Chapter 8

Discussion Questions
8-1. It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of forgoing 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. Larger firms tend to be in a net creditor position because they have the financial resources to be suppliers to credit. The smaller firm must look to the larger manufacturer or wholesaler to help carry the firm's financing requirements. 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. In competitive markets banks may actually charge preferred customers less than prime. The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are actually made available to the borrower. A $125,000 loan with a $25,000 compensating balance requirement means only $100,000 is being provided on a net basis. This benefit to the lender need not be a disadvantage to the borrower. The borrower may, in turn, receive a lower quoted interest rate and certain gratuitous services because of the compensating balance requirement. Bankers have tended towards eliminating both compensating balances and gratuitous services. The stated interest rate is the percentage rate unadjusted for time or method of repayment. The annual interest rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days provides a 20 percent annual rate. The financial manager should recognize the annual rate as the true cost of borrowing. An effective rate would include any compounding effects over the relevant period. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporation's 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. In comparison to bank borrowing, commercial paper can generally be issued at below the prime rate. Furthermore, there are no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank. Finally, there is a certain degree of prestige associated with the issuance of commercial paper. A bankers acceptance offers the guarantee of payment from a chartered bank.

8-2.

8-3.

8-4.

8-5.

8-6.

8-7.

8-8.

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8-9.

Major types of collateralized short-term loans include: a. Pledging accounts receivable: borrowing with receivables as collateral. b. Factoring account receivables: selling accounts at a discount to a finance company. c. Borrowing with inventory as collateral through (1) Blanket inventory lien-general claim against inventory or collateral. No specific items are marked or designated. (2) Trust receipt-borrower holds the inventory in trust for the lender. Each item is marked and has a serial number. When the inventory is sold, the trust receipt is canceled and the funds go into the lender's account. (3) Warehousing-the inventory is physically identified, segregated, and stored under the direction of an independent warehouse company that controls the movement of the goods. If done on the premises of the warehousing firm, it is termed public warehousing. An alternate arrangement is field warehousing whereby the same procedures are conducted on the borrower's property.

8-10. A public offering backed by an asset (accounts receivable) as collateral. Essentially a firm sells its receivables into the securities markets. 8-11. Hedging means to engage in a transaction that partially or fully reduces a prior risk exposure. In selling a financial futures contract, if interest rates go up, one is able to buy back the contract at a profit. This will help to offset the higher interest charges to a corporation or other business entity. Hedging involves the matching of maturities of assets and liabilities to reduce risk.

Internet Resources and Questions

1. www.me.org/produits_en/produits_d_inter_court_en.php www.cme.com/products/index.cfm 2. www.moneysense.ca/eng/banking_credit/index.jsp

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Problems 8-1. Cost of forgoing the cash discount

K DIS = d% 365 100% d% f ( date) - d ( date) )

a. b. c. d.

K DIS = K DIS = K DIS = K DIS =

2% 365 = .1862 = 18.62% 100% 2% f ( 50 ) d (10 ) 2% 365 = .2980 = 29.80% 100% 2% f ( 40 ) d (15) 3% 365 = .3225 = 32.25% 100% 3% f ( 45) d (10 ) 3% 365 = .0664 = 6.64% 100% 3% f (180 ) d (10 )

8-2.

Arbutus Ltd.

a. Accounts payable forgoing discount: Annual purchases/365 Final due date = $9,210,000/ 365 45 = Accounts payable taking discount: Annual purchases/365 Discount period = $9,210,000/ 365 10 = Additional financing available = b. Cost of forgoing the cash discount
K DIS = 2% 365 = .2128 = 21.28% 100% 2% f ( 45) d (10 )

$1,135,480

252,329 $ 883,151

8-3. a. COGS

S. Pumpkins = Average inventory turnover rate = $630,000 8 = $5,040,000

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Average accounts payable= COGS/ 365 average payment period = $5,040,000/ 365 45 = $621,370 b. Annual sales = Average A/R 365/Average collection period = $520,250 365/30 = $6,329,708 8-4.
K DIS =

