Financial managment Solution Manual: Financing Current Assets

After reading this chapter, students should be able to: • Identify and distinguish among the three different current asset financing policies. • Briefly explain the advantages and disadvantages of short-term financing. • List the four major types of short-term funds. • Distinguish between free and costly trade credit, calculate both the nominal and effective annual percentage costs of not taking discounts, given specific credit terms, and explain what stretching accounts payable is and how it reduces the cost of trade credit. • Describe the importance of short-term bank loans as a source of short-term financing and discuss some of the key features of bank loans. • Calculate the effective interest rate for (1) simple interest, (2) discount interest, (3) add-on interest loans; and explain the effect of compensating balances on the effective cost of a loan. • List some factors that should be considered when choosing a bank. • Explain why large, financially strong corporations issue commercial paper, and why this source of short-term credit is typically less reliable than bank loans if the firm gets into financial difficulties. • Define what a “secured” loan is and what type of collateral can be used to secure a loan.

After reading this chapter, students should be able to:

• Identify and distinguish among the three different current asset

financing policies

• Briefly explain the advantages and disadvantages of short-term

financing

• List the four major types of short-term funds

• Distinguish between free and costly trade credit, calculate both the

nominal and effective annual percentage costs of not taking discounts,given specific credit terms, and explain what stretching accountspayable is and how it reduces the cost of trade credit

• Describe the importance of term bank loans as a source of

short-term financing and discuss some of the key features of bank loans

• Calculate the effective interest rate for (1) simple interest, (2)

discount interest, (3) add-on interest loans; and explain the effect ofcompensating balances on the effective cost of a loan

• List some factors that should be considered when choosing a bank

• Explain why large, financially strong corporations issue commercial

paper, and why this source of short-term credit is typically lessreliable than bank loans if the firm gets into financial difficulties

• Define what a “secured” loan is and what type of collateral can be used

to secure a loan

Chapter 16 Financing Current Assets

LEARNING OBJECTIVES

This chapter is relatively short, and students can read and understand most of

it on their own Also, since we have only one chapter on financing currentassets, we try to go all the way through it

Assuming that you do cover the entire chapter, the details of what we

cover, and the way we cover it, can be seen by scanning Blueprints, Chapter

16 For other suggestions about the lecture, please see the “LectureSuggestions” in Chapter 2, where we describe how we conduct our classes

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

LECTURE SUGGESTIONS

16-1 The more seasonal the business, the more variation in its asset

requirements While short-term credit could theoretically be used tomatch maturities with the fluctuating level of required current assets,uncertainty about the exact pattern of seasonal flows might dictate amore prudent policy of maintaining some sort of safety stock of liquidassets financed by longer-term sources of funds

16-2 If an asset’s life and returns can be positively determined, the

maturity of the asset can be matched to the maturity of the liabilityincurred to finance the asset This matching will ensure that funds areborrowed only for the time they are required to finance the asset andthat adequate funds will have been generated by the asset by the timethe financing must be repaid

A basic fallacy is involved in the above discussion, however.Borrowing to finance receivables or inventories may be on a short-termbasis because these turn over 8 to 12 times a year But as a firm’ssales grow, its investment in receivables and inventories grow, eventhough they turn over Hence, longer-term financing should be used tofinance the permanent components of receivables and inventoryinvestments

16-3 From the standpoint of the borrower, short-term credit is riskier

because short-term interest rates fluctuate more than long-term rates,and the firm may be unable to repay the debt If the lender will notextend the loan, the firm could be forced into bankruptcy

A firm might borrow short-term if it thought that interest rates weregoing to fall and, therefore, that the long-term rate would go evenlower A firm might also borrow short-term if it were only going to needthe money for a short while and the higher interest would be offset bylower administration costs and no prepayment penalty Thus, firms doconsider factors other than interest rates when deciding on the maturity

of their debt

16-4 People or firms borrow on a short-term basis in spite of increased risk

for reasons of flexibility If its need for funds is seasonal orcyclical, a firm may not want to commit itself to long-term debt.Furthermore, short-term interest rates are generally lower than long-term rates

16-5 This statement is false A firm cannot ordinarily control its accrued

liabilities since payrolls and the timing of wage payments are set byeconomic forces and by industry custom, while tax payment dates areestablished by law

