Describe the various ways in which inventory can be used as short-term-

LG 6 Describe the various ways in which inventory can be used as short-term-

loan collateral. Inventory can be used as short-term-loan collateral under a floating lien, a trust receipt arrangement, or a warehouse receipt loan.

Opener-in-Review

In the chapter opener you learned that Memorial Sloan-Kettering Cancer Center had created significant cash flow by using electronic invoicing and taking advan- tage of discounts on accounts payable. Do these gains in working capital efficiency affect Sloan-Kettering’s operating risk, and if so how?

PART 7

Short-Term Financial Decisions

Self-Test Problem (Solution in Appendix)

LG 1 LG 2 ST16–1 Cash discount decisions The credit terms for each of three suppliers are shown in

the following table. ( Note: Assume a 365-day year.)

Supplier

Credit terms

X 1/10 net 55 EOM

2/10 net 30 EOM

2/20 net 60 EOM

a. Determine the approximate cost of giving up the cash discount from each

supplier. b. Assuming that the firm needs short-term financing, indicate whether it would be

better to give up the cash discount or take the discount and borrow from a bank at 15% annual interest. Evaluate each supplier separately using your findings in

part a. c. What impact, if any, would the fact that the firm could stretch its accounts

payable (net period only) by 20 days from supplier Z have on your answer in part b relative to this supplier?

Warm-Up Exercises All problems are available in

LG 1 E16–1 Lyman Nurseries purchased seeds costing $25,000 with terms of 3/15 net 30 EOM on January 12. How much will the firm pay if it takes the cash discount? What is the approximate cost of giving up the cash discount, using the simplified formula?

LG 2 E16–2 Cleaner’s, Inc., is switching to paying employees every 2 weeks rather than weekly and will therefore “skip” 1 week’s pay. The firm has 25 employees who work a 60- hour week and earn an average wage of $12.50 per hour. Using a 10% rate of interest, how much will this change save the firm annually?

LG 3 E16–3 Jasmine Scents has been given two competing offers for short-term financing. Both offers are for borrowing $15,000 for 1 year. The first offer is a discount loan at 8%; the second offer is for interest to be paid at maturity at a stated interest rate of 9%. Calculate the effective annual rates for each loan and indicate which loan offers the better terms.

LG 3 E16–4 Jackson Industries has borrowed $125,000 under a line-of-credit agreement. While the company normally maintains a checking account balance of $15,000 in the lending bank, this credit line requires a 20% compensating balance. The stated interest rate on the borrowed funds is 10%. What is the effective annual rate of interest on the line of credit?

LG 4 E16–5 Horizon Telecom sold $300,000 worth of 120-day commercial paper for $298,000. What is the dollar amount of interest paid on the commercial paper? What is the

CHAPTER 16

Current Liabilities Management

Problems All problems are available in

LG 1 P16–1 Payment dates Determine when a firm must pay for purchases made and invoices dated on November 25 under each of the following credit terms:

a. net 30 date of invoice b. net 30 EOM c. net 45 date of invoice d. net 60 EOM

LG 1 P16–2 Cost of giving up cash discounts Determine the cost of giving up the cash discount under each of the following terms of sale. ( Note: Assume a 365-day year.)

a. 2/10 net 30 b. 1/10 net 30 c. 2/10 net 45 d. 3/10 net 45 e. 1/10 net 60 f. 3/10 net 30 g. 4/10 net 180

LG 1 P16–3 Credit terms Purchases made on credit are due in full by the end of the billing period. Many firms extend a discount for payment made in the first part of the

billing period. The original invoice contains a type of shorthand notation that explains the credit terms that apply. ( Note: Assume a 365-day year.)

a. Write the shorthand expression of credit terms for each of the following:

Cash

Beginning of

Cash discount

discount period

Credit period

credit period

date of invoice 2 10 30 end of month 2 7 28 date of invoice 1 10 60 end of month

b. For each of the sets of credit terms in part a, calculate the number of days until

full payment is due for invoices dated March 12. c. For each of the sets of credit terms, calculate the cost of giving up the cash

discount. d. If the firm’s cost of short-term financing is 8%, what would you recommend in

regard to taking the discount or giving it up in each case? LG 1 P16–4 Cash discount versus loan Erica Stone works in an accounts payable department.

She has attempted to convince her boss to take the discount on the 3/10 net 45 credit terms most suppliers offer, but her boss argues that giving up the 3% discount is less costly than a short-term loan at 14%. Prove to whoever is wrong that the other is correct. ( Note: Assume a 365-day year.)