Paul Promptly
3% 365 = .2258 = 22.58% 100% 3% f ( 60 ) d (10 )

In this problem, Mr. Promptly has the use of funds for only 50 extra days (60 10), instead of 60 extra days (70 10). Mr. Promptlys suppliers are offering terms of 3/10, net 70. Mr. Promptly is actually accepting terms of 3/10, net 60. 8-5.
K DIS =

Regis Clothiers
2% 365 = .1665 = 16.65% 100% 2% f ( 60 ) d (15)

Regis should accept the banks terms and borrow at 11% to take the cash discount. The cost of forgoing the discount is 16.65%. 8-6. Treasury Bills
100 P 365 100 98 .671 365 =r = = 0.0540 = 5.40 % P d 98.671 91

8-7.

Treasury Bills

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100 P 365 100 98 .097 365 =r = = 0.0389 = 3.89 % P d 98 .097 182

8-8.

McGriff Dog Food Company

a. Accounts receivable = Average daily credit sales average collection period = $10,000 25 = $250,000 Accounts payable = Average daily credit purchases average payment period = $9,000 20 = $180,000 Net credit position = Accounts receivable Account payable Net credit position = $250,000 $180,000 = $70,000 b. Accounts receivable will remain at Accounts payable = $9,000 32 Net credit position $250,000 288,000 ($38,000)

McGriff has improved its cash position and cash flow. Instead of extending $79,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $38,000 in credit.

8-9.
R ANNUAL =

Your Bank
I 365 $45 365 = = 0.1095 =10 .95 % P d $3,000 50
365

rEFF

$45 50 = 1 + 1 = 0.1148 = 11 .48 % $3,000

8-10.
RDIS =

I. M. Boring One years interest = $5,000 0.13 = $650

I 365 $650 365 = = 0.1495 = 14 .95 % P-I d $5,000 $650 365

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8-11.

Simpson Orange Juice Company

a. Accounts receivable = Average daily credit sales average collection period = $7,000 28 = $196,000 Accounts payable = Average daily credit purchases average payment period = $6,000 20 = $120,000 Net credit position = Accounts receivable Account payable Net credit position = $196,000 $120,000 = $76,000 b. Accounts receivable will remain at Accounts payable = $6,000 35 Net credit position $196,000 210,000 ($14,000)

Simpson has improved its cash position and cash flow. Instead of extending $76,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $14,000 in credit.

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8-12.

Carey Company

Annual rate of interest with 20% compensating balance:

RCOMP = I 365 $24 ,000 365 = = 0.15 =15 % P B d $200 ,000 $40 ,000 365

OR:
RCOMP = I 12 % = = 0.15 = 15 % (1 c ) (1 .20 )

Installment loan with compensating balance:

RINSTALL
RINSTALL

=
=

2 Annual number of payments I (Total number of payments +1) P

2 12 $24 ,000 (12 +1) ( $200 ,000 $40 ,000 $576 ,000 = $2,080 ,000 = 0.2769 = 27 .69 %

$576 ,000 (13 ) $160 ,000

8-13.

Capone Child Care Centers, Inc. Annual rate of interest:

RCOMP = I 365 $25 ,000 365 = P B d $250 ,000 $32 ,000 * 365 = 0.1147 =11 .47 %

*Compensating balance = 20% $250,000 = $50,000 Normal funds = 18,000 Restricted compensating balance = $32,000

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8-14.

Hi-Cost Supermarkets Annual rate of interest:

RCOMP = I 365 $1,479 * 365 = P B d $30 ,000 $2,000 * * 180 = 0.1071 =10 .71 %

* (10% $30,000) 180/365 = **Compensating balance = 15% $30,000 = Normal funds = Restricted compensating balance = 8-15. Tucker Drilling Corp.

