Chapter 23
Short-Term Financing
ANSWERS TO END-OF-CHAPTER QUESTIONS



23-1 a. Permanent current assets are those current assets required when the economy is weak and seasonal sales are at their low point. Thus, this level of current assets always requires financing and can be regarded as permanent. Temporary current assets are those current assets required above the permanent level when the economy is strong and/or seasonal sales are high.

b. A moderate current asset financing policy matches asset and liability maturities. It is also referred to as the maturity matching, or "self-liquidating" approach. When a firm finances all of its fixed assets with long-term capital but part of its permanent current assets with short-term, nonspontaneous credit this is referred to as an aggressive current asset financing policy. With a conservative current asset financing policy permanent capital is used to finance all permanent asset requirements, as well as to meet some or all of the seasonal demands.

c. A financing policy that matches asset and liability maturities. This is a moderate policy.

d. Continually recurring short-term liabilities, especially accrued wages and accrued taxes.

e. Trade credit is debt arising from credit sales and recorded as an account receivable by the seller and as an account payable by the buyer. Stretching accounts payable is the practice of deliberately paying accounts payable late. Free trade credit is credit received during the discount period. Credit taken in excess of free trade credit, whose cost is equal to the discount lost is termed costly trade credit.

f. A promissory note is a document specifying the terms and conditions of a loan, including the amount, interest rate, and repayment schedule. A line of credit is an arrangement in which a bank agrees to lend up to a specified maximum amount of funds during a designated period. A revolving credit agreement is a formal, committed line of credit extended by a bank or other lending institution.

g. Prime rate is a published interest rate charged by commercial banks to large, strong borrowers.

h. The situation when interest is not compounded, that is, interest is not earned on interest, is simple interest. Discount interest is interest that is calculated on the face amount of a loan but is paid in advance. Add-on interest is interest that is calculated and added to funds received to determine the face amount of an installment loan.

i. A compensating balance (CB) is a minimum checking account balance that a firm must maintain with a commercial bank, generally equal to 10 to 20 percent of the amount of loans outstanding.

j. Commercial paper is unsecured, short-term promissory notes of large firms, usually issued in denominations of $100,000 or more and having an interest rate somewhat below the prime rate.

k. A secured loan is backed by collateral, often inventories or receivables.

23-2 The more seasonal the business, the more variation in its asset requirements. While short-term credit could theoretically be used to match maturities with the fluctuating level of required current assets, uncertainty about the exact pattern of seasonal flows might dictate a more prudent policy of maintaining some sort of safety stock of liquid assets financed by longer term sources of funds.

23-3 If an asset's life and returns can be positively determined, the maturity of the asset can be matched to the maturity of the liability incurred to finance the asset. This matching will insure that funds are borrowed only for the time they are required to finance the asset and that adequate funds will have been generated by the asset by the time the 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-term basis because these turn over 8 to 12 times a year. But as a firm's sales grow, its investment in receivables and inventories grow, even though they turn over. Hence, longer term financing should be used to finance the permanent components of receivables and inventory investments.

23-4 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 not extend the loan, the firm could be forced into bankruptcy.
A firm might borrow short-term if it thought that interest rates were going to fall and, therefore, that the long-term rate would go even lower. A firm might also borrow short-term if it were only going to need the money for a short while and the higher interest would be offset by lower administration costs and no prepayment penalty. Thus, firms do consider factors other than interest rates when deciding on the maturity of their debt.

23-5 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 or cyclical, a firm may not want to commit itself to long-term debt. Furthermore, short-term interest rates are generally lower than long-term rates.

23-6 This statement is false. A firm cannot ordinarily control its accruals since payrolls and the timing of wage payments are set by economic forces and by industry custom, while tax payment dates are established by law.

23-7 Yes. Trade credit and accruals generally increase automatically as sales increase.

23-8 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 the discount period, it has obtained "free" trade credit. However, taking additional trade credit by paying after the discount period can be quite costly.

23-9 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. In addition, larger firms are typically older and, thus, have had more time to build up retained earnings and other internal sources of funds than new, smaller firms.

23-10 Commercial paper refers to promissory notes of large, strong corporations. These notes have maturities that generally vary from 2 to 6 months, and the return is usually 1? to 3 percentage points below the prime lending rate. Mamma and Pappa Gus could not use the commercial paper market.

23-11 The commercial paper market is completely impersonal, while bank loans are negotiated and the parties involved get to know and trust one another. Commercial paper can be sold only by firms whose credit is utterly above question. Suppose a fundamentally sound firm that uses a good deal of short-term credit in the form of commercial paper is suddenly faced with a crippling strike. This may cause commercial paper dealers to refuse to handle its paper, and, as the already outstanding notes begin to mature, the firm may be faced with a financial crisis. On the other hand, if the firm had maintained continuous banking relations, it is far more likely that its bank would have stuck by it and helped it ride out the storm. It is assumed that the firm did not utilize bank credit earlier.
Furthermore, commercial paper maturities vary from 2 to 6 months, and a firm may desire longer-term debt.

23-12 a. Approximately 5.25 to 6.75 percent.

b. A firm may be limited in the amount of commercial paper that dealers are willing to sell, or it may wish to establish relations with a bank. Furthermore, commercial paper maturities vary from 2 to 6 months, and a firm may desire longer-term debt.




SOLUTIONS TO END-OF-CHAPTER PROBLEMS

23-1 Nominal cost of trade credit =
= 0.0309 ? 24 = 0.7423 = 74.23%.

Effective cost of trade credit = (1.0309)24 - 1.0 = 1.0772 = 107.72%.


23-2 Effective cost of trade credit = (1 + 1/99)8 - 1.0
= 0.0837 = 8.37%.


23-3 Net purchase price of inventory = $500,000/day.

Credit terms = 2/15, net 40.

$500,000 ? 15 = $7,500,000.


23-4 $25,000 interest-only loan, 11% nominal rate. Interest calculated as simple interest based on 365-day year. Interest for 1st month = ?