ANSWERS TO END-OF-CHAPTER QUESTIONS

16-6 Yes Trade credit and accrued liabilities generally increase

automati-cally as sales increase

16-7 Yes If a firm is able to buy on credit at all, if the credit terms

include a discount for early payment, and if the firm pays during thediscount period, it has obtained “free” trade credit However, takingadditional trade credit by paying after the discount period can be quitecostly

16-8 Larger firms have greater access to the capital markets than smaller

firms, because they can sell stocks and bonds Smaller firms are,therefore, forced to rely on bank loans to a greater extent Inaddition, larger firms are typically older and, thus, have had more time

to build up retained earnings and other internal sources of funds thannew, smaller firms

16-9 Commercial paper refers to promissory notes of large, strong

corporations These notes have maturities that generally vary from oneday to 9 months, and the return is usually 1½ to 3 percentage pointsbelow the prime lending rate Mamma and Pappa Gus could not use thecommercial paper market

16-10 The commercial paper market is completely impersonal, while bank loans

are negotiated and the parties involved get to know and trust oneanother Commercial paper can be sold only by firms whose credit isutterly above question Suppose a fundamentally sound firm that uses agood deal of short-term credit in the form of commercial paper issuddenly faced with a crippling strike This may cause commercial paperdealers to refuse to handle its paper, and, as the already outstandingnotes begin to mature, the firm may be faced with a financial crisis

On the other hand, if the firm had maintained continuous bankingrelations, it is far more likely that its bank would have stuck by itand helped it ride out the storm It is assumed that the firm did notutilize bank credit earlier

16-11 a Approximately 1.75 to 3.25 percent

b A firm may be limited in the amount of commercial paper that dealersare willing to sell, or it may wish to establish relations with abank Furthermore, commercial paper maturities vary from one day to 9months, and a firm may desire longer-term debt

16-1 Nominal cost of trade credit =

1530

53697

3 ×

= 0.0309 × 24.33 = 0.7526 = 75.26%

Effective cost of trade credit = (1.0309)24.33 - 1.0 = 1.0984 = 109.84%

16-2 Effective cost of trade credit = (1 + 1/99)8.11 - 1.0

= 0.0849 = 8.49%

16-3 Net purchase price of inventory = $500,000/day

Credit terms = 2/15, net 40

$500,000 × 15 = $7,500,000

16-4 $25,000 interest-only loan, 11 percent nominal rate Interest

calculated as simple interest based on 365-day year Interest for 1stmonth = ?

Interest rate per day = 0.11/365 = 0.000301

Interest charge for period = (31)(0.11/365)($25,000)

= $233.56

16-5 $15,000 installment loan, 11 percent nominal rate

Effective annual rate, assuming a 365-day year = ?

FV = 0, and then press I to obtain 1.6432% However, this is a monthlyrate

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

i = ?

Effective annual rateAdd-on = (1 + kd) - 1.0

1 × = 73.74%

b

50

53698

2 × = 14.90%

c

35

53697

3 × = 32.25%

d

35

53698

2 × = 21.28%

e

25

53698

2 × = 29.80%

16-7 a

2045

53697

08.(

12 d t

000,

$)

k1

67.166,

$

kd, the monthly interest rate, is 1.1326 percent, found with afinancial calculator Input N = 12; PV = 50000; PMT = -4166.67; FV =-4000; and I = ? The precise effective annual rate is (1.011326)12 -1.0 = 14.47%

Alternative b has the lowest effective interest rate

16-9 Accounts payable:

Nominal cost = (0.03093)(4.5625)= 1 11%

80

53697

With a financial calculator, enter N = 1, PV = 440000, PMT = 0, and FV =-500000 to solve for I = 13.636% ≈ 13.64%.