$1,479 $4,500 2,500 $2,000

Annual rate of interest with 20% compensating balance: Interest = $20,000 (0.08 + 0.5) = $17,000: $17,000/ ($200,000 $40,000) = $17,000/ $160,000 = 0.10625 = 10.625% 8-16.
a.

Your Company simple interest with a 10% compensating balance:

RCOMP = I 3 65 $700 ,000 * 36 5 = P B d $5,000 ,00 $500 ,0 0 00 * * 36 5 =0.1556 =15 .5 % 6

* $5,000,000 0.14 = ** $5,000,000 0.10 =

$700,000 $500,000

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b.

discounted interest:
RDIS = I 365 $700 ,000 365 = P-I d $5,000 ,000 $700 ,000 365 = 0.1628 = 16 .28 %

c.

an installment loan with 12 payments:

RINSTALL =

2 12 $700 ,000 $16 ,800 ,000 = (13 ) $5,000 ,000 (12 +1) $5,000 ,000 $16 ,800 ,000 = $65 ,000 ,000 = 0.2585 = 25 .85 %

d.

discounted interest with a 5% compensating balance: $700,000/ ($5,000,000 $700,000 $250,000) = $700,000/ $4,050,000 = 0.1728 = 17.28% Your borrowing $900/ 12,000 = 7.5% Use formula 86 for b, c, and d.

8-17.
a.

b. R c. R d. R

INSTALL

= = =

2 2 $900 $3,600 = = 0.1000 =10 .00 % (3) $12 ,000 $36 ,000 2 4 $900 $7,200 = = 0.1200 =12 .00 % (5) $12 ,000 $60 ,000 2 12 $900 $21,600 = = 0.1385 =13 .85 % (13 ) $12 ,000 $156 ,000

INSTALL

INSTALL

8-18.
RINSTALL RINSTALL = =

Vroom Motorcycle Company

2 Annual number of payments I (Total number of payments +1) P 2 1 2 $9,000 $216 ,000 = = 0.1946 =19 .46 % (36 +1) $30 ,000 $1,110 ,000

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8-19.

Morrisette Records Annualized yield on discounted paper:

100 P 365 100 98.512 365 =r = = 0.0735 = 7.35 % P d 98 .512 75

Effective annual yield = 7.57%

rEFF 100 98 .512 75 = 1 + 1 = 0.0757 = 7.57 % 98 .512
365

8-20.

Bankers Acceptance
100 P 365 100 ,000 97 ,285 365 =r = = 0.1132 = 11 .32 % P d 97 ,285 90

Effective annual yield = 11.81% FV = 100,000 PV = 97,285 (neg.) CPT % i =?

PMT = 0

N = 90/ 365

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8-21.

Blue Grass Filters

d% 365 100% d% f ( date) - d ( date) )
2% 365 = .1241 = 12.41% 100% 2% f ( 75 ) d (15)

a. Cost of forgoing the cash discount:

K DIS =
K DIS =

Effective annual yield = 13.08% Choose the bank at 11%. b. No security requirements More convenient and more readily available No life story required 8-22.
K DIS =
K DIS =

The Ogden Timber Company Cost of forgoing the cash discount:

d% 365 100% d% f ( date) - d ( date) )
2% 365 = .1862 = 18.62% 100% 2% f ( 50 ) d (10 )

We use 50 days instead of 35 days as the final due date because Ogdens suppliers have effectively made this the due date even though the stated due date is 35 days. Annual rate of interest; 25% compensating balance requirement:
RCOMP = I 15 % = = 0.20 = 20 % (1 c ) (1 0.25 )

The annual cost of the loan, 20%, is more than the cost of passing up the discount, 18.62%. Ogden Timber Company should continue to pay in 50 days and pass up the discount.

8-23.

The Ogden Timber Company (Continued) Annual rate of interest; 10% compensating balance requirement:
RCOMP = I 15 % = = 0.1667 = 16 .67 % (1 c ) (1 0.10 )

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The answer now changes. The annual cost of the loan, 16.67%, is less than the cost of passing up the discount. Ogden Timber Company should borrow the funds and take the discount.