Interest rate per day = 0.11/365 = 0.000301.

Interest charge for period = (31)(0.11/365)($25,000)
= $233.56.


23-5 $15,000 installment loan, 11% nominal rate.
Effective annual rate, assuming a 365-day year = ?

Add-on interest = 0.11($15,000) = $1,650.

Monthly Payment = = $1,387.50.

0 1 2 11 12
| | | · · · | |
15,000 -1,387.50 -1,387.50 -1,387.50 -1,387.50

With a financial calculator, enter N = 12, PV = 15000, PMT = -1387.50,
FV = 0, and then press I to obtain 1.6432%. However, this is a monthly rate.



Effective annual rateAdd-on = (1 + kd)n - 1.0
= (1.016432)12 - 1.0
= 1.2160 - 1.0 = 0.2160 = 21.60%.

23-6 a. = 72.73%.

b. = 14.69%.

c. = 31.81%.

d. = 20.99%.

e. = 29.39%.


23-7 a. = 44.54%.

Because the firm still takes the discount on Day 20, 20 is used as the discount period in calculating the cost of non-free trade credit.

b. Paying after the discount period, but still taking the discount gives the firm more credit than it would receive if it paid within 15 days.


23-8 a. Effective rate = 12%.

b. 0 1
| |
50,000 -50,000
- 4,500
-10,000 (compensating balance) 10,000
40,000 -44,500

With a financial calculator, enter N = 1, PV = 40000, PMT = 0, and
FV = -44500 to solve for I = 11.25%.

Note that, if Hawley actually needs $50,000 of funds, he will have to borrow = $62,500. The effective interest rate will still be 11.25%.


c. 0 1
| |
50,000 -50,000
- 4,375 (discount interest) 7,500
- 7,500 (compensating balance) -42,500
38,125

With a financial calculator, enter N = 1, PV = 38125, PMT = 0, and
FV = -42500 to solve for I = 11.4754% ? 11.48%.

Note that, if Hawley actually needs $50,000 of funds, he will have to borrow = $65,573.77. The effective interest rate will still be 11.48%.

d. Approximate annual rate = = = 16%.
Precise effective rate:

$50,000 =

kd, the monthly interest rate, is 1.1326%, found with a financial 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.


23-9 Sales per day = = $12,500.

Discount sales = 0.5($12,500) = $6,250.

A/R attributable to discount customers = $6,250(10) = $62,500.

A/R attributable to nondiscount customers:

Total A/R $437,500
Discount customers' A/R 62,500
Nondiscount customers' A/R $375,000

= = 60 days.





Alternatively,

DSO = $437,500/$12,500 = 35 days.

35 = 0.5(10) + 0.5(DSONondiscount)
DSONondiscount = 30/0.5 = 60 days.

Thus, although nondiscount customers are supposed to pay within 40 days, they are actually paying, on average, in 60 days.

Cost of trade credit to nondiscount customers equals the rate of return to the firm:

Nominal rate = = 0.0204(7.2) = 14.69%.

Effective cost = (1 + 2/98)360/50 - 1 = 15.66%.


23-10 Accounts payable:

Nominal cost = = (0.0204(7.2) = 14.69%.

EAR cost = (1.03093)4.5 - 1.0 = 14.69%.

Bank loan:

0 1
| |
500,000 -500,000
-60,000 (discount interest)
440,000

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 to borrow = $568,181.82. The effective interest rate will still be 13.64%.

The bank loan is the lowest cost source of capital available to D.J. Masson at 13.64%.


23-11 a. Simple interest: 12%.

b. 3-months: (1 + 0.115/4)4 - 1 = 12.0055%, or use the interest conversion feature of your calculator as follows:

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

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

Loan = Funds needed(1 + kd).
PMT = Loan/12.

Assume you borrowed $100. Then, Loan = $100(1.06) = $106.
PMT = $106/12 = $8.8333.

$100 = .

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 the effective annual rate = (1.00908032)12 - 1 = 0.1146 = 11.46%.

d. Trade credit: 1/99 = 1.01% on discount if pay in 15 days, otherwise pay 45 days later. So, get 60 - 15 = 45 days of credit at a cost of 1/99 = 1.01%. There are 360/45 = 8 periods, so the effective cost rate is:

(1 + 1/99)8 - 1 = (1.0101)8 - 1 = 8.3723%.

Thus, the least expensive type of credit for Yonge is trade credit with an effective cost of 8.3723 percent.


23-12 a. = ? 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. = ? 30 = $10,000 ? 30 = $300,000.

Nominal cost = (2/98)(360/20) = 36.73%,

or $73,469/($300,000 - $100,000) = 36.73%.

Effective cost = (1 + 2/98)360/20 - 1 = 0.4386 = 43.86%.

d. Nominal rate = ? = 24.49%.

Effective cost = (1 + 2/98)360/30 - 1 = 0.2743 = 27.43%.





23-13 a. Bank Loan 13%, discount interest

0 1
| |
300,000 -300,000
-39,000 (discount interest)
261,000

With a financial calculator, enter N = 1, PV = 261000, PMT = 0, and
FV = -300000 to solve for I = 14.9425% ? 14.94%.

Note that, if Thompson actually needs $300,000 of funds, it will have to borrow = $344,827.59. The effective interest rate will still be 14.9425% ? 14.94%.
Trade Credit

Terms: 2/10, net 30. But the firm plans delaying payments 35 additional days, which is the equivalent of 2/10, net 65.

Nominal cost =
= = = 0.0204(6.55) = 13.36%.

Effective cost = (1 + 2/98)360/55 - 1 = 14.14%.

Just comparing effective interest costs, the Thompson Corporation might be tempted to obtain financing from trade credit.

b. The interest rate comparison had favored trade credit, but Thompson Corporation should take into account how its trade creditors would look upon a 35-day delay in making payments. Thompson would become a "slow pay" account, and in times when suppliers were operating at full capacity, Thompson would be given poor service and would also be forced to pay on time.