Note that, if Masson actually needs $500,000 of funds, he will have toborrow

NOM% = 11.5; P/YR = 4; EFF% = ? EFF% = 12.0055%

c Add-on: Interest = Funds needed(kd)

Loan = Funds needed(1 + kd)

t

d)k1

8333

$

Enter N = 12, PV = 100, PMT = -8.8333, FV = 0, and press I to get

I = 0.908032% = kd This is a monthly periodic rate, so theeffective annual rate = (1.00908032)12 - 1 = 0.1146 = 11.46%

d Trade credit: 1/99 = 1.01% on discount if pay in 15 days, otherwisepay 45 days later So, get 60 - 15 = 45 days of credit at a cost of1/99 = 1.01% There are 365/45 = 8.1111 periods, so the effectivecost rate is:

000,650,

$

× 10 days = $10,000 × 10 = $100,000

b There is no cost of trade credit at this point The firm is using

“free” trade credit

c (netAverageof discount)payables =

365

000,650,

53698

outstandinis

creditDays

365percent

Discount-

100

percentDiscount

21065

5362

100

Effective cost = (1 + 2/98)365/55 - 1 = 14.35%

Comparing effective interest costs, the Thompson Corporation might betempted to obtain financing from a bank (For reason see solution toPart b.)

i = ?

b The interest rate comparison had favored trade credit, but ThompsonCorporation should take into account how its trade creditors wouldlook upon a 35-day delay in making payments Thompson would become a

“slow pay” account, and in times when suppliers were operating atfull capacity, Thompson would be given poor service and would also beforced to pay on time

16-13 a Size of bank loan = (Purchases/Day)(Days late)

goutstandinpayablesDays

Purchases

= ($600,000/60)(60 - 30) = $10,000(30) = $300,000.Alternatively, one could simply recognize that accounts payable must

be cut to half of its existing level, because 30 days is half of 60days

b Given the limited information, the decision must be based on therule-of-thumb comparisons, such as the following:

The company appears to be carrying excess current assets andfinancing extensively with debt Bank borrowings are already high,and the liquidity situation is poor On the basis of theseobservations, the loan should be denied, and the treasurer should beadvised to seek permanent capital, especially equity capital

16-14 a The quarterly interest rate is equal to 11.25%/4 = 2.8125%

Effective annual rate = (1 + 0.028125)4 - 1

With a financial calculator, enter N = 1, PV = 1166250, PMT = 0, and

FV = -1200000 to solve for I = 2.89389% ≈ 2.89% However, this is aperiodic rate

Effective annual rate = (1 + 0.0289389)4 - 1 = 12.088% ≈ 12.09%.Note that, if Gifts Galore actually needs $1,500,000 of funds, itwill have to borrow

0.2 0.0225

c Installment loan:

Nominal quarterly rate =

received/2Amount

Interest

=

/2000,500,

$

750,33

$

= 4.5%

Nominal annual rate = 4.5% × 4 = 18%

16-15 a Malone’s current accounts payable balance represents 60 days

purchases Daily purchases can be calculated as

If Malone takes discounts its A/P balance would be $83.33 The cash

it would need to be loaned is $500 - $83.33 = $416.67

Since the loan is a discount loan with compensating balances, Malonewould require more than a $416.67 loan

Face amount of loan =

65

67.416

$20.15.1

67.416

−

Doesn’t Take Discounts:

If Malone doesn’t take discounts, its A/P balance would be $250 Thecash needed from the bank is $500 - $250 = $250

Face amount of loan =

65

250

$20.15.1

250

−

c Nonfree Trade Credit:

Nominal annual cost:

Discountg

outstandinis

creditDays

365

%Discount100

%Discount

Bank Loan: 15% Discount Loan with 20% compensating balance.

Assume the firm doesn’t take discounts so it needs $250 and borrows

$384.62 (The cost will be the same regardless of how much the firmborrows.)

With a financial calculator, input the following data, N = 1, PV =

250, PMT = 0, FV = -307.70, and then solve for I = 23.08%

Just to show you that it doesn’t matter how much the firm borrows,assume the firm takes discounts and it reduces A/P to $83.33 so itneeds $416.67 cash and borrows $641.03

d Pro Forma Balance Sheet (Thousands of Dollars):

Accounts receivable 450.0 Notes payableb 434.6Inventory 750.0 Accrued liabilities 50.0Prepaid interest 57.7

$250,000/0.99 = $252,525.25 The lost discount is the differencebetween the full cost of the payables and the amount that is reportednet of discount: Lost discount = $252,525.25 - $250,000.00 =

$2,525.25 The aftertax cost of the lost discount is $2,525.25(1 0.40) = $1,515.15 Notice that this provides a tax shield in theamount of $2,525.25(0.40) = $1,010.10 The total amount of cash thatMalone needs to pay down $250,000 of accounts payable is the grossamount minus the tax shield: $252,525.25 - $1,010.10 = $251,515.15