Personal Finance Problem

LG 2 P16–5 Borrow or pay cash for an asset Bob and Carol Gibbs are set to move into their

PART 7

Short-Term Financial Decisions

buffet. Dining room sets are typically one of the more expensive home furnishing items, and the store offers financing arrangements to customers. Bob and Carol have the cash to pay for the furniture, but it would definitely deplete their savings, so they want to look at all their options.

The dining room set costs $3,000 and Furniture R’Us offers a financing plan that would allow them to either (1) put 10% down and finance the balance at 4% annual interest over 24 months or (2) receive an immediate $200 cash rebate, thereby paying only $2,800 cash to buy the furniture.

Bob and Carol currently earn 5.2% annual interest on their savings. a. Calculate the cash down payment for the loan. b. Calculate the monthly payment on the available loan. ( Hint: Treat the current

loan as an annuity and solve for the monthly payment.) c. Calculate the initial cash outlay under the cash purchase option. d. Assuming that they can earn a simple interest rate of 5.2% on savings, what will

Bob and Carol give up (opportunity cost) over the 2 years if they pay cash? e. What is the cost of the cash alternative at the end of 2 years? f. Should Bob and Carol choose the financing or the cash alternative?

LG 1 LG 2 P16–6 Cash discount decisions Prairie Manufacturing has four possible suppliers, all of which offer different credit terms. Except for the differences in credit terms, their

products and services are virtually identical. The credit terms offered by these sup- pliers are shown in the following table. ( Note: Assume a 365-day year.)

Supplier

Credit terms

1/10 net 30 EOM

2/20 net 80 EOM

1/20 net 60 EOM

3/10 net 55 EOM

a. Calculate the approximate cost of giving up the cash discount from each supplier. b. If the firm needs short-term funds, which are currently available from its com-

mercial bank at 16%, and if each of the suppliers is viewed separately, which, if any, of the suppliers’ cash discounts should the firm give up? Explain why.

c. What impact, if any, would the fact that the firm could stretch by 30 days its accounts payable (net period only) from supplier M have on your answer in part

b relative to this supplier?

LG 2 P16–7 Changing payment cycle On accepting the position of chief executive officer and chairman of Reeves Machinery, Frank Cheney changed the firm’s weekly payday

from Monday afternoon to the following Friday afternoon. The firm’s weekly pay- roll was $10 million, and the cost of short-term funds was 13%. If the effect of this change was to delay check clearing by 1 week, what annual savings, if any, were realized?

LG 2 P16–8 Spontaneous sources of funds, accruals When Tallman Haberdashery, Inc., merged with Meyers Men’s Suits, Inc., Tallman’s employees were switched from a weekly to a biweekly pay period. Tallman’s weekly payroll amounted to $750,000. The cost of funds for the combined firms is 11%. What annual savings, if any, are realized by

CHAPTER 16

Current Liabilities Management

LG 3 P16–9 Cost of bank loan Data Back-Up Systems has obtained a $10,000, 90-day bank

loan at an annual interest rate of 15%, payable at maturity. ( Note: Assume a 365-day year.)

a. How much interest (in dollars) will the firm pay on the 90-day loan? b. Find the 90-day rate on the loan. c. Annualize your result in part b to find the effective annual rate for this loan,

assuming that it is rolled over every 90 days throughout the year under the same terms and circumstances.

Personal Finance Problem LG 3 P16–10 Unsecured sources of short-term loans John Savage has obtained a short-term loan from First Carolina Bank. The loan matures in 180 days and is in the amount of $45,000. John needs the money to cover start-up costs in a new business. He hopes to have sufficient backing from other investors by the end of the next 6 months. First Carolina Bank offers John two financing options for the $45,000 loan: a fixed- rate loan at 2.5% above prime rate, or a variable-rate loan at 1.5% above prime.

Currently, the prime rate of interest is 6.5%, and the consensus forecasts of a group of mortgage economists for changes in the prime rate over the next 180 days are as follows: Sixty days from today the prime rate will rise by 0.5%; 90 days from today the prime rate will rise another 1%; 180 days from today the prime rate will drop by 0.5%.

Using the forecast prime rate changes, answer the following questions. a. Calculate the total interest cost over 180 days for a fixed-rate loan. b. Calculate the total interest cost over 180 days for a variable-rate loan. c. Which is the lower-interest-cost loan for the next 180 days?

LG 3 P16–11 Effective annual rate

A financial institution made a $10,000, 1-year discount loan at 10% interest, requiring a compensating balance equal to 20% of the face value of the loan. Determine the effective annual rate associated with this loan. (Note: Assume that the firm currently maintains $0 on deposit in the financial institution.)