23-14 a. Size of bank loan = (Purchases/Day)(Days late)
= (Days outstanding – 30)
= ($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 60 days.

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

1. Debt ratio = ($1,500,000 + $700,000)/$3,000,000 = 73%.
Raattama's debt ratio is 73%, as compared to a typical debt ratio of 50%. The firm appears to be undercapitalized.

2. Current ratio = $1,800,000/$1,500,000 = 1.20.

The current ratio appears to be low, but current assets could cover current liabilities if all accounts receivable can be collected and if the inventory can be liquidated at its book value.

3. Quick ratio = $400,000/$1,500,000 = 0.27.

The quick ratio indicates that current assets, excluding inventory, are only sufficient to cover 27% of current liabilities, which is very bad.

The company appears to be carrying excess inventory and financing extensively with debt. Bank borrowings are already high, and the liquidity situation is poor. On the basis of these observations, the loan should be denied, and the treasurer should be advised to seek permanent capital, especially equity capital.


23-15 a. The quarterly interest rate is equal to 11.25%/4 = 2.8125%.

Effective annual rate = (1 + 0.028125)4 - 1
= 1.117336 - 1 = 0.117336 = 11.73%.

b. 0 1
| |
1,500,000 -1,500,000
-33,750 (discount interest) 300,000
-300,000 (compensating balance) -1,200,000
1,166,250

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 a periodic 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, it will have to borrow = = $1,929,260.45. The effective interest rate will still be 12.088% ? 12.09%.


c. Installment loan:

PMT = ($1,500,000 + $33,750)/3 = $511,250.
INPUT N = 3, PV = 1500000, PMT = -511250, FV = 0.
OUTPUT = I = 1.121% per month. Nominal annual rate = 12(1.121%) = 13.45%.


23-16 a. Malone’s current accounts payable balance represents 60 days purchases. Daily purchases can be calculated as = $8.33.
If Malone takes discounts then the accounts payable balance would include only 10 days purchases, so the A/P balance would be $8.33 ? 10 = $83.33.

If Malone doesn’t take discounts but pays in 30 days, its A/P balance would be $8.33 ? 30 = $250.

b. Takes Discounts:
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, Malone would require more than a $416.67 loan.

Face amount of loan = = $641.03.

Doesn’t Take Discounts:
If Malone doesn’t take discounts, its A/P balance would be $250. The cash needed from the bank is $500 - $250 = $250.

Face amount of loan = = $384.62.

c. Nonfree Trade Credit:
Nominal annual cost:
= = 18.18%.

Effective cost:

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 firm borrows.)


0 1
| |
384.62 -384.62
-57.69 Discount interest +76.92
-76.92 Compensating balance -307.70
250.00

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 it needs $416.67 cash and borrows $641.03.

0 1
| |
641.03 -641.03
-96.15 Discount interest +128.21
-128.21 Compensating balance -512.82
416.67

With a financial calculator, input the following data, N = 1, PV = 416.67, PMT = 0, FV = -512.82, and then solve for I = 23.08%.

Because the cost of nonfree trade credit is less than the cost of the bank loan, Malone should forge discounts and reduce its payables only to $250,000.

d. Pro Forma Balance Sheet (Thousands of Dollars):

Casha $ 126.9 Accounts payable $ 250.0
Accounts receivable 450.0 Notes payableb 434.6
Inventory 750.0 Accruals 50.0
Prepaid interest 57.7
Total current Total current
assets $1,384.6 liabilities $ 734.6
Fixed assets 750.0 Long-term debt 150.0
_ Common equity 1,250.0
Total assets $2,134.6 Total claims $2,134.6

a $384,615(0.2) = $76,923 = Compensating balance.
Cash = $50 + $76.923 = $126.9.
b Notes payable = $50 + $384.6 = $434.6.

e. To reduce the accounts payable by $250,000, which reflects the 1% discount, Malone must pay the full cost of the payables, which is $250,000/0.99 = $252,525.25. The lost discount is the difference between the full cost of the payables and the amount that is reported net of discount: Lost discount = $252,525.25 - $250,000.00 = $2,525.25. The after-tax cost of the lost discount is $2,525.25(1-0.40) = $1,515.15. Notice that this provides a tax shield in the amount of $2,525.25(0.40) = $1,010.10. The total amount of cash that Malone needs to pay down $250,000 of accounts payable is the gross amount minus the tax shield: $252,525.25 - $1,010.10 = $251,515.15.

Face amount of loan = = $386,946.38.


Pro Forma Balance Sheet (Thousands of Dollars):

Casha $ 127.4 Accounts payable $ 250.0
Accounts receivable 450.0 Notes payableb 436.9
Inventory 750.0 Accruals 50.0
Prepaid interest 58.0
Total current Total current
assets $1,385.4 liabilities $ 736.9
Fixed assets 750.0 Long-term debt 150.0
Common equityc 1,248.5
Total assets $2,135.4 Total claims $2,135.4

a $386,946.38(0.2) = $77,389.27 = Compensating balance.
Cash = $50 + $77.4 = $127.4.
b Notes payable = $50 + $386.9 = $436.9.
c Common equity = Previous common equity – after-tax lost discount
= $1,250 - $1.5 = $1,248.5


23-17 a. 1. Line of credit:
Commitment fee = (0.005)($2,000,000)(11/12) = $ 9,167
Interest = (0.11)(1/12)($2,000,000) = 18,333
Total $27,500

2. Trade discount:
a. = = 24.49 ? 24.5%.

Total cost = 0.245($2,000,000)/12 = $40,833.

b. Effective cost = (1 + 2/98)360/30 - 1 = 0.2743 = 27.43%.

Total cost = 0.2743($2,000,000)/12 = $45,717.