8-24.

Bosworth Petroleum
I 365 $8,100 365 = = 0.0986 = 9.86 % P d $500 ,000 60

a. Annual rate on bank loan:

R ANNUAL =

b.

Cost of forgoing cash discount

K DIS = 2% 365 = .1241 = 12.41% 100 % 2% f ( 70 ) d (10 )

c. Yes, because the cost of borrowing is less than the cost of losing the discount.
Amount to be borrowed =

d.
=

Amount needed (1 c)

$500 ,000 $500 ,000 = = $625 ,000 (1 .20 ) .80

e.

RCOMP

I 365 $13 ,000 365 = P B d $625 ,000 $125 ,000 60 = 0.1582 =15 .82 %

No, do not borrow with a compensating balance of 20 percent since the annual rate is greater than the cost of forgoing the cash discount.

8-25.
a.

Rockford Filing Ltd. Annual commitment fee Interest expense Annual rate of interest:
R ANNUAL =

= 0.01 $1,000,000 = $10,000 = $1,000,000 10% 45/365 = $12,328.77

I 35 6 $1 ,0 0 +$1 ,3 8 .7 * 3 5 0 0 2 2 7 6 = P d $1,0 0 ,0 0 0 0 4 5 =0.1 1 = 8 .1 % 81 1 1

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*Note: The interest cost also includes the commitment fee. b. Cost of forgoing the cash discount:
K DIS = 2% 365 = .1655 = 16.55% 100% 2% f ( 60 ) d (15)

c. Discounted commercial paper

100 P 365 1.25 365 =r = = 0.1027 = 10 .27 % P d 100 1.25 45

Choose the commercial paper. It is the cheapest alternative.

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8-26.

Bernies Macs = $4,750 = $600,000 7% 60/365 = $6,904.11

a. Annual commitment fee Interest expense Annual rate of interest:

R ANNUAL =

I 35 6 $4,7 0 +$6,9 4 .1 * 3 5 5 0 1 6 = P d $ 6 0 ,0 0 0 0 6 0 =0.1 8 1 2 =1 .8 % 1 2

*Note: The interest cost also includes the commitment fee. b. Cost of forgoing the cash discount:
K DIS = 2% 365 = .1241 = 12.41% 100 % 2% f ( 90 ) d ( 30 )

d. Discounted commercial paper

100 P 365 1.91 365 =r = = 0.1185 = 11.85% P d 100 1.91 60

Choose the bank loan. It is the cheapest alternative.

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8-27.

Nanaimo Shipping Company

a. Bankcorp of B.C. Annual interest rate

RINSTALL = 2 4 $10 ,000 ( 4 +1) ( $100 ,000 $20 ,000 $10 ,000 = 0.2286 = 22 .86 %

Victoria Bank Annual interest rate

RINSTALL = 2 12 $10 ,000 (12 +1) ( $100 ,000 $10 ,000 = 0.2051 = 20 .51 %

Choose Victoria Bank since it has the lowest annual 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. Bankcorp of B.C. Annual interest rate
RINSTALL = 2 4 $10 ,000 ( 4 +1) ( $100 ,000 $10 ,000 = 0.1778 =17 .78 %

Victoria Bank Annual interest rate

RINSTALL = 2 $10 ,00 12 0 (1 +1) $1 0 ,0 0 2 0 0 =0.18 46 =18 .4 % 6

c. The compensating balance assumption changed interest rates as follows: Interest rate Bankcorp With compensating balance 22.86% Without compensating balance 17.78
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Difference in cost

5.08%

2.05%

Yes. If compensating balances are maintained at both banks in the normal course of business, then Bankcorp of B.C. should be chosen over Victoria Bank. The annual cost of its loan will be less.

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8-28.
a.

