Solution manual financial management 10e by keown chapter 18

Current liabilities can be used to match the timing of a firm's short-term financing needs exactly... The hedging principle, or rule of self-liquidating debt involves the following: Thos

CHAPTER OUTLINE

I Managing current assets

A Like fixed assets, the firm's investment in current assets is determined by the

marginal benefits derived from investing in them compared with theiracquisition cost

B However, the mix of current and fixed assets of the firm's investment in total

assets is an important determinant of the firm's liquidity That is, the greaterthe firm's investment in current assets, other things remaining the same, thegreater the firm's liquidity This is generally true since current assets areusually more easily converted into cash

C The firm can invest in marketable securities to increase its liquidity

However, such a policy involves committing the firm's funds to a relativelylow-yielding (in comparison to fixed assets) investment

II Managing the firm's use of current liabilities

A The greater the firm's use of current liabilities, other things being the same,

the less will be the firm's liquidity

B There are a number of advantages associated with the use of current

liabilities for financing the firm's asset investments

1 Flexibility Current liabilities can be used to match the timing of a

firm's short-term financing needs exactly

2 Interest cost Historically, the interest cost on short-term debt has

been lower than that on long-term debt

C Following are the disadvantages commonly associated with the use of

short-term debt:

1 Short-term debt exposes the firm to an increased risk of illiquidity

because short-term debt matures sooner and in greater frequency, bydefinition, than does long-term debt

2 Since short-term debt agreements must be renegotiated from

year-to-year, the interest cost of each year's financing is uncertain

III Determining the appropriate level of working capital

A Pragmatically, it is impossible to derive the "optimal" level of working

capital for the firm Such a derivation would require estimation of thepotential costs of illiquidity which, to date, have eluded precisemeasurement

B However, the "hedging principle" provides the basis for the firm's

working-capital decisions

1 The hedging principle, or rule of self-liquidating debt involves the

following: Those asset needs of the firm not financed by spontaneoussources (i.e., payables and accruals) should be financed inaccordance with the following rule: Permanent asset investments arefinanced with permanent sources and temporary asset investmentsare financed with temporary sources of financing

2 A permanent investment in an asset is one which the firm expects to

hold for a period longer than one year Such an investment mayinvolve current or fixed assets

3 Temporary asset investments comprise the firm's investment in

current assets that will be liquidated and not replaced during theyear

4 Spontaneous sources of financing include all those sources that are

available upon demand (e.g., trade credit Accounts Payable) or thatarise naturally as a part of doing business (e.g., wages payable,interest payable, taxes payable, etc.)

5 Temporary sources of financing include all forms of current or

short-term financing not categorized as spontaneous Examples includebank loans, commercial paper, and finance company loans

6 Permanent sources of financing include all long-term sources such as

debt having a maturity longer than one year, preferred stock, andcommon stock

C Although the hedging principle provides a useful guide to the firm's

working-capital decisions, no firm will follow its tenets strictly At times afirm may rely too much on temporary financing for its cash needs or it may

IV Determining the appropriate level of short-term financing

A The hedging concept was presented as one basis for determining the firm's

use of short-term debt

B Hedging involves attempting to match temporary needs for funds with

short-term sources of financing and permanent needs with long-short-term sources

V Measuring the effectiveness of managing net working capital

A The firm’s goal should be to minimize net working capital This can be

accomplished by:

1 faster collection of cash from sales

2 increasing inventory turns

3 slowing down disbursements to suppliers

B Cash conversion cycle (CCC) measures these three factors

1 CCC = Days of sales outstanding (DSO) + Days of sales in inventory

(DSI) – Days of payables outstanding (DPO)

2 Decreasing DSO or DSI or increasing DPO will lead to a shorter

cash conversion cycle

VI Selecting a source of short-term financing

A In general, there are three basic factors that should be considered in

selecting a source of short-term financing:

1 The effective cost of the credit source

2 The availability of credit

3 The effect of the use of a particular source of credit on the cost and

availability of other sources

B The basic procedure used in estimating the cost of short-term credit utilizes

the basic interest equation, i.e., interest = principal x rate x time

C The problem faced in assessing the cost of a source of short-term financing

involves estimating the annual percentage rate (APR) where the interestamount, the principal sum, and the time for which financing will be needed

is known Thus, the basic interest equation is "rearranged" as follows:

APR =

principal

interest

x time1

D Compound interest was not considered in the simple APR calculation To

consider compounding, the following relation is used:

