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b. Assuming that the firm needs short-term financing, indicate whether it would
be better to give up the cash discount or take the discount and borrow from a
bank at 15% annual interest. Evaluate each supplier separately using your
findings in part a.
552 PART 5 Short-Term Financial Decisions


c. What impact, if any, would the fact that the firm could stretch its accounts
payable (net period only) by 20 days from supplier Z have on your answer in
part b relative to this supplier?


PROBLEMS
14“1 Payment dates Determine when a firm must pay for purchases made and
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invoices dated on November 25 under each of the following credit terms.
a. net 30 date of invoice c. net 45 date of invoice
b. net 30 EOM d. net 60 EOM

14“2 Cost of giving up cash discounts Determine the cost of giving up cash dis-
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counts under each of the following terms of sale.
a. 2/10 net 30 e. 1/10 net 60
b. 1/10 net 30 f. 3/10 net 30
c. 2/10 net 45 g. 4/10 net 180
d. 3/10 net 45

14“3 Credit terms Purchases made on credit are due in full by the end of the billing
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period. Many firms extend a discount for payment made in the first part of the
billing period. The original invoice contains a type of “short-hand” notation that
explains the credit terms that apply.
a. Write the short-hand expression of credit terms for each of the following.

Cash Beginning of
Cash discount discount period Credit period credit period

1% 15 days 45 days date of invoice
2 10 30 end of month
2 7 28 date of invoice
1 10 60 end of month


b. For each of the sets of credit terms in part a, calculate the number of days
until full payment is due for invoices dated March 12.
c. For each of the sets of credit terms, calculate the cost of giving up the cash
discount.
d. If the firm™s cost of short-term financing is 8%, what would you recommend
in regard to taking the discount or giving it up in each case?

14“4 Cash discount versus loan Erica Stone works in an accounts payable depart-
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ment. She has attempted to convince her boss to take the discount on the 3/10
net 45 credit terms most suppliers offer, but her boss argues that giving up the
3% discount is less costly than a short-term loan at 14%. Prove to whoever is
wrong that the other is correct.

14“5 Cash discount decisions Prairie Manufacturing has four possible suppliers, all
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of whom offer different credit terms. Except for the differences in credit terms,
their products and services are virtually identical. The credit terms offered by
these suppliers are shown in the following table.
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CHAPTER 14 Current Liabilities Management


Supplier Credit terms

J 1/10 net 30 EOM
K 2/20 net 80 EOM
L 1/20 net 60 EOM
M 3/10 net 55 EOM



a. Calculate the approximate cost of giving up the cash discount from each
supplier.
b. If the firm needs short-term funds, which are currently available from its
commercial bank at 16%, and if each of the suppliers is viewed separately,
which, if any, of the suppliers™ cash discounts should the firm give up?
Explain why.
c. What impact, if any, would the fact that the firm could stretch its accounts
payable (net period only) by 30 days from supplier M have on your answer in
part b relative to this supplier?

14“6 Changing payment cycle Upon accepting the position of chief executive officer
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and chairman of Reeves Machinery, Frank Cheney changed the firm™s weekly
payday from Monday afternoon to the following Friday afternoon. The firm™s
weekly payroll was $10 million, and the cost of short-term funds was 13%. If
the effect of this change was to delay check clearing by 1 week, what annual sav-
ings, if any, were realized?

14“7 Spontaneous sources of funds, accruals When Tallman Haberdashery, Inc.,
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merged with Meyers Men™s Suits, Inc., Tallman™s employees were switched from
a weekly to a bi-weekly pay period. Tallman™s weekly payroll amounted to
$750,000. The cost of funds for the combined firms is 11%. What annual
savings, if any, are realized by this change of pay period?

14“8 Cost of bank loan Data Back-Up Systems has obtained a $10,000, 90-day
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bank loan at an annual interest rate of 15%, payable at maturity. (Note: Assume
a 360-day year.)
a. How much interest (in dollars) will the firm pay on the 90-day loan?
b. Find the effective 90-day rate on the loan.
c. Annualize your result in part b to find the effective annual rate for this loan,
assuming that it is rolled over every 90 days throughout the year under the
same terms and circumstances.

14“9 Effective annual rate A financial institution made a $10,000, 1-year discount
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loan at 10% interest, requiring a compensating balance equal to 20% of the
face value of the loan. Determine the effective annual rate associated with this
loan.