3. 30-day commercial paper:
Interest = (0.095)($2,000,000)(1/12) = $15,833
Transaction fee = (0.005)($2,000,000) = 10,000
$25,833

4. 60-day commercial paper:
Interest = (0.09)($2,000,000)(2/12) = $30,000
Transaction fee = (0.005)($2,000,000) = 10,000
$40,000

Marketable securities interest received
= (0.094)($2,000,000)(1/12) = -15,667

Transactions cost, marketable securities
= (0.004)($2,000,000) = +8,000
$32,333

The 30-day commercial paper has the lowest cost.

b. The lowest cost of financing is not necessarily the best. The use of 30-day commercial paper is the cheapest; however, sometimes the commercial paper market is tight and funds are not available. This market also is impersonal. A banking arrangement may provide financial counseling and a long-run relationship in which the bank performs almost as a "partner and counselor" to the firm. Note also that while the use of 60-day commercial paper is more expensive than the use of 30-day paper, it provides more flexibility in the event the money is needed for more than 30 days. However, the line of credit provides even more flexibility than the 60-day commercial paper and at a lower cost.



SOLUTION TO SPREADSHEET PROBLEMS




23-18 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution for Ch 23-18 Build a Model.xls) and on the instructor’s side of the Harcourt College Publishers’ web site, http://www.harcourtcollege.com/finance/theory10e.


23-19 a. The income statements for each company in each state of the economy are given below:

STRONG ECONOMY:

INPUT DATA:
Aggressive Moderate Conservative
Sales $1,800,000 $1,875,000 $1,950,000
Fixed costs 300,000 405,000 577,500
Variable costs 0.70 0.65 0.60
Tax rate 40.00% 40.00% 40.00%

Current assets $ 225,000 $ 300,000 $ 450,000
Net fixed assets 300,000 300,000 300,000
Current liability 12.00% 300,000 150,000 75,000
Long-term debt 10.00% 0 150,000 300,000
Equity 225,000 300,000 375,000

INCOME STATEMENTS:
Aggressive Moderate Conservative
Less cost of goods sold 1,560,000 1,623,750 1,747,500
EBIT $ 240,000 $ 251,250 $ 202,500
Interest on debt 36,000 33,000 39,000
EBT $ 204,000 $ 218,250 $ 163,500
Taxes 81,600 87,300 65,400
Net income $ 122,400 $ 130,950 $ 98,100

Basic Earning Power
(EBIT/Assets) 46% 42% 27%
Return on equity 54% 44% 26%

AVERAGE ECONOMY:

INPUT DATA:
Aggressive Moderate Conservative
Sales $1,350,000 $1,500,000 $1,725,000
Fixed costs 300,000 405,000 577,500
Variable costs 0.70 0.65 0.60
Tax rate 40.00% 40.00% 40.00%

Current assets $ 225,000 $ 300,000 $ 450,000
Net fixed assets 300,000 300,000 300,000
Current liability 12.00% 300,000 150,000 75,000
Long-term debt 10.00% 0 150,000 300,000
Equity 225,000 300,000 375,000

INCOME STATEMENTS:
Aggressive Moderate Conservative
Sales $1,350,000 $1,500,000 $1,725,000
Less cost of goods sold 1,245,000 1,380,000 1,612,500
EBIT $ 105,000 $ 120,000 $ 112,500
Interest on debt 36,000 33,000 39,000
EBT $ 69,000 $ 87,000 $ 73,500
Taxes 27,600 34,800 29,400
Net income $ 41,400 $ 52,200 $ 44,100

Basic Earning Power
(EBIT/Assets) 20% 20% 15%
Return on equity 18% 17% 12%

WEAK ECONOMY:

INPUT DATA:
Aggressive Moderate Conservative
Sales $1,050,000 $1,200,000 $1,575,000
Fixed costs 300,000 405,000 577,500
Variable costs 0.70 0.65 0.60
Tax rate 40.00% 40.00% 40.00%

Current assets $ 225,000 $ 300,000 $ 450,000
Net fixed assets 300,000 300,000 300,000
Current liability 12.00% 300,000 150,000 75,000
Long-term debt 10.00% 0 150,000 300,000
Equity 225,000 300,000 375,000

INCOME STATEMENTS:
Aggressive Moderate Conservative
Sales $1,050,000 $1,200,000 $1,575,000
Less cost of goods sold 1,035,000 1,185,000 1,522,500
EBIT $ 15,000 $ 15,000 $ 52,500
Interest on debt 36,000 33,000 39,000
EBT ($ 21,000) ($ 18,000) $ 13,500
Taxes ( 8,400) ( 7,200) 5,400
Net income ($ 12,600) ($ 10,800) $ 8,100

Basic Earning Power
(EBIT/Assets) 3% 3% 7%
Return on equity -6% -4% 2%

b. The aggressive company has the highest EBIT/assets and return on equity in a strong economy. In an average economy, the aggressive and the moderate companies have virtually the same EBIT/assets and return on equity, and both outperform the conservative company. But in a weak economy, the conservative company does best, and is, in fact, the only company with a positive ROE.

c. The aggressive company's ROE falls from 18% to 12%; the moderate company's ROE falls from 17% to 15%; and the conservative company's ROE falls from 12% to 11%.

INPUT DATA:
Aggressive Moderate Conservative
Sales $1,350,000 $1,500,000 $1,725,000
Fixed costs 300,000 405,000 577,500
Variable costs 0.70 0.65 0.60
Tax rate 40.00% 40.00% 40.00%

Current assets $ 225,000 $ 300,000 $ 450,000
Net fixed assets 300,000 300,000 300,000
Current liability 20.00% 300,000 150,000 75,000
Long-term debt 10.00% 0 150,000 300,000
Equity 225,000 300,000 375,000

MODEL-GENERATED DATA:

INCOME STATEMENTS:
Aggressive Moderate Conservative
Sales $1,350,000 $1,500,000 $1,725,000
Less cost of goods sold 1,245,000 1,380,000 1,612,500
EBIT $ 105,000 $ 120,000 $ 112,500
Interest on debt 60,000 45,000 45,000
EBT $ 45,000 $ 75,000 $ 67,500
Taxes 18,000 30,000 27,000
Net income $ 27,000 $ 45,000 $ 40,500

Basic Earning Power
(EBIT/Assets) 20% 20% 15%
Return on equity 12% 15% 11%

d. The aggressive company's ROE would, at a normal sales level and a 12 percent short-term rate, fall from +18% to -18%. Indeed, all of the companies' ROEs are quite sensitive to the variable cost ratio, but the aggressive company's VC ratio is the one that is most likely to vary from the expected level.

e. The central idea is that while working capital should be managed carefully, there is an optimum level. If working capital is above the optimum, some assets are being under-utilized, and are not contributing to the profitability of the firm even though income may be higher. On the other hand, if working capital is too tightly managed, sales missed due to stockouts will rise. This also will affect customer goodwill, causing further reduction of sales. Variable costs may also increase if management of working capital is too restrictive, particularly if orders for merchandise have to be placed frequently and for inefficient quantities. If trade credit terms are too restrictive, sales will also be lost in this way.