VII Sources of short-term credit

A The two basic sources of short-term credit are unsecured and secured credit

1 Unsecured credit consists of all those sources that have as their

security only the lender's faith in the ability of the borrower to repaythe funds when due

2 Secured funds include additional security in the form of assets that

are pledged as collateral in the event the borrower defaults inpayment of principal or interest

B There are three major sources of unsecured short-term credit: trade credit,

unsecured bank loans, and commercial paper

1 Trade credit provides one of the most flexible sources of financing

available to the firm To arrange for credit, the firm need only place

an order with one of its suppliers The supplier then checks the firm'scredit and if the credit is good, the supplier sends the merchandise

2 Commercial banks provide unsecured short-term credit in two basic

forms: lines of credit and transaction loans (notes payable).Maturities of both types of loans are usually 1 year or less with rates

of interest depending on the credit-worthiness of the borrower andthe level of interest rates in the economy as a whole

3 A line of credit is generally an informal agreement or understanding

between the borrower and the bank as to the maximum amount ofcredit that the bank will provide the borrower at any one time There

is no "legal" commitment on the part of the bank to provide thestated credit There is another variant of this form of financingreferred to as a revolving credit agreement whereby such a legalobligation is involved The line of credit generally covers a period ofone year corresponding to the borrower's "fiscal" year

4 Transaction loans are another form of unsecured short-term bank

credit The transaction loan, in contrast to a line of credit, is made for

a specific purpose

5 Only the largest and most creditworthy companies are able to use

commercial paper, which consists of unsecured promissory notessold in the money market

a The maturities of commercial paper are generally six months

or less with the interest rate slightly lower than the prime rate

on commercial bank loans The new issues of commercialpaper are either directly placed or dealer placed

b There are a number of advantages that accrue to the user of

commercial paper: interest rates are generally lower thanrates on bank loans and comparable sources of short-termfinancing; no minimum balance requirements are associatedwith commercial paper; and commercial paper offers the firmwith very large credit needs a single source for all its short-term financing needs Since it is widely recognized that onlythe most creditworthy borrowers have access to thecommercial paper market, its use signifies a firm's creditstatus

c However, a very important "risk" is involved in using this

source of short-term financing; the commercial paper market

is highly impersonal and denies even the most credit-worthyborrower any flexibility in terms of repayment

B Secured sources of short-term credit have certain assets of the firm, such as

accounts receivable or inventories, pledged as collateral to secure a loan.Upon default of the loan agreement, the lender has first claim to the pledgedassets

1 Generally, a firm's receivables are among its most liquid assets Two

secured loan arrangements are generally made with accountsreceivable as collateral:

a Under the arrangement of pledged accounts receivable, the

amount of the loan is stated as a percentage of the face value

of the receivables pledged

b Factoring accounts receivable involves the outright sale of a

firm's accounts receivables to a factor

2 Four secured loan arrangements are generally made with inventory

as collateral:

a Under the floating lien agreement, the borrower gives the

lender a lien against all its inventories

b The chattel mortgage agreement involves having specific

items of inventory identified in the security agreement

c The field warehouse financing agreements means that the

inventories used as collateral are physically separated fromthe firm's other inventories and are placed under the control

of a third-party field warehousing firm

d Terminal warehouse agreements involve transporting the

inventories pledged as collateral to a public warehouse that isphysically removed from the borrower's premises

ANSWERS TO END-OF-CHAPTER QUESTIONS

18-l Working capital has traditionally been defined as the firm's

investment in current assets Current assets are comprised of allassets which the firm expects to convert into cash within one yearincluding: cash, marketable securities, accounts receivable, andinventories Net working capital refers to the difference in thefirm's current assets and its current liabilities, i.e., net workingcapital = current assets - current liabilities

18-2 The final composition of the firm's current and fixed asset investments is an

important determinant of the firm's liquidity since, other things remaining the same,the greater the firm's investment in current assets the greater its liquidity

The firm may choose to invest additional funds in cash and/or marketable securities

as a means of increasing its liquidity However, this type of action involves a off between the risk of illiquidity and the firm's return on invested funds Byincreasing its investment in cash and marketable securities, the firm reduces its risk

trade-of illiquidity However, the firm has increased its investment in assets which earnlittle or no return The firm can reduce its risk of illiquidity only by reducing itsoverall return on invested funds and vice versa

18-3 Advantages of Short-Term Debt:

(1) The interest rate is usually lower (i.e., the term structure of interest rates is

generally upward sloping) for short-term debt

(2) Funds are paid for only when they are used

Disadvantages:

