encircle the letter that corresponds to the best answer of the following problems.
1. What is the effective annualized cost of foregoing the trade discount on terms 2/10 net 80 (round to the nearest
.1%)?
a. 9.0%
b. 10.5%
c. 11.3%
d. 12.0%
2. What is the effective annualized cost of foregoing the trade discount with terms 2/15 net 70 (round to the nearest
.1%)?
a. 13.1%
b. 13.4%
c. 14.3%
d. 14.7%
3.
Stanley Shoe Company established a line of credit with a local bank. The maximum amount that can be
borrowed under the terms of the agreement is P100,000 at an annual rate of 12%. A compensating balance
averaging 10% of the amount borrowed is required. Prior to the agreement, the company had no deposit with
the bank. Shortly after signing the agreement, the company needed P50,000 to pay off a note that was due. It
borrowed the P50,000 from the bank by drawing on the line of credit. What is the effective annual cost of
credit?
a.
13.2%
b.
13.3%
c.
13.6%
d.
13.9%
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4.
Smith & Smith Enterprises has a line of credit with National Bank that allows the company to borrow up to
P350,000 at an interest rate of 15%. However, the firm must keep a compensating balance of 10% of any amount
borrowed on deposit at the bank. The company does not normally keep a cash balance account with the bank.
What is the effective annual cost of credit?
a. 17.8%
b. 17.52%
c. 16.91
d. 16.67%
5.
The Azurin Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with
a 20% compensating balance. The term of the loan is 1 year. The effective cost of borrowing is (rounded to the
nearest hundredth):
a. 8.75%.
b. 9.41%.
c. 9.52%.
d. 9.59%.
6.
Salguero, Inc. can issue 3-month commercial paper with a face value of ₱1,000,000 for ₱980,000. Transaction
costs will be ₱1,200. The effective annualized percentage cost of the financing, based on a 360-day year, will
be:
a. 8.48%.
b. 8.66%.
c. 8.99%.
d. 9.02%.
7.
When a company offers credit terms of 2/10, net 30, the annual interest cost, based on a 360-day year, is:
a. 24.0%.
b. 35.3%.
c. 36.0%.
d. 36.7%.
8.
If a firm's credit terms require payment within 45 days but allow a discount of 2% if paid within 15 days
(using a 360-day year), the approximate cost or benefit of the trade credit terms is:
a. 14%.
b. 16%.
c. 20%.
d. 24%.
9.
Tolentino, Inc. buys on terms of 2/10, net 30 days. It does not take discounts, and it typically pays 35 days
after the invoice date. Net purchases amount to P720,000 per year. What is the nominal annual cost of its
non-free trade credit?
a. 14%.
b. 16%.
c. 20%.
d. 24%.
10. Assume that the current borrowing rate is at 15%. Which of the following discounts should the firm take?
a. 2/10, net/45
b. 1/15, net/75
c. 3/10, net/80
d. 1/10, net/45
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PROBLEMS
6.1
Assume that Lasaleta company purchase P5,000 worth of supplies every 60 days and never take the trade
discount of 2/10 net 60.
1. How much the company could save each (360-day) year if the company took the discount? P600
2. What is the effective annualized (365 days) cost of foregoing a trade credit discount of 3/10 net 45? 32.35%
6.2
.
Required:
1. What is the annual cost associated with each financing arrangement?
2. Discuss some considerations other than cost that may influence management’s decision between factoring
and a commercial bank loan.
1
2
Commercial bank loans
Amount loaned P250,000 x 75%
Discount P187,500 x ( 9%/12 months)
Compensating balance = P187,500 x 20%
Amount received
187,500.00
(1,406.25)
(37,500.00)
148,593.75
Annual costs:
Interest expense
Credit department costs
Bad debts
Total annual costs
P187,500 x 9%
P4,000 x 12 months
2% x P250,000 x 12 months
16,875.00
48,000.00
60,000.00
124,875.00
Factoring
Amount loaned
Factoring commission
Prepaid interest
Amount received
P250,000 x 85%
P250,000 x 3.5%
(P212,500 - P8,750) x 9%/12
212,500.00
(8,750.00)
(1,528.00)
202,222.00
Annual Costs
Annual Commissions
Annual Interest
Total annual costs
P8,750 x 12
P203,750 x 9%
105,000.00
18,337.50
123,337.50
The annual factoring costs are slightly lower than the cost of bank loan and the factor is willing to
advance greater amount. However, the elimination of the credit department could reduce the
firm's options in the future.
6.3
Carmen Traders, Inc. needs ₱100,000 to pay a supplier’s invoice for merchandise purchased with terms of
2/10, net 30. The company wants to pay on the 10th day of the credit term so it can avail of the 2% discount.
The funds needed can be raised by obtaining a short-term loan from a bank which agrees to grant a 30-day
loan at 12% discounted interest per annum. The bank requires that a compensating balance of 10% be maintained
in the borrower’s non-interest earning deposit account.
Required:
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1.
2.
3.
4.
What is the amount needed by Carmen Traders to pay the invoice within the discount period?