CYBERPROBLEM



23-20 The detailed solution for the cyberproblem is available on the instructor’s side of the Harcourt College Publishers’ web site: http://www.harcourtcollege.com/finance/theory10e.






MINI CASE



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 WHICH 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: THERE ARE THREE ALTERNATIVE CURRENT ASSET FINANCING POLICIES: AGGRESSIVE, MODERATE, AND RELAXED. A MODERATE FINANCING POLICY MATCHES ASSET AND LIABILITY MATURITIES. (OF COURSE EXACT MATURITY MATCHING IS NOT POSSIBLE BECAUSE OF (1) THE UNCERTAINTY OF ASSET LIVES AND (2) SOME COMMON EQUITY MUST BE USED AND COMMON EQUITY HAS NO MATURITY.) WITH THIS STRATEGY, THE FIRM MINIMIZES ITS RISK THAT IT WILL BE UNABLE TO PAY OFF MATURING OBLIGATIONS. AN AGGRESSIVE FINANCING POLICY OCCURS WHEN THE FIRM FINANCES ALL OF ITS FIXED ASSETS WITH LONG-TERM CAPITAL, BUT PART OF ITS PERMANENT CURRENT ASSETS WITH SHORT-TERM, NONSPONTANEOUS CREDIT. THERE ARE DEGREES OF AGGRESSIVENESS, IN FACT, A FIRM COULD CHOOSE TO FINANCE ALL OF ITS PERMANENT CURRENT ASSETS AND PART OF ITS FIXED ASSETS WITH SHORT-TERM CREDIT; THIS WOULD BE A HIGHLY AGGRESSIVE POSITION, AND ONE THAT WOULD SUBJECT THE FIRM TO THE DANGERS OF RISING INTEREST RATES AS WELL AS TO LOAN RENEWAL PROBLEMS. A CONSERVATIVE FINANCING POLICY OCCURS WHEN THE FIRM FINANCES ALL OF ITS PERMANENT ASSET REQUIREMENTS AND SOME OF ITS SEASONAL DEMANDS WITH PERMANENT CAPITAL. THIS POSITION IS A VERY SAFE ONE. THEREFORE, AN AGGRESSIVE FINANCING POLICY USES THE GREATEST AMOUNT OF SHORT-TERM DEBT, WHILE THE CONSERVATIVE POLICY USES THE LEAST. THE MATURITY MATCHING POLICY FALLS BETWEEN THESE TWO POLICIES.

B. WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF USING SHORT-TERM CREDIT AS A SOURCE OF FINANCING?

ANSWER: ALTHOUGH USING SHORT-TERM CREDIT IS GENERALLY RISKIER THAN USING LONG-TERM CREDIT, SHORT-TERM CREDIT DOES HAVE SOME SIGNIFICANT ADVANTAGES. A SHORT-TERM LOAN CAN BE OBTAINED MUCH FASTER THAN LONG-TERM CREDIT. LENDERS INSIST ON A MORE THOROUGH FINANCIAL EXAMINATION BEFORE EXTENDING LONG-TERM CREDIT. IF A FIRM'S NEEDS FOR FUNDS ARE SEASONAL OR CYCLICAL, IT MAY NOT WANT TO COMMIT TO LONG-TERM DEBT BECAUSE: (1) FLOTATION COSTS ARE GENERALLY HIGH FOR LONG-TERM DEBT BUT TRIVIAL FOR SHORT-TERM DEBT. (2) PREPAYMENT PENALTIES WITH LONG-TERM DEBT CAN BE EXPENSIVE. SHORT-TERM DEBT PROVIDES FLEXIBILITY. (3) LONG-TERM LOAN AGREEMENTS CONTAIN PROVISIONS WHICH CONSTRAIN A FIRM'S FUTURE ACTIONS. SHORT-TERM CREDIT AGREEMENTS ARE LESS ONEROUS. (4) THE YIELD CURVE IS NORMALLY UPWARD SLOPING, INDICATING THAT INTEREST RATES ARE GENERALLY LOWER ON SHORT-TERM THAN ON LONG-TERM DEBT.
EVEN THOUGH SHORT-TERM DEBT IS OFTEN LESS EXPENSIVE THAN LONG-TERM DEBT, SHORT-TERM DEBT SUBJECTS THE FIRM TO MORE RISK THAN LONG-TERM FINANCING. THE REASONS FOR THIS ARE: (1) IF A FIRM USES LONG-TERM DEBT, ITS INTEREST COSTS WILL BE RELATIVELY STABLE OVER TIME; HOWEVER, IF THE FIRM USES SHORT-TERM DEBT, ITS INTEREST EXPENSE WILL FLUCTUATE WIDELY. (2) IF A FIRM BORROWS HEAVILY ON A SHORT-TERM BASIS, IT MAY FIND ITSELF UNABLE TO REPAY THIS DEBT, AND IT MAY BE IN SUCH A WEAK FINANCIAL POSITION THAT THE LENDER WILL NOT EXTEND THE LOAN, WHICH COULD FORCE THE FIRM INTO BANKRUPTCY.


