2 3 Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of

Example 16.2 3 Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of

2/10 net 30 EOM. If the firm takes the cash discount, it must pay $980 3$1,000 - (0.02 * $1,000)4 by March 10, thereby saving $20.

Giving Up the Cash Discount If the firm chooses to give up the cash dis- count, it should pay on the final day of the credit period. There is an implicit cost

cost of giving up a cash associated with giving up a cash discount. The cost of giving up a cash discount is discount

The implied rate of interest

the implied rate of interest paid to delay payment of an account payable for an

paid to delay payment of an

additional number of days. In other words, when a firm gives up a discount, it

account payable for an

pays a higher cost for the goods that it orders. The higher cost that the firm pays

PART 7

Short-Term Financial Decisions

FIGURE 16.1

Credit Period Payment Options

Firm

Cash Discount

Ends; Payment options for

Makes

Period Ends;

Pay $1,000 Lawrence Industries

Credit Period Begins

Cost of Additional 20 Days = $1,000 – $980 = $20

days that the purchaser can delay payment to the seller. This cost can be illus- trated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period).

Example 16.3 3 In Example 16.2, we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the

cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must give up an opportunity to pay $980 for its $1,000 purchase. In other words, it will cost the firm $20 to delay payment for 20 days. Figure 16.1 shows the payment options that are open to the company.

To calculate the cost of giving up the cash discount, the true purchase price must be viewed as the discounted cost of the merchandise, which is $980 for Lawrence Industries. Another way to say this is that Lawrence Industries’ sup- plier charges $980 for the goods as long as the bill is paid in 10 days. If Lawrence takes 20 additional days to pay (by paying on day 30 rather than on day 10), they have to pay the supplier an additional $20 in “interest.” Therefore, the interest rate on this transaction is 2.04% ($20 , $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. Equation 16.1 provides the general expression for calculating the annual percentage cost of giving up a cash discount: 1

CD 365

Cost of giving up cash discount =

100% - CD N

1. Equation 16.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each

CHAPTER 16

Current Liabilities Management

where

CD = stated cash discount in percentage terms N= number of days that payment can be

delayed by giving up the cash discount Substituting the values for CD (2%) and N (20 days) into Equation 16.1

results in an annualized cost of giving up the cash discount of 37.24% 3(2% , 98%) * (365 , 20)4 .

A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 16.1:

365 Approximate cost of giving up cash discount = CD *

N The smaller the cash discount, the closer the approximation to the actual cost of

giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% 32% * (365 , 20)4 .

Using the Cost of Giving Up a Cash Discount in Decision Making The financial manager must determine whether it is advisable to take a cash discount.

A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other insti- tution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier.

Example 16.4 3 Mason Products, a large building-supply company, has four possible suppliers, each offering different credit terms. Otherwise, their products and services are

identical. Table 16.1 presents the credit terms offered by suppliers A, B, C, and D and the cost of giving up the cash discounts in each transaction. The approxima- tion method of calculating the cost of giving up a cash discount (Equation 16.2) has been used. The cost of giving up the cash discount from supplier A is 36.5%; from supplier B, 8.1%; from supplier C, 21.9%; and from supplier D, 29.2%.

If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 13%, and if each of the suppliers is viewed separately, which (if any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier

A, the firm takes the cash discount, because the cost of giving it up is 36.5%, and

TA B L E 1 6 . 1 Cash Discounts and Associated Costs

for Mason Products

Approximate cost of Supplier

Credit terms

giving up a cash discount

A 2/10 net 30 EOM

B 1/10 net 55 EOM

C 3/20 net 70 EOM

D 4/10 net 60 EOM

PART 7

Short-Term Financial Decisions

then borrows the funds it requires from its bank at 13% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of this action is less than the cost of borrowing money from the bank (8.1% versus 13%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the 13% cost of borrowing from the bank.

The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain bank borrowing costs. However, other factors relative to payment strategies may also need to be con- sidered. For example, some firms, particularly small firms and poorly managed firms, routinely give up all discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions.

stretching accounts payable

Effects of Stretching Accounts Payable

Paying bills as late as possible

A strategy that is often employed by a firm is stretching accounts payable—that

without damaging the firm’s

is, paying bills as late as possible without damaging its credit rating. Such a

credit rating.

strategy can reduce the cost of giving up a cash discount.

Example 16.5 3 Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of giving up the cash discount, assuming payment on the last day of the credit period, was approximately 36.5% 32% * (365 , 20)4 . If the firm were able to

stretch its account payable to 70 days without damaging its credit rating, the cost of giving up the cash discount would be only 12.2% 32% * (365 , 60)4 . Stretching accounts payable reduces the implicit cost of giving up a cash discount.

Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases.

Personal Finance Example 16.6 3 Jack and Mary Nobel, a young married couple, are in the process of purchasing a 50-inch HD TV at a cost of $1,900.

The electronics dealer currently has a special financing plan that would allow them to either (1) put $200 down and finance the balance of $1,700 at 3% annual interest over 24 months, resulting in payments of $73 per month; or (2) receive an immediate $150 cash rebate, thereby paying only $1,750 cash. The Nobels, who have saved enough to pay cash for the TV, can currently earn 5% annual interest on their savings. They wish to determine whether to borrow or to pay cash to purchase the TV.

The upfront outlay for the financing alternative is the $200 down payment, whereas the Nobels will pay out $1,750 up front under the cash purchase alterna- tive. So the cash purchase will require an initial outlay that is $1,550 ($1,750 - $200) greater than under the financing alternative. Assuming that they can earn a simple interest rate of 5% on savings, the cash purchase will cause the

CHAPTER 16

Current Liabilities Management

If they choose the financing alternative, the $1,550 would grow to $1,705 ($1,550 + $155) at the end of 2 years. But under the financing alternative, the Nobels will pay out a total of $1,752 (24 months * $73 per month) over the 2-year loan term. The cost of the financing alternative can be viewed as $1,752, and the cost of the cash payment (including forgone interest earnings) would be $1,705. Because it is less expensive, the Nobels should pay cash for the TV. The lower cost of the cash alternative is largely the result of the $150 cash rebate.

ACCRUALS The second spontaneous source of short-term business financing is accruals.

accruals Accruals are liabilities for services received for which payment has yet to be

Liabilities for services received

made. The most common items accrued by a firm are wages and taxes. Because

for which payment has yet to

taxes are payments to the government, their accrual cannot be manipulated by

be made.

the firm. However, the accrual of wages can be manipulated to some extent. This is accomplished by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work. The pay period for employees who earn an hourly rate is often governed by union regulations or by state or federal law. However, in other cases, the frequency of payment is at the discretion of the company’s management.

focus on ETHICS Accruals Management

in practice On June 2, 2010,

Each of these activities allowed Diebold, Inc., agreed

A number of the SEC’s claims

Diebold to inflate the company’s finan- to pay a $25 million fine to settle

focused on premature revenue recogni-

tion. For example, Diebold was charged cial performance. According to the accounting fraud charges brought by

SEC’s complaint, Diebold’s fraudulent the U.S. Securities and Exchange

with improper use of “bill and hold”

activities misstated reported pretax earn- Commission (SEC). According to the

transactions. Under generally accepted

ings by at least $127 million between SEC, the management of the Ohio-

accounting principles, revenue is typi-

2002 and 2007. Two years prior to based manufacturer of ATMs, bank

cally recognized after a product is

shipped. However, in some cases, sellers the settlement, Diebold restated earnings security systems, and electronic voting

for the period covered by the charges. machines regularly received reports

can recognize revenue before shipment

The clawback provision of the 2002 comparing the company’s earnings to

for certain bill and hold transactions. The

Sarbanes-Oxley antifraud law requires analyst forecasts. When earnings were used bill and hold accounting to record

SEC claimed that Diebold improperly

executives to repay compensation they below forecasts, management identified revenue prematurely.

receive while their company misled share- opportunities, some of which amounted

The SEC also claimed that Diebold holders. Diebold’s former CEO, Walden to accounting fraud, to close the gap.

O’Dell, agreed to return $470,000 in “Diebold’s financial executives bor-

manipulated various accounting accru-

als. Diebold was accused of understat- cash, plus stock and options. The SEC is rowed from many different chapters of

currently pursuing a lawsuit against three the deceptive accounting playbook to

ing liabilities tied to its Long Term

Incentive Plan, commissions to be paid other former Diebold executives for their fraudulently boost the company’s bottom to sales personnel, and incentives to be part in the matter. line,” SEC Enforcement Director Robert

paid to service personnel. Diebold tem-

Khuzami said in a statement. “When Why might financial managers porarily reduced a liability account set 3 executives disregard their professional still be tempted to manage earn- up for payment of customer rebates. obligations to investors, both they and ings when a clawback is a legiti- The company was also accused of their companies face significant legal mate possibility? overstating the value of inventory and

consequences.” a improper inventory write-ups.

a U.S. Securities and Exchange Commission, “SEC Charges Diebold and Former Executives with Accounting Fraud,” press release, June 2, 2010, www.sec.gov/news/press/2010/2010-93.htm .

PART 7

Short-Term Financial Decisions

Example 16.7 3 Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm

were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 * $400,000) .