Alberta Oil Supplies 0 - 30 days B D G L Total loan % loan 31 - 40 days A E J Total loan % loan 41-45 days I K Amount $ 80,000 10,000 40,000 60,000 190,000 90% $171,000 Amount $ 50,000 250,000 25,000 325,000 80% $260,000 Amount $ 15,000 200,000 215,000 70% $150,500

Total loan % loan

Maximum Loan = $171,000 + $260,000 + $150,500 = $581,500 b. Loan balances Interest, 15% annual One month's interest $581,500 0.0125 per month $ 7,269

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8-29.

Towers Arcades Bank cost: Interest: $560,000 10% 1/12 = Processing charge = $800,000 .5% = Factor cost: Interest: $560,000 11% 1/12 = Processing fee = $800,000 2% = Less credit department savings = Choose the factor. $ 4,667 4,000 $ 8,667 $ 5,133 16,000 (15,000) $ 6,133

8-30.

Thornton Pipe and Steel Company

$105,000 94,500 10,500 5 $ 52,500

a. Sales price: December Treasury bond contract (Sale takes place in July) Purchase price, December Treasury bond contract: (10% price decline) .9 $105,000 = Gain per contract Number of contracts Profit on futures contracts

b. Profit occurred because the bond value fell due to increasing rates. This

meant the subsequent purchase price was less than the initial sales price. c. Increased interest cost Profit from hedging Net cost
Net cost = $8,300 = 0.1365 =13 .65 % $60 ,800

$60,800 52,500

$ 8,300

The net cost is 13.65%. This means 86.35% of the increased interest cost was hedged away. d. If interest rates went down, there would be a loss on the futures contracts. The lower interest rates would lead to higher bond prices and a purchase price that exceeded the original sales price.

8-31.

Fresh and Fruity Foods, Inc. (Short-term Financing)

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Purpose: The student must focus on accounts receivable as an investment (use of funds) and the financial advantages of reducing the commitment to this asset. At the same time the firm is also considering reductions to its accounts payable balance in order to take cash discounts. This alternative will call for additional bank financing and comparative costs must be carefully assessed. The case utilizes many calculations that are covered in the text, but places them in a more complex, decision oriented framework. Suggested Questions: a. Using the data in the income statement and the balance sheet that follow, compute the companys average collection period (ACP) in days. Use a 365day year when calculating sales per day. b. Compute the cost, as a percent, that the company is paying for not taking the suppliers discounts. (The suppliers terms are 2/10, net 60; but note from the bottom of the balance sheet that Fresh & Fruity has been taking 67 days to pay its suppliers). c. Assume Alice Plummers first initiative to offer a 10 percent discount was implemented, and the companys average collection period dropped to 32 days. If net sales per day remained the same, as Alice expects, what would be the new accounts receivable balance? How much cash was freed up by the reduction in accounts receivable? What is the new accounts payable balance if the money is used to pay off suppliers? d. As a result of Alices first initiative described in part c, Fresh & Fruity is able to take advantage of the 2 percent discount on one-third of its purchases (see the income statement). What will be the cash discount figure on the income statement? What effect does this have on net income (after taxes)? The simplest way to get this figure is to multiply the cash discount figure by (1 Tax rate) and add this figure to the net income aftertax figure on the income statement. Also what is the effect on the return-on-sales ratio shown toward the bottom of the balance sheet? Consider the effect on the return-onequity ratio as well. e. Alices second initiative calls for Fresh & Fruity to obtain a bank loan of a sufficient size to enable the company to take all suppliers discounts. What is the minimum size of this loan? Hint: To take all suppliers discounts, the average payment period must be 10 days, and net purchases will be Purchases (Purchases from Figure 1 .02). Assume all this happens, and solve the following formula for the new accounts payable balance, using: Accounts payable = Average payment period Purchase per day* Now compare the accounts payable you just solved with the new accounts payable balance you found in part c. The difference is the size of the loan
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that is required. f. Assume Fresh & Fruity obtains an 8 percent loan for one year in the amount you solved in part e, and it reduces its accounts payable balance accordingly. Now the company is taking 2 percent discounts on all purchases and paying 8 percent a year on the loan balance. What is the net gain from taking the discounts and paying the interest on a before-tax basis? (on an aftertax basis?) g. (Optional) Suppose the 8 percent loan that Fresh & Fruity obtained was a discount loan, and the bank further required a 20 percent compensating balance of the full loan amount. What is the annual rate of interest to Fresh & Fruity? How does this compare to your answer in question b for the cost of not taking a cash discount? Answers