(1) Short-term debts must be repaid sooner; thus, there is a greater risk of

illiquidity

(2) Interest costs on short-term debts vary from year-to-year, whereas long-term

debt agreements "lock in" the cost of funds to the firm

18-4 The use of current liabilities, or short-term debt as opposed to long-term debt,

subjects the firm to a greater risk of illiquidity That is, short-term debt by its verynature must be repaid or "rolled over" more often than long-term debt Thus, thepossibility that the firm's financial condition might deteriorate to a point where theneeded funds might not be available is enhanced where short-term debt is used.18-5 The hedging principle involves matching the maturities of the sources of financing

for the firm's assets with the useful lives of the assets To implement the hedgingprinciple, the firm must fund all its permanent assets investments not financed byspontaneous sources (payables) with long-term sources of funds, and then, financeall its temporary asset investments not funded by spontaneous sources with short-term sources of funds

18-6 Definitions:

(1) A permanent asset investment is one which the firm expects to hold for a

period longer than one year

(2) Temporary asset investments are comprised of the firm's investments in

current assets which will be liquidated and not replaced within the currentyear

(3) Permanent sources of financing include intermediate and long-term debt,

preferred stock, and common equity

(4) Temporary sources of financing consist of the various sources of short-term

debt: including secured and unsecured bank loans, commercial paper, loanssecured by accounts receivable, and loans secured by inventories

(5) Spontaneous sources of financing consist of the trade credit and other

accounts payable which arise "spontaneously" in the firm's day-to-dayoperations Examples include wages and salaries payable, accrued interest,and accrued taxes

18-7 The important factors in selecting a source of short-term credit are as follows:

(1) the effective cost of credit

(2) the availability of credit

(3) the effect of the use of a particular source of credit on the cost and

availability of other sources of credit

18-8 The procedure used in estimating the cost of short-term credit relies on the use of

the basic interest equation:

i = P x R x TThe problem faced in assessing the cost of a source of short-term financing,however, generally involves estimating the annual effective rate for which both theinterest amount, the principal sum, and the time for which financing will be needed

i = P

i

x T1

18-9 Compound interest was not considered in the simple APR calculation To consider

the influence of compounding we can use the following relation:

APY = (1 + i/m)m - 1

where i is the nominal rate of interest per year and m is the number of

compounding periods within a year This cost of credit relationship is frequentlyreferred to as the Annual Percentage Yield, or APY

18-10 The trade credit term "2/10, net 30" means that a 2 percent discount is offered for

payment within 10 days or the full amount is due in 30 days: "4/20, net 60" 4percent discount within 20 days, full amount due in 60 days; 3/15, net 45 3 percentdiscount within 15 days, full amount due in 45 days

18-11 (a) A line of credit is generally an informal agreement or understanding

between the borrower and the bank as to the maximum amount of creditwhich the bank will provide the borrower at any one time

(b) Commercial paper consists of unsecured promissory notes of firms that aresold in the money market

(c) Compensating balance is a minimum balance that a borrower must maintain

in a bank throughout a loan period

(d) The prime rate represents the interest rate which a bank charges its mostcreditworthy borrowers on short-term loans

18-12 The four advantages of commercial paper are:

(1) Interest rate Commercial paper rates are generally lower than rates on bank

loans and comparable sources of short-term financing

(2) Compensating balance requirements No minimum balance requirements are

associated with commercial paper

(3) Amount of credit Commercial paper offers the firm with very large credit

needs a single source for all its short-term financing needs

(4) Prestige Since it is widely recognized that only the most creditworthy

borrowers have access to the commercial paper market, its use signifies afirm's credit status

18-13 The "risk" involved with the firm's use of commercial paper as a source of

short-term debt relates to the fact that the commercial paper market is highly impersonaland denies even the most credit-worthy borrower any flexibility in terms ofrepayment

18-14 There are two basic procedures which can be used in arranging for financing on

receivables pledging and factoring

Under pledging, the borrower simply offers his accounts receivable as collateral for

a loan obtained from either a commercial bank or a finance company The amount

of the loan is stated as a percent of the face value of the receivables pledged The primary advantage of pledging as a source of short-term credit relates to theflexibility it provides the borrower Financing is available on a continuous basis.Furthermore, the lender may provide credit services which eliminate or reduce theneed for similar services within the firm

Factoring receivables involves the outright sale of a firm's accounts to a factor Thefactor, in turn, bears the risk of collection and services the accounts for a fee Inaddition, the factor provides advances or loans to the borrower on which interest ischarged for the term of the advance