C. IS IT LIKELY THAT B&B COULD MAKE SIGNIFICANTLY GREATER USE OF ACCRUALS?

ANSWER: NO, B&B COULD NOT MAKE GREATER USE OF ITS ACCRUALS. ACCRUALS ARISE BECAUSE (1) WORKERS ARE PAID AFTER THEY HAVE ACTUALLY PROVIDED THEIR SERVICES, AND (2) TAXES ARE PAID AFTER THE PROFITS HAVE BEEN EARNED. THUS, ACCRUALS REPRESENT CASH OWED EITHER TO WORKERS OR TO THE IRS.
THE COST OF ACCRUALS IS GENERALLY CONSIDERED TO BE ZERO, SINCE NO EXPLICIT INTEREST MUST BE PAID ON THESE ITEMS.
THE AMOUNT OF ACCRUALS IS GENERALLY LIMITED BY THE AMOUNT OF WAGES PAID AND THE FIRM'S PROFITABILITY, AS WELL AS BY INDUSTRY CONVENTIONS REGARDING WHEN WAGE PAYMENTS ARE MADE AND IRS REGULATIONS REGARDING TAX PAYMENTS (INCREASINGLY, CONGRESS IS PUTTING BUSINESSES ON A PAY-AS-YOU-GO, OR EVEN PAY-AHEAD-OF-TIME BASIS THROUGH THE USE OF ESTIMATED TAXES.) A FIRM CANNOT ORDINARILY CONTROL ITS ACCRUALS. FIRMS USE ALL THE ACCRUALS THEY CAN, BUT THEY HAVE LITTLE CONTROL OVER THE LEVELS OF THESE ACCOUNTS.


D. ASSUME THAT B&B BUYS ON TERMS OF 1/10, NET 30, BUT THAT IT CAN GET AWAY WITH PAYING ON THE 40TH DAY IF IT CHOOSES NOT TO TAKE DISCOUNTS. ALSO, ASSUME THAT IT PURCHASES $3 MILLION OF COMPONENTS PER YEAR, NET OF DISCOUNTS. HOW MUCH FREE TRADE CREDIT CAN THE COMPANY GET, HOW MUCH COSTLY TRADE CREDIT CAN IT GET, AND WHAT IS THE PERCENTAGE COST OF THE COSTLY CREDIT? SHOULD B&B TAKE DISCOUNTS?

ANSWER: IF B&B'S NET PURCHASES ARE $3,000,000 ANNUALLY, THEN, WITH A 1 PERCENT DISCOUNT, ITS GROSS PURCHASES ARE $3,000,000/0.99 = $3,030,303. IF WE ASSUME A 360-DAY YEAR, THEN NET DAILY PURCHASES FROM THIS SUPPLIER ARE $3,000,000/360 = $8,333.33.
IF THE DISCOUNT IS TAKEN, THEN B&B MUST PAY THIS SUPPLIER AT THE END OF DAY 10 FOR PURCHASES MADE ON DAY 1, ON DAY 11 FOR PURCHASES MADE ON DAY 2, AND SO ON. THUS, IN A STEADY STATE, B&B WILL ON AVERAGE HAVE 10 DAYS' WORTH OF PURCHASES IN PAYABLES, SO,

PAYABLES = 10($8,333.33) = $83,333.33.

IF THE DISCOUNT IS NOT TAKEN, THEN B&B WILL WAIT 40 DAYS BEFORE PAYING, SO

PAYABLES = 40($8,333.33) = $333,333.33.

THEREFORE:

TRADE CREDIT IF DISCOUNTS ARE NOT TAKEN: $333,333.33 = TOTAL TRADE CREDIT
TRADE CREDIT IF DISCOUNTS ARE TAKEN: - 83,333.33 = FREE TRADE CREDIT
DIFFERENCE: $250,000.00 = COSTLY TRADE CREDIT

TO OBTAIN $250,000 OF COSTLY TRADE CREDIT, B&B MUST GIVE UP 0.01($3,030,303) = $30,303 IN LOST DISCOUNTS ANNUALLY. SINCE THE FORGONE DISCOUNTS PAY FOR $250,000 OF CREDIT, THE NOMINAL ANNUAL INTEREST RATE IS 12.12 PERCENT:
= 0.1212 = 12.12%.

HERE IS A FORMULA WHICH CAN BE USED TO FIND THE NOMINAL ANNUAL INTEREST RATE OF COSTLY TRADE CREDIT:

= .

IN THIS SITUATION,

= 0.0101 ? 12 = 0.1212 = 12.12%.

NOTE (1) THAT THE FORMULA GIVES THE SAME NOMINAL ANNUAL INTEREST RATE AS WAS CALCULATED EARLIER, (2) THAT THE FIRST TERM IS THE PERIODIC COST OF THE CREDIT (B&B SPENDS $1 TO GET THE USE OF $99), AND (3) THAT THE SECOND TERM IS THE NUMBER OF "SAVINGS PERIODS" PER YEAR (B&B DELAYS PAYMENT FOR 40 - 10 = 30 DAYS, AND THERE ARE 360/30 = 12 30-DAY PERIODS IN A YEAR. THEREFORE, WE COULD CALCULATE THE EXACT EFFECTIVE ANNUAL INTEREST RATE AS: EFFECTIVE RATE = (1.0101)12 – 1 = 12.82%.
IF B&B CAN OBTAIN FINANCING FROM ITS BANK (OR FROM OTHER SOURCES) AT AN INTEREST RATE OF LESS THAN 12.82 PERCENT, IT SHOULD BORROW THE FUNDS AND TAKE DISCOUNTS.