a. Average collection period = Accounts receivable/ Average daily credit sales Accounts receivable = $209,686 Average daily credit sales = $1,179,000/ 365 = $3,230 Average collection period = $209,686/ $3,230 = 64.92 days b. Cost of forgoing the cash discount:
K DIS = 2% 365 = .1307 = 13.07% 100 % 2% f ( 67 ) d (10 )

The formula tells us that Fresh and Fruity is effectively paying 13.07% interest to delay paying the discounted amount for 57 days (the 67 days on which they pay less the 10 day discount period).

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c.

Average collection period Average daily credit sales = New accounts receivable 32 $3,230 = $103,360 Freed-up cash = Old accounts receivable New accounts receivable Old accounts payable Funds from accounts receivable New accounts payable $209,686 103,360 $106,326 $180,633 106,326 $ 74,307 $969,000 $323,000 $ 6,460

d.

Purchases (Figure 1) 1/3 exposed to purchase discount 2% purchase discount savings

With the firm in a 33 percent tax bracket, a savings of $6,460 will produce $4,328 in aftertax income. The answer is equal to the cost savings (1 - T).

$6,460 (1 .33) = $6,460 (.67) This means total income will now be: Old income New aftertax income Total aftertax income Return on sales will be: Net income (aftertax)/ Sales

= $4,328 $50,623 4,328 $54,951

= $54,951/ $1,179,000 = 0.0466 = 4.66%

This, of course, represents an improvement over the old figure of 4.29%. Return on equity will be: Net income (aftertax)/ Equity = $54,951/ $123,600 = 44.46%

This, also, represents an improvement over the old ratio of 40.96%. (Note: This firm has a particularly high return on equity because of rapid asset

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turnover and high current liabilities). If the added profit is included in equity, the return is 42.95% ($54,951/ $127,928).
e.

Accounts payable = Average payment period Purchases per day Average payment period = 10 days Purchases per day = [969,000 (.02 969,000)]/365 = [969,000 $19,380]/ 365 = $2,602 Accounts payable = 10 $2,602 = $26,020 Accounts payable from question c $74,307 Accounts payable from question e 26,020 Size of loan required $48,287 This is the size of the loan required to take all cash discounts in 10 days.

f.

The cost is the 8 percent interest on the bank loan of $48,287 or $3,863. The gain is the cash discounts taken of $19,380. The net gain before tax is $15,517 ($19,380 $3,863). On an aftertax basis this translates to a gain of $10,396 ($15,517 0.67).

g. First determine the amount of funds on which interest must be paid. $48,287 (.08 $48,287) (.20 $48,287) = $48,287 $3,863 $9,657 = $34,767 Then divide the interest payment by this value. Interest/ Useable funds $3,863/ $34,767 = 0.1111 or 11.11%
The cost goes up from 8% to 11.11%. However, this value is still less than the cost of forgoing the cash discount of 13.07%, computed in part (b). Thus, it is advantageous to borrow and take the cash discount. Note: Alert students may point out that Fresh & Fruity still needs $48,287 in cash no matter what kind of loan it is. Therefore if the interest is to be
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charged on a discounted basis, and a compensating balance is required, Fresh & Fruity must borrow a larger amount to make up for it. Solve for the larger amount using algebra where L is the larger amount.

L (.08 L) (.20 L) L .08L .20L L .28L .72L L L

= $48,287 = $48,287 = $48,287 = $48,287 = $48,287/ .72 = $67,065

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