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

18-1A The financial statements for both firms are found below:

Firm A

Cash 100,000 Accounts Payable 200,000 Accounts Receivable 100,000 Notes Payable 200,000 Inventories 300,000 Bonds 600,000 Net Fixed Assets 1,500,000 Common Equity 1,000,000 Total 2,000,000 Total 2,000,000 Firm B

Cash 150,000 Accounts Payable 400,000Accounts Receivable 50,000 Notes Payable 200,000Inventories 300,000 Current Liabilities 600,000Net Fixed Assets 1,500,000 Bonds 400,000Total 2,000,000 Common Equity 1,000,000

Total 2,000,000Financial measures of firm liquidity

Firm A Firm BWorking Capital 500,000 500,000

Net Working Capital 100,000 (100,000)

by it more aggressive use of current liabilities

18-2A The information contained in the problem provides the basis for the following:

Purchases = $480,000

Discount Period = 15 days

Cash Discount = 1%

Deferred Period = 30 days

Maximum Credit Period = 45 days

Purchases per day = 480,000 ÷ 360 = 1,333.33

a Purchases/day x 15 day discount period = 20,000.00

b Purchases/day x 45 day maximum credit period = 60,000.00

c The Annual Percentage Rate for forgoing the discount = 12.12%18-3A.First we calculate the interest expense for the three month loan as follows:

Note that both the interest expense and the issue fee are prepaid

18-5A

(a)

98.0

02.0

x

360/20

1 = 0.36734 or 36.73%

(b)

97.0

03.0

x

360/151 = 0.74226 or 74.23%

(c)

97.0

03.0

x

360/30

1 = 0.37113 or 37.11%

(d)

98.0

02.0

x

360/45

1 = 0.16327 or 16.33%

18-6A

Instructor’s Note: This problem can be easily solved using the exponent function(yx) on a hand calculator Simply let y = (1+r/m) and x = m, then solve for yx.Finally subtract "1" to obtain the effective cost of credit with compounding ofinterest

APY = (1 + i/m)m - 1

i = Nominal interest rate

m = # of compounding periods in a year

(a) APY = (1 +

18

3673.0

)8 - 1

= 1.1755 - 1

= 1755 or 17.55%

18-7A (a)

Interest = 14 x $100,000

= $14,000Therefore, the effective rate of interest on the loan is calculated as follows:

APR =

000,14000,100

$

000,14

$

 x

360/3601

= 1628 or 16.28%

Dealer Financing Alternative

APR =

000,100

$

300,16

$

x

360/3601

= 163 or 16.3%

Analysis The costs of the two sources of financing are identical for practicalpurposes The final choice can now be made based upon other nonquantitativefactors For example, the firm may find that using dealer financing is less timeconsuming and allows the firm to leave its credit line within the bank unchanged.Since bank credit can be used for a much wider array of financing needs than dealerfinancing, R Morin would find that using dealer financing leaves the firm withgreater flexibility in raising funds for its future needs

(b) If the compensating balance becomes binding, then the effective rate on the

bank loan alternative will be Interest = 14 x $100,000

= $14,000Compensating Balance = 15 x $100,000

= $15,000

APR =

000,15000,14000,100

$

000,14

is clearly less costly

Note that equipment dealers will frequently price their merchandise so as tocompensate them for offering "below market" rates of interest for financing Thismay well be the case here such that R Morin should use the dealer financing unless

18-8A Interest = 13 x 100,000

= $13,000

$1083/month interestCompensating balance = 100,000 x 20

= $20,000

(a) APR =

000,100

$

000,13

$

x

360/360

1 = 0.13 or 13%

(b) APR =

000,20000,100

$

000,13

$

 x

360/360

1 = 0.1625 or 16.25%

Interest expense for the loan is $13,000; however, the firm gets the use of only 8 x

APR =

625,25000,12000,500

$

000,12625,25

= 1627 = 16.27%

(b) The risk involved with the issue of commercial paper should be considered

This risk relates to the fact that the commercial paper market is highlyimpersonal and denies even the most credit-worthy borrower any flexibility

in terms of when repayment is made

In addition, commercial paper is a viable source of credit to only the mostcredit-worthy borrowers Thus, it may simply not be available to the firm.18-10A.(a) Interest = P x R x T = (400,000 x 75) x 13 x 1 = $39,000

Fee = $200,000 x 01 x 12 = $24,000APR =

principal

interest

x time1

APR =

.75

x 000,400

$

000,24000,39

$ 

x

360/3601 = 21 or 21%