14“10 Compensating balances and effective annual rates Lincoln Industries has a line
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of credit at Bank Two that requires it to pay 11% interest on its borrowing and to
maintain a compensating balance equal to 15% of the amount borrowed. The
firm has borrowed $800,000 during the year under the agreement. Calculate the
554 PART 5 Short-Term Financial Decisions


effective annual rate on the firm™s borrowing in each of the following
circumstances:
a. The firm normally maintains no deposit balances at Bank Two.
b. The firm normally maintains $70,000 in deposit balances at Bank Two.
c. The firm normally maintains $150,000 in deposit balances at Bank Two.
d. Compare, contrast, and discuss your findings in parts a, b, and c.

14“11 Compensating balance vs. discount loan Weathers Catering Supply, Inc., needs
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to borrow $150,000 for 6 months. State Bank has offered to lend the funds at a
9% annual rate subject to a 10% compensating balance. Frost Finance Co. has
offered to lend the funds at a 9% annual rate with discount-loan terms. The
principal of both loans would be payable at maturity as a single sum.
a. Calculate the effective annual rate of interest on each loan.
b. What could Weathers do that would reduce the effective annual rate on the
State Bank loan?

14“12 Integrative”Comparison of loan terms Cumberland Furniture wishes to estab-
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lish a prearranged borrowing agreement with its local commercial bank. The
bank™s terms for a line of credit are 3.30% over the prime rate, and each year the
borrowing must be reduced to zero for a 30-day period. For an equivalent
revolving credit agreement, the rate is 2.80% over prime with a commitment fee
of 0.50% on the average unused balance. With both loans, the required compen-
sating balance is equal to 20% of the amount borrowed. The prime rate is cur-
rently 8%. Both agreements have $4 million borrowing limits. The firm expects
on average to borrow $2 million during the year no matter which loan agreement
it decides to use.
a. What is the effective annual rate under the line of credit?
b. What is the effective annual rate under the revolving credit agreement?
(Hint: Compute the ratio of the dollars that the firm will pay in interest and
commitment fees to the dollars that the firm will effectively have use of.)
c. If the firm does expect to borrow an average of half the amount available,
which arrangement would you recommend for the borrower? Explain why.

14“13 Cost of commercial paper Commercial paper is usually sold at a discount. Fan
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Corporation has just sold an issue of 90-day commercial paper with a face value
of $1 million. The firm has received initial proceeds of $978,000.
a. What effective annual rate will the firm pay for financing with commercial
paper, assuming that it is rolled over every 90 days throughout the year?
b. If a brokerage fee of $9,612 was paid from the initial proceeds to an
investment banker for selling the issue, what effective annual rate will the
firm pay, assuming that the paper is rolled over every 90 days throughout
the year?


14“14 Accounts receivable as collateral Kansas City Castings (KCC) is attempting to
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obtain the maximum loan possible using accounts receivable as collateral. The
firm extends net-30-day credit. The amounts that are owed KCC by its 12 credit
customers, the average age of each account, and customer™s average payment
period are as shown in the following table.
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CHAPTER 14 Current Liabilities Management


Account Average age Average payment
Customer receivable of account period of customer

A $37,000 40 days 30 days
B 42,000 25 50
C 15,000 40 60
D 8,000 30 35
E 50,000 31 40
F 12,000 28 30
G 24,000 30 70
H 46,000 29 40
I 3,000 30 65
J 22,000 25 35
K 62,000 35 40
L 80,000 60 70


a. If the bank will accept all accounts that can be collected in 45 days or less as
long as the customer has a history of paying within 45 days, which accounts
will be acceptable? What is the total dollar amount of accounts receivable
collateral? (Note: Accounts receivable that have an average age greater than
the customer™s average payment period are also excluded.)
b. In addition to the conditions in part a, the bank recognizes that 5% of credit
sales will be lost to returns and allowances. Also, the bank will lend only
80% of the acceptable collateral (after adjusting for returns and allowances).
What level of funds would be made available through this lending source?


14“15 Accounts receivable as collateral Springer Products wishes to borrow $80,000
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from a local bank using its accounts receivable to secure the loan. The bank™s
policy is to accept as collateral any accounts that are normally paid within 30
days of the end of the credit period, as long as the average age of the account is
not greater than the customer™s average payment period. Springer™s accounts
receivable, their average ages, and the average payment period for each customer
are shown in the following table. The company extends terms of net 30 days.