LG 3 P16–12 Compensating balances and effective annual rates Lincoln Industries has a line of credit at Bank Two that requires it to pay 11% interest on its borrowing and to maintain a compensating balance equal to 15% of the amount borrowed. The firm has borrowed $800,000 during the year under the agreement. Calculate the effective annual rate on the firm’s borrowing in each of the following circumstances:

a. The firm normally maintains no deposit balances at Bank Two. b. The firm normally maintains $70,000 in deposit balances at Bank Two. c. The firm normally maintains $150,000 in deposit balances at Bank Two.

d. Compare, contrast, and discuss your findings in parts a, b, and c.

LG 3 P16–13 Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $150,000 for 6 months. State Bank has offered to lend the funds at a 9% annual rate subject to a 10% compensating balance. ( Note: Weathers currently maintains $0 on deposit in State Bank.) Frost Finance Co. has offered to lend the funds at a 9% annual rate with discount-loan terms. The principal of both loans would be payable at maturity as a single sum.

a. Calculate the effective annual rate of interest on each loan. b. What could Weathers do that would reduce the effective annual rate on the State

PART 7

Short-Term Financial Decisions

LG 3 P16–14 Integrative—Comparison of loan terms Cumberland Furniture wishes to establish a prearranged borrowing agreement with a local commercial bank. The bank’s terms

for a line of credit are 3.30% over the prime rate, and each year the borrowing must be reduced to zero for a 30-day period. For an equivalent revolving credit agree- ment, the rate is 2.80% over prime with a commitment fee of 0.50% on the average unused balance. With both loans, the required compensating balance is equal to 20% of the amount borrowed. ( Note: Cumberland currently maintains $0 on deposit at the bank.) The prime rate is currently 8%. Both agreements have $4 million bor- rowing limits. The firm expects on average to borrow $2 million during the year no matter which loan agreement it decides to use.

a. What is the effective annual rate under the line of credit? b. What is the effective annual rate under the revolving credit agreement? (Hint:

Compute the ratio of the dollars that the firm will pay in interest and commit- ment fees to the dollars that the firm will effectively have use of.)

c. If the firm does expect to borrow an average of half the amount available, which arrangement would you recommend for the borrower? Explain why.

LG 4 P16–15 Cost of commercial paper Commercial paper is usually sold at a discount. Fan Corporation has just sold an issue of 90-day commercial paper with a face value of $1 million. The firm has received initial proceeds of $978,000. ( Note: Assume a 365-day year.)

a. What effective annual rate will the firm pay for financing with commercial paper, assuming that it is rolled over every 90 days throughout the year?

b. If a brokerage fee of $9,612 was paid from the initial proceeds to an investment banker for selling the issue, what effective annual rate will the firm pay, assuming

that the paper is rolled over every 90 days throughout the year? LG 5 P16–16 Accounts receivable as collateral Kansas City Castings (KCC) is attempting to

obtain the maximum loan possible using accounts receivable as collateral. The firm extends net-30-day credit. The amounts that are owed KCC by its 12 credit cus- tomers, the average age of each account, and the customer’s average payment period are as shown in the following table:

Account

Average age

Average payment

Customer

receivable

of account

period of customer

A $37,000

40 days

30 days

B 42,000

C 15,000

D 8,000

E 50,000

F 12,000

G 24,000

H 46,000

I 3,000

CHAPTER 16

Current Liabilities Management

a. If the bank will accept all accounts that can be collected in 45 days or less as long as the customer has a history of paying within 45 days, which accounts will

be acceptable? What is the total dollar amount of accounts receivable collateral? ( Note: Accounts receivable that have an average age greater than the customer’s average payment period are also excluded.)

b. In addition to the conditions in part a, the bank recognizes that 5% of credit sales will be lost to returns and allowances. Also, the bank will lend only 80% of the acceptable collateral (after adjusting for returns and allowances). What level of funds would be made available through this lending source?

LG 5 P16–17 Accounts receivable as collateral Springer Products wishes to borrow $80,000 from a local bank using its accounts receivable to secure the loan. The bank’s policy is to accept as collateral any accounts that are normally paid within 30 days of the end of the credit period, as long as the average age of the account is not greater than the customer’s average payment period. Springer’s accounts receivable, their average ages, and the average payment period for each customer are shown in the following table. The company extends terms of net 30 days.

Average payment Customer

Account

Average age

receivable

of account

period of customer

a. Calculate the dollar amount of acceptable accounts receivable collateral held by Springer Products.

b. The bank reduces collateral by 10% for returns and allowances. What is the level of acceptable collateral under this condition?

c. The bank will advance 75% against the firm’s acceptable collateral (after adjusting for returns and allowances). What amount can Springer borrow against these accounts?

