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CHAPTER 20
SHORT-TERM SOURCES
FOR FINANCING CURRENT ASSETS
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. It is advisable to borrow in order to take a cash discount when the cost of
borrowing is less than the cost of foregoing the discount. If it cost us 36
percent to miss a discount, we would be much better off finding an
alternate source of funds for 8 to 10 percent.
2. The prime rate is the rate that a bank charges its most creditworthy
customers. The average customer can expect to pay one or two percent
(or more) above prime.
3. The stated interest rate is the percentage rate unadjusted for time or
method of repayment. The effective interest rate is the true rate and
considers all these variables. A 5 percent stated rate for 90 days provides
a 20 percent effective rate. The financial manager should recognize the
effective rate as the true cost of borrowing. The effective rate is also
referred to as the APR (Annual Percentage Rate).
4. Commercial paper can be either purchased or issued by a corporation.
To the extent one corporation purchases another corporations
commercial paper as a short-term investment, it is a current asset.
Conversely, if a corporation issues its own commercial paper, it is a
current liability.
5. Pledging accounts receivable means receivables are used as collateral for
a loan; factoring account receivables means they are sold outright to a
finance company.
6. Three types of lender control used in inventory financing are
20-1
Chapter 20
A
B
D
B
D
16.
17.
18.
19.
20.
B
A
C
D
D
31.
32.
33.
34.
35.
D
A
A
A
C
46.
47.
48.
49.
50.
D
A
B
B
C
6. C
7. A
8. D
9. B
10. D
21.
22.
23.
24.
25.
D
C
D
C
D
36.
37.
38.
39.
40.
D
C
D
B
C
51.
52.
53.
54.
55.
A
C
C
A
C
11. A
12. A
13. B
14. C
15. B
26.
27.
28.
29.
30.
D
A
B
B
D
41.
42.
43.
44.
45.
D
D
C
C
D
56. D
57. D
20-2
Chapter 20
III. Problems
Problem 1
The discounted interest cost of the commercial paper issue is calculated as
follows:
Interest expense = .10P10
x P200
million
x 180 / 360 = P10 million
million
+ P125,000
1
180 / 360
million
P125,000
P10asmillion
The effective costP200
of credit
can now
be calculated
follows:
RATE =
RATE = 46%
Problem 2
Loanfor
proceeds
a. Interest
two months = .14 x x P500,000
(for P500,000 loan)
= P11,667
P11,667
12
= P500,000
(.2
x
P500,000
+ P11,667)
P388,333
2
= P383,333
RATE =
20-3
Chapter 20
Pledging fee
RATE
x P500,000
= P10,000
P10,000 + P3,750
P500,000
= .005 x P750,000
= P3,750
12
2
.18 x P200,000
1
P200,000
1
= .0275 x 6 = .165, or 16.5%
Problem 3
a. RATE
=
=
b. RATE
=
=
c. RATE
.16 x P200,000
P200,000 .20 x P200,000
x
1
1
1
1
.20, or 20%
x
20-4
Chapter 20
.21212, or 21.212%
360
x
Final due dateDiscount period
= 2.04% x 8 = 16.32%
Interest rate / (1 C)
14% / (1 .2)
14% / (.8) = 17.5%
The effective cost of the loan, 17.5%, is more than the cost of passing up the
discount, 16.32%. Kiwi Corporation should continue to pay in 55 days and
pass up the discount.
Problem 5
a. Effective rate of interest =
P5,500
P300,000
360
60
= 1.83% x 6 = 10.98%
b. Cost of lost discount
2%
98%
360
(70 10)
= 2.04% x 6 = 12.24%
c. Yes, because the cost of borrowing is less than the cost of losing the
discount.
20-5
Chapter 20
d.
P300,000
(1 C)
P6,850
P300,000P375,000 P300,000
P75,000
=.80
(1= .20)
P6,850
P300,000
360
60
x 6
= 2.28% x 6
= 13.68%
No, do not borrow with a compensating balance of 20 percent since the
effective rate is greater than the savings from taking the cash discount.
2 x 4 x P9,000
Problem 6
(P100,000 P20,000 P9,000) x (4 + 1)
a. Trust Bank
Effective interest rate
=
2 x 12 x P9,000
= P72,000 / P355,000 = 20.28%
(P100,000 P10,000) x (12 + 1)
Northeast Bank
Effective interest rate
=
= P216,000 / P1,170,000 = 18.46%
Choose Northeast Bank since it has the lowest effective interest rate.
b. The numerators stay the same as in part (a) but the denominator increases
to reflect the use of more money because compensating balances are
already maintained at both banks.
20-6
Chapter 20
Trust Bank
Effective interest rate
Northeast Bank
Effective interest rate
Problem 8
a. Cost of commercial paper =
Cost of commercial paper in the first quarter
Cost of issuing commercial paper:
Interest (P4,000,000 x .0775 x )
Placement fee (P4,000,000 x .00125)
5,000
77,500
82,500
P4,000,000
P400,000
82,500
482,500
P3,517,500
Chapter 20
P 82,500
P3,517,500
=
2.345%
77,500
P4,000,000
P400,000
77,500
477,500
P3,522,500
P 77,500
P3,522,500
=
2.20%
Familia Inc. should choose commercial paper because the cost of bank
financing (10.4 percent) exceeds the cost of commercial paper (8.95
percent) by greater than 1 percent.
b. The characteristics Familia Inc. should possess in order to deal regularly
in the commercial paper market include:
1. Have a prestigious reputation, be financially strong, and have a
high credit rating.
2. Have flexibility to arrange for large amounts of funds through
regular banking channels.
20-8
Chapter 20
Problem 9
a. The expected monthly cost of bank financing is the sum of the interest
cost, processing cost, bad debt expense, and credit department cost. The
calculations are as follows:
Interest
.15 / 12 x P180,000
Processing
.02 x P180,000 / .75
Credit department
Bad debt expense
.0175 x .7 x P900,000
Expected monthly cost of bank financing
= P 2,250
=
4,800
=
2,500
= 11,025
P20,575
b. The expected monthly cost of factoring is the sum of the interest cost and
the factor cost. The calculations are as follows:
Interest
.015 x P180,000
Factor
.025 x .7 x P900,000
Expected monthly cost of factoring
= P 2,700
= 15,750
P18,450
Chapter 20
2. Factoring removes one of the most liquid of the firms assets and
weakens the position of creditors. It may mar their credit rating
and increase the cost of other borrowing arrangements.
3. Customers could react unfavorably to a firms factoring their
accounts receivable.
Discount
1.00 Discount
360 days
Credit period Discount period
The cost of each supplier must be weighted by the proportion of the total
provided by the supplier.
Supplier
Fort Co.
Jester Co.
Jam Co.
Smitt & Co.
Total
Annual
Percentage Cost
(1)
.367
.242
.172
20-10
Weight
(2)
.30
.25
.35
.10
1.00
Weighted
Average Cost
(1) x (2)
.110
.061
.017
.188
Chapter 20
20-11
Chapter 20
20-12