What is the principal amount of the loan that must be obtained from the bank to raise the needed fund?
What is the effective interest rate of the loan?
If Carmen Traders fails to pay the discount and pays the account on the 30 th day of the term, what is the
annual cost of this non-free trade credit?
Answer
1) Invoice Amount
Less: 2% Discount
Net Amount of Funds Needed
2)
Let x
98,000
98,000
x
₱ 100,000
2,000
₱ 98,000
= Principal Amount of the Loan
= x – 0.10x 0 0.01x
= 0.89x
= ₱ 110,112.36
3)
Annual Interest Expense (₱ 110,112.36 × 12%)
/ Usable Loan Amount
Effective Annual Interest Rate
4)
Annual Cost Rate =
2
98
×
360
30 - 10
₱ 13,213.48
98,000.00
13.48%
= 36.73%
6.4
Cubone & Ive's Lithography has a Cost of Goods Sold of ₱ 95 million. The company's accounts payable
balance is ₱ 9.5 million. Calendar period: 360 days. Its accounts payable deferral period is __________ days.
Accounts Payable Deferral Period
=
360
/ ( ₱ 95 / ₱9.5 )
=
36
days
6.5
Graveler Mining plans to borrow ₱100,000 for one year under a line of credit with a stated interest rate of
7.5 percent and a 15 percent compensating balance.
Case A:
If the firm normally keeps a balance of about ₱10,000 in its checking account and is willing to accept loan
proceeds lesser than ₱100,000.
1. The loan proceeds would be ₱______________________ . (Round-off to 2 d.p.)
2. The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2
d.p.)
3. The effective annual interest rate on the loan is ________% (Round-off to 2 d.p.)
Case B:
1.
2.
If the fi rm normally keeps almost no money in its checking account. Loan proceeds: ₱100,000.
The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2
d.p.)
The amount borrowed would be ₱______________________ . (Round-off to 2 d.p.)
Answer:
A. If the firm normally keeps a balance of about ₱10,000 in its checking account and is willing to accept loan
proceeds lesser than ₱100,000.
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1.
The loan proceeds would be ₱______________________ . (Round-off to 2 d.p.)
Compensating Balance
= 15% of Loan
=
₱100,000.00
x
15.00%
=
₱15,000.00
less: DD ₱10,000
LOAN
PROCEEDS
=
₱100,000.00
₱5,000.00
=
₱95,000.00
2.
The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2 d.p.)
=
=
INT
3.
₱5,000.00
₱100,000.00
₱7,500.00
x
7.50% x
12 / 12
- NOT DISCOUNTED, will be repaid at end of term
The effective annual interest rate on the loan is ________% (Round-off to 2 d.p.)
=
APR
=
₱100,000.00
7.89%
₱7,500.00
-
x
₱5,000.00
1
12 / 12
B. If the firm normally keeps almost no money in its checking account. Loan proceeds: ₱100,000.
1.
The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2
d.p.)
=
=
INT
₱117,647.06
₱8,823.53
x
7.50%
Nor The amount borrowed would be ₱______________________ . (Round-off to 2 d.p.)
BONUS:
ann
B
B
B
2.
=
=
=
₱100,000.00
₱100,000.00
₱117,647.06
/ (100% - 15%)
/
85%
Compensating Balance
= 15% of Loan
=
₱117,647.06
x
15.00%
=
₱17,647.06
LOAN
PROCEEDS
=
₱117,647.06
₱17,647.06
=
₱100,000.00
The effective annual interest rate on the loan is ________% (Round-off to 2 d.p.)
APR
=
=
₱8,823.53
₱117,647.06
₱17,647.06
8.82%
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6.6
A retailer’s terms of trade are 3/10, n/45 with a particular supplier. (assume a 360-day year)
Required:
What is the cost on an annual basis of not taking the discount? 31.81%
6.7
A company obtained a short-term bank loan of P250,000 at an annual interest rate of 6%. As a condition of
the loan, the company is required to maintain a 20% compensating balance in its checking account. Ordinarily, the
company maintains a balance of P25,000 in its checking account for transactions purposes.
Required:
What is the effective interest rate of the loan? 6.67%
6.8
▪
▪
▪
NOP Co. has agreed to the following loan proposal by a bank:
Stated interest rate of 10% on a one-year discounted note
15% of the loan as compensating balance with zero-interest current account to be maintained with the bank.
The loan will have net proceeds of P1,500,000.
Required:
1. How much is the principal amount of the loan? P2,000,000
2. What is the effective interest rate of the loan? 13.33%
6.9
Quennie Company recently borrowed P500,000 from a bank. The bank loan is for a period of 120 days at an
annual rate of 6%. (assume a 360-day year).
Required:
1. How much is the total interest expense for this loan? P10,000
2. What is the effective annual rate? 6.12%
6.10
GHI Company has a revolving line of credit of P300,000 with a one-year maturity. The terms call for a 6%
interest rate and a ½% commitment fee on the unused portion of the credit line. The average loan balance during
the year was P100,000.
Required:
How much is the annual cost (in pesos) of this financing arrangement? P7,000
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