LG 3 LG 5 P16–18 Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed the accounts receivable of Scientific Software, Inc. The bank has chosen eight

accounts totaling $134,000 that it will accept as collateral. The bank’s terms include a lending rate set at prime + 3% and a 2% commission charge. The prime rate cur- rently is 8.5%. a. The bank will adjust the accounts by 10% for returns and allowances. It then will lend up to 85% of the adjusted acceptable collateral. What is the maximum amount that the bank will lend to Scientific Software?

b. What is Scientific Software’s effective annual rate of interest if it borrows $100,000 for 12 months? For 6 months? For 3 months? ( Note: Assume a 365-

PART 7

Short-Term Financial Decisions

LG 5 P16–19 Factoring Blair Finance factors the accounts of the Holder Company. All eight fac- tored accounts are shown in the following table, with the amount factored, the date

due, and the status on May 30. Indicate the amounts that Blair should have remitted to Holder as of May 30 and the dates of those remittances. Assume that the factor’s commission of 2% is deducted as part of determining the amount of the remittance.

Account

Amount

Date due

Status on May 30

A $200,000

May 30

Collected May 15

Collected May 30

E 120,000

May 30

Collected May 27

F 180,000

June 15

Collected May 30

Collected May 30

LG 1 LG 6 P16–20 Inventory financing Raymond Manufacturing faces a liquidity crisis—it needs a loan of $100,000 for 1 month. Having no source of additional unsecured bor-

rowing, the firm must find a secured short-term lender. The firm’s accounts receiv- able are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is fin- ished goods. ( Note: Assume a 365-day year.) (1) City-Wide Bank will make a $100,000 trust receipt loan against the finished

goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.

(2) Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month period at an annual interest rate of 13%. (3) Citizens’ Bank and Trust will lend $100,000 against a warehouse receipt on the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be levied against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.

a. Calculate the dollar cost of each of the proposed plans for obtaining an initial loan

amount of $100,000. b. Which plan do you recommend? Why? c. If the firm had made a purchase of $100,000 for which it had been given terms of

2/10 net 30, would it increase the firm’s profitability to give up the discount and not borrow as recommended in part b? Why or why not?

LG 2 P16–21 ETHICS PROBLEM Rancco Inc. reported total sales of $73 million last year, including $13 million in revenue (labor, sales to tax-exempt entities) exempt from sales tax. The company collects sales tax at a rate of 5%. In reviewing its informa- tion as part of its loan application, you notice that Rancco’s sales tax payments show a total of $2 million in payments over the same time period. What are your conclusions regarding the financial statements that you are reviewing? How might

CHAPTER 16

Current Liabilities Management

Spreadsheet Exercise

Your company is considering manufacturing carrying cases for the portable video game machines that are currently popular. Management decides to borrow $200,000 from each of two banks—First American and First Citizen. On the day that you visit both banks, the quoted prime interest rate is 7%. Each loan is similar in that each involves a 60-day note, with interest to be paid at the end of 60 days.

The interest rate was set at 2% above the prime rate on First American’s fixed- rate note. Over the 60-day period, the rate of interest on this note will remain at the 2% premium over the prime rate regardless of fluctuations in the prime rate.

First Citizen sets its interest rate at 1.5% above the prime rate on its floating-rate note. The rate charged over the 60 days will vary directly with the prime rate.

TO DO First, create a spreadsheet to calculate the following for the First American loan:

a. Calculate the total dollar interest cost on the loan. Assume a 365-day year. b. Calculate the 60-day rate on the loan. c. Assume that the loan is rolled over each 60 days throughout the year under iden-

tical conditions and terms. Calculate the effective annual rate of interest on the fixed-rate, 60-day First American note.

Next, create a spreadsheet to calculate the following for the First Citizen loan:

d. Calculate the initial interest rate. e. If the prime rate immediately jumps to 7.5%, and after 30 days it drops to

7.25%, calculate the interest rate for the first 30 days and the second 30 days of the loan.

f. Calculate the total dollar interest cost. g. Calculate the 60-day rate of interest. h. Assume the loan is rolled over each 60 days throughout the year under the same

conditions and terms. Calculate the effective annual rate of interest. i. Which loan would you choose, and why?

Visit www.myfinancelab.com for Chapter Case: Selecting Kanton Company’s Financing Strategy and Unsecured Short-Term Borrowing Arrangement, Group Exercises, and numerous online resources.

Integrative Case 7 Casa de Diseño