E. WHAT IS COMMERCIAL PAPER? WOULD IT BE FEASIBLE FOR B&B TO FINANCE WITH COMMERCIAL PAPER?

ANSWER: COMMERCIAL PAPER IS A TYPE OF UNSECURED PROMISSORY NOTE ISSUED BY LARGE, STRONG FIRMS AND SOLD PRIMARILY TO OTHER BUSINESS FIRMS, INSURANCE COMPANIES, PENSION FUNDS, MONEY MARKET MUTUAL FUNDS AND BANKS. THE USE OF COMMERCIAL PAPER IS RESTRICTED TO A COMPARATIVELY SMALL NUMBER OF VERY LARGE FIRMS THAT ARE EXCEPTIONALLY GOOD CREDIT RISKS. COMMERCIAL PAPER DEALINGS ARE GENERALLY LESS PERSONAL THAN ARE BANK RELATIONSHIPS. HOWEVER, USING COMMERCIAL PAPER PERMITS A CORPORATION TO TAP A WIDE RANGE OF CREDIT SOURCES, INCLUDING FINANCIAL INSTITUTIONS OUTSIDE ITS OWN AREA AND INDUSTRIAL CORPORATIONS ACROSS THE INDUSTRY, AND THIS CAN REDUCE INTEREST COSTS.
IT WOULD NOT BE FEASIBLE FOR B&B TO FINANCE WITH COMMERCIAL PAPER. COMMERCIAL PAPER IS UNSECURED, SHORT-TERM DEBT ISSUED BY LARGE, FINANCIALLY STRONG FIRMS AND SOLD PRIMARILY TO OTHER BUSINESS FIRMS, TO INSURANCE COMPANIES, TO PENSION FUNDS, TO MONEY MARKET MUTUAL FUNDS, AND TO BANKS. MATURITIES ARE GENERALLY 270 DAYS (9 MONTHS) OR LESS, BECAUSE SEC REGISTRATION IS REQUIRED ON MATURITIES BEYOND 270 DAYS. THERE IS A VERY ACTIVE, LIQUID MARKET FOR COMMERCIAL PAPER, AND, SINCE THERE IS VIRTUALLY NO DEFAULT RISK, COMMERCIAL PAPER RATES ARE GENERALLY LESS THAN THE PRIME RATE, AND NOT MUCH MORE THAN THE T-BILL RATE. NOTE, THOUGH, THAT ISSUERS OF COMMERCIAL PAPER ARE REQUIRED TO HAVE BACK-UP LINES OF BANK CREDIT WHICH CAN BE USED TO PAY OFF THE PAPER IF NEED BE WHEN IT MATURES. THESE BACK-UP CREDIT LINES HAVE A COST, AND THIS COST MUST BE ADDED TO THE INTEREST RATE ON THE PAPER TO DETERMINE ITS EFFECTIVE COST. SINCE ONLY LARGE, WELL-KNOWN, FINANCIALLY STRONG COMPANIES CAN ISSUE COMMERCIAL PAPER, IT WOULD BE IMPOSSIBLE FOR B&B TO TAP THIS MARKET.


F. SUPPOSE B&B DECIDED TO RAISE AN ADDITIONAL $100,000 AS A 1-YEAR LOAN FROM ITS BANK, FOR WHICH IT WAS QUOTED A RATE OF 8 PERCENT. WHAT IS THE EFFECTIVE ANNUAL COST RATE ASSUMING (1) SIMPLE INTEREST, (2) DISCOUNT INTEREST, (3) DISCOUNT INTEREST WITH A 10 PERCENT COMPENSATING BALANCE, AND (4) ADD-ON INTEREST ON A 12-MONTH INSTALLMENT LOAN? FOR THE FIRST THREE OF THESE ASSUMPTIONS, WOULD IT MATTER IF THE LOAN WERE FOR 90 DAYS, BUT RENEWABLE, RATHER THAN FOR A YEAR?

ANSWER: 1. WITH A SIMPLE INTEREST LOAN, B&B GETS THE FULL USE OF THE $100,000 FOR A YEAR, AND THEN PAYS 0.08($100,000) = $8,000 IN INTEREST AT THE END OF THE TERM, ALONG WITH THE $100,000 PRINCIPAL REPAYMENT. FOR A 1-YEAR SIMPLE INTEREST LOAN, THE NOMINAL RATE, 8 PERCENT, IS ALSO THE EFFECTIVE ANNUAL RATE.

2. ON A DISCOUNT INTEREST LOAN, THE BANK DEDUCTS THE INTEREST FROM THE FACE AMOUNT OF THE LOAN IN ADVANCE; THAT IS, THE BANK "DISCOUNTS" THE LOAN. IF THE LOAN HAD A $100,000 FACE AMOUNT, THEN THE 0.08($100,000) = $8,000 WOULD BE DEDUCTED UP FRONT, SO THE BORROWER WOULD HAVE THE USE OF ONLY $100,000 - $8,000 = $92,000. AT THE END OF THE YEAR, THE BORROWER MUST REPAY THE $100,000 FACE AMOUNT.
THUS, THE EFFECTIVE ANNUAL RATE IS 8.7 PERCENT:

EFFECTIVE RATE = = 0.087 = 8.7%.

NOTE THAT A TIMELINE CAN ALSO BE USED TO CALCULATE THE EFFECTIVE ANNUAL RATE OF THE 1-YEAR DISCOUNT LOAN:

0 1
| |
100,000 -100,000
-8,000 (DISCOUNT INTEREST)
92,000

WITH A FINANCIAL CALCULATOR, ENTER N = 1, PV = 92000, PMT = 0, AND FV = -100000 TO SOLVE FOR I = 8.6957% . 8.7%.

3. IF THE LOAN IS A DISCOUNT LOAN, AND A COMPENSATING BALANCE IS ALSO REQUIRED, THEN THE EFFECTIVE RATE IS CALCULATED AS FOLLOWS:

AMOUNT BORROWED = = $121,951.22.

0 1
| |
121,951.22 -121,951.22
- 9,756.10 (DISCOUNT INTEREST) 12,195.12
-12,195.12 (COMPENSATING BALANCE) -109,756.10
100,000.00

WITH A FINANCIAL CALCULATOR, ENTER N = 1, PV = 100000, PMT = 0, AND FV = -109756.10 TO SOLVE FOR I = 9.7561% . 9.76%.