Account Average age Average payment
Customer receivable of account period of customer

A $20,000 10 days 40 days
B 6,000 40 35
C 22,000 62 50
D 11,000 68 65
E 2,000 14 30
F 12,000 38 50
G 27,000 55 60
H 19,000 20 35


a. Calculate the dollar amount of acceptable accounts receivable collateral held
by Springer Products.
556 PART 5 Short-Term Financial Decisions


b. The bank reduces collateral by 10% for returns and allowances. What is the
level of acceptable collateral under this condition?
c. The bank will advance 75% against the firm™s acceptable collateral (after
adjusting for returns and allowances). What amount can Springer borrow
against these accounts?

14“16 Accounts receivable as collateral, cost of borrowing Maximum Bank has ana-
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lyzed the accounts receivable of Scientific Software, Inc. The bank has chosen
eight accounts totaling $134,000 that it will accept as collateral. The bank™s
terms include a lending rate set at prime 3% and a 2% commission charge.
The prime rate currently is 8.5%.
a. The bank will adjust the accounts by 10% for returns and allowances. It then
will lend up to 85% of the adjusted acceptable collateral. What is the maxi-
mum amount that the bank will lend to Scientific Software?
b. What is Scientific Software™s effective annual rate of interest if it borrows
$100,000 for 12 months? For 6 months? For 3 months? (Assume that the
prime rate remains at 8.5% during the life of the loan.)

14“17 Factoring Blair Finance factors the accounts of the Holder Company. All eight
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factored accounts are shown in the following table, with the amount factored,
the date due, and the status on May 30. Indicate the amounts that Blair should
have remitted to Holder as of May 30 and the dates of those remittances.
Assume that the factor™s commission of 2% is deducted as part of determining
the amount of the remittance.

Account Amount Date due Status on May 30

A $200,000 May 30 Collected May 15
B 90,000 May 30 Uncollected
C 110,000 May 30 Uncollected
D 85,000 June 15 Collected May 30
E 120,000 May 30 Collected May 27
F 180,000 June 15 Collected May 30
G 90,000 May 15 Uncollected
H 30,000 June 30 Collected May 30



14“18 Inventory financing Raymond Manufacturing faces a liquidity crisis”it needs
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a loan of $100,000 for 30 days. Having no source of additional unsecured bor-
rowing, the firm must find a secured short-term lender. The firm™s accounts
receivable are quite low, but its inventory is considered liquid and reasonably
good collateral. The book value of the inventory is $300,000, of which
$120,000 is finished goods.
(1) City-Wide Bank will make a $100,000 trust receipt loan against the
finished goods inventory. The annual interest rate on the loan is 12%
on the outstanding loan balance plus a 0.25% administration fee levied
against the $100,000 initial loan amount. Because it will be liquidated as
inventory is sold, the average amount owed over the month is expected to
be $75,000.
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CHAPTER 14 Current Liabilities Management


(2) Sun State Bank will lend $100,000 against a floating lien on the book value
of inventory for the 30-day period at an annual interest rate of 13%.
(3) Citizens™ Bank and Trust will lend $100,000 against a warehouse receipt on
the finished goods inventory and charge 15% annual interest on the out-
standing loan balance. A 0.5% warehousing fee will be levied against the
average amount borrowed. Because the loan will be liquidated as inventory is
sold, the average loan balance is expected to be $60,000.

a. Calculate the dollar cost of each of the proposed plans for obtaining an initial
loan amount of $100,000.
b. Which plan do you recommend? Why?
c. If the firm had made a purchase of $100,000 for which it had been given
terms of 2/10 net 30, would it increase the firm™s profitability to give
up the discount and not borrow as recommended in part b? Why or
why not?



CHAPTER 14 CASE Selecting Kanton Company™s Financing Strategy
and Unsecured Short-Term Borrowing Arrangement

M orton Mercado, the CFO of Kanton Company, carefully developed the
estimates of the firm™s total funds requirements for the coming year. These
are shown in the following table.

Month Total funds Month Total funds

January $1,000,000 July $6,000,000
February 1,000,000 August 5,000,000
March 2,000,000 September 5,000,000
April 3,000,000 October 4,000,000
May 5,000,000 November 2,000,000
June 7,000,000 December 1,000,000


In addition, Morton expects short-term financing costs of about 10% and
long-term financing costs of about 14% during that period. He developed the
three possible financing