-Face amount of loan =

65

15.515,251

$20.15.1

15.515,251

−

Pro Forma Balance Sheet (Thousands of Dollars:

Accounts receivable 450.0 Notes payableb 436.9Inventory 750.0 Accrued liabilities 50.0Prepaid interest 58.0

4 60-day commercial paper:

The 30-day commercial paper has the lowest cost

b The lowest cost of financing is not necessarily the best The use of30-day commercial paper is the cheapest; however, sometimes thecommercial paper market is tight and funds are not available Thismarket also is impersonal A banking arrangement may providefinancial counseling and a long-run relationship in which the bankperforms almost as a “partner and counselor” to the firm Note alsothat while the use of 60-day commercial paper is more expensive thanthe use of 30-day paper, it provides more flexibility in the eventthe money is needed for more than 30 days However, the line ofcredit provides even more flexibility than the 60-day commercial paperand at a lower cost

16-17 The detailed solution for the spreadsheet problem is available both on

the instructor’s resource CD-ROM and on the instructor’s side of Western’s web site, http://brigham.swlearning.com

South-SPREADSHEET PROBLEM

Bats and Balls Inc.

Working Capital Financing Policy

16-18 BATS AND BALLS (B&B) INC., A BASEBALL EQUIPMENT MANUFACTURER, IS A

SMALL COMPANY WITH SEASONAL SALES EACH YEAR BEFORE THE BASEBALL SEASON, B&B PURCHASES INVENTORY THAT IS FINANCED THROUGH A COMBINATION OF TRADE CREDIT AND SHORT-TERM BANK LOANS AT THE END OF THE SEASON, B&B USES SALES REVENUES TO REPAY ITS SHORT-TERM OBLIGATIONS THE COMPANY IS ALWAYS LOOKING FOR WAYS TO BECOME MORE PROFITABLE, AND SENIOR MANAGEMENT HAS ASKED ONE OF ITS EMPLOYEES, ANN TAYLOR, TO REVIEW THE COMPANY’S CURRENT ASSET FINANCING POLICIES PUTTING TOGETHER HER REPORT, ANN IS TRYING TO ANSWER EACH OF THE FOLLOWING QUESTIONS:

A B&B TRIES TO MATCH THE MATURITY OF ITS ASSETS AND LIABILITIES.

DESCRIBE HOW B&B COULD ADOPT EITHER A MORE AGGRESSIVE OR MORE CONSERVATIVE FINANCING POLICY.

ANSWER: [SHOW S16-1 THROUGH S16-4 HERE.] THERE ARE THREE ALTERNATIVE CURRENT

ASSET FINANCING POLICIES: AGGRESSIVE, MODERATE, AND RELAXED AMODERATE FINANCING POLICY MATCHES ASSET AND LIABILITY MATURITIES.(OF COURSE EXACT MATURITY MATCHING IS NOT POSSIBLE BECAUSE OF (1) THEUNCERTAINTY OF ASSET LIVES AND (2) SOME COMMON EQUITY MUST BE USEDAND COMMON EQUITY HAS NO MATURITY.) WITH THIS STRATEGY, THE FIRMMINIMIZES ITS RISK THAT IT WILL BE UNABLE TO PAY OFF MATURINGOBLIGATIONS AN AGGRESSIVE FINANCING POLICY OCCURS WHEN THE FIRMFINANCES ALL OF ITS FIXED ASSETS WITH LONG-TERM CAPITAL, BUT PART OFITS PERMANENT CURRENT ASSETS WITH SHORT-TERM, NONSPONTANEOUS CREDIT.THERE ARE DEGREES OF AGGRESSIVENESS, IN FACT, A FIRM COULD CHOOSE TOFINANCE ALL OF ITS PERMANENT CURRENT ASSETS AND PART OF ITS FIXEDASSETS WITH SHORT-TERM CREDIT; THIS WOULD BE A HIGHLY AGGRESSIVEPOSITION, AND ONE THAT WOULD SUBJECT THE FIRM TO THE DANGERS OFRISING INTEREST RATES AS WELL AS TO LOAN RENEWAL PROBLEMS A

INTEGRATED CASE