4. IN AN INSTALLMENT (ADD-ON) LOAN, THE INTEREST IS CALCULATED AND ADDED ON TO THE REQUIRED CASH AMOUNT, AND THEN THIS SUM IS THE FACE AMOUNT OF LOAN, AND IT IS AMORTIZED BY EQUAL PAYMENTS OVER THE STATED LIFE. THUS, THE INTEREST WOULD BE $100,000 ? 0.08 = $8,000, THE FACE AMOUNT WOULD BE $108,000, AND EACH MONTHLY PAYMENT WOULD BE $9,000: $108,000/12 = $9,000.
HOWEVER, THE FIRM WOULD RECEIVE ONLY $100,000, AND IT MUST BEGIN TO REPAY THE PRINCIPAL AFTER ONLY ONE MONTH. THUS, IT WOULD GET THE USE OF $100,000 IN THE FIRST MONTH, THE USE OF $100,000 - $9,000 = $91,000 IN THE SECOND MONTH, AND SO ON, FOR AN AVERAGE OF $100,000/2 = $50,000 OVER THE YEAR. SINCE THE INTEREST EXPENSE IS $8,000, THE APPROXIMATE COST IS 16 PERCENT, OR TWICE THE STATED RATE:

APPROXIMATE COST = = = 0.16 = 16%.

TO FIND THE EXACT EFFECTIVE ANNUAL RATE, RECOGNIZE THAT B&B HAS RECEIVED $100,000 AND MUST MAKE 12 MONTHLY PAYMENTS OF $9,000:

PV =
100,000 =

ENTER IN N = 12, PV = 100000, AND PMT = -9000 IN A FINANCIAL CALCULATOR, WE FIND THE MONTHLY RATE TO BE 1.2043%, WHICH CONVERTS TO AN EFFECTIVE ANNUAL RATE OF 15.45 PERCENT:

(1.012043)12 - 1.0 = 0.1545 = 15.45%,

WHICH IS CLOSE TO THE 16 PERCENT APPROXIMATE ANNUAL INTEREST RATE.

IF THE LOAN WERE FOR 90 DAYS:

1. SIMPLE INTEREST. B&B WOULD HAVE HAD TO PAY (0.08/4)($100,000) = 0.02($100,000) = $2,000 IN INTEREST AFTER 3 MONTHS, PLUS REPAY THE PRINCIPAL. IN THIS CASE THE NOMINAL 2 PERCENT RATE MUST BE CONVERTED TO AN ANNUAL RATE, AND THE EFFECTIVE ANNUAL RATE IS 8.24 PERCENT:

EARSIMPLE = (1.02)4 - 1 = 1.0824 - 1 = 0.0824 = 8.24%.

IN GENERAL, THE SHORTER THE MATURITY (WITHIN A YEAR), THE HIGHER THE EFFECTIVE COST OF A SIMPLE LOAN.

2. DISCOUNT INTEREST. IF B&B BORROWS $100,000 FACE VALUE AT A NOMINAL RATE OF 8 PERCENT, DISCOUNT INTEREST, FOR 3 MONTHS, THEN m = 12/3 = 4, AND THE INTEREST PAYMENT IS (0.08/4)($100,000) = $2,000, SO

EARDISCOUNT =
= (1.0204)4 - 1 = 0.0842 = 8.42%.

DISCOUNT INTEREST IMPOSES LESS OF A PENALTY ON SHORTER-TERM THAN ON LONGER-TERM LOANS.

3. DISCOUNT INTEREST WITH COMPENSATING BALANCE. EVERYTHING IS THE SAME AS IN #2 ABOVE, EXCEPT THAT WE MUST ADD THE COMPENSATING BALANCE TERM TO THE DENOMINATOR.

EAR =
= (1.0227)4 - 1 = 0.0941 = 9.41%


G. HOW LARGE WOULD THE LOAN ACTUALLY BE IN EACH OF THE CASES IN PART F?

ANSWER: SIMPLE INTEREST. THE FACE VALUE OF THE LOAN WOULD BE $100,000.

DISCOUNT INTEREST. THE FACE VALUE OF THE LOAN IS CALCULATED AS:

FACE VALUE = = = $108,695.65.

DISCOUNT INTEREST WITH COMPENSATING BALANCE. THE FACE VALUE OF THE LOAN IS CALCULATED AS:

FACE VALUE = = = $121,951.22.

INSTALLMENT LOAN. THE FACE VALUE OF THE LOAN IS $100,000. NOTE THAT B&B WOULD ONLY HAVE FULL USE OF THE $100,000 FOR THE FIRST MONTH AND, OVER THE COURSE OF THE YEAR, IT WOULD ONLY HAVE APPROXIMATE USE OF $100,000/2 = $50,000.

QUARTERLY BASIS: SIMPLE INTEREST. THE FACE VALUE OF THE LOAN IS $100,000.

DISCOUNT INTEREST. THE FACE VALUE IS CALCULATED AS:

FACE VALUE = = = $102,040.82.
DISCOUNT INTEREST WITH COMPENSATING BALANCE. THE FACE VALUE OF THE LOAN IS CALCULATED AS:

FACE VALUE = = = $113,636.36.


H. WHAT ARE THE PROS AND CONS OF BORROWING ON A SECURED VERSUS AN UNSECURED BASIS?

ANSWER: GIVEN A CHOICE, IT IS ORDINARILY BETTER TO BORROW ON AN UNSECURED BASIS, SINCE THE BOOKKEEPING COSTS OF SECURED LOANS ARE OFTEN HIGH. HOWEVER, WEAK FIRMS MAY FIND THAT THEY CAN BORROW ONLY IF THEY PUT UP SOME TYPE OF SECURITY TO PROTECT THE LENDER, OR THAT BY USING SECURITY THEY CAN BORROW AT A MUCH LOWER RATE.
MOST SECURED SHORT-TERM BUSINESS BORROWING INVOLVES THE USE OF ACCOUNTS RECEIVABLE AND INVENTORY AS COLLATERAL. IF RECEIVABLES ARE USED TO SECURE A LOAN THEY MAY BE PLEDGED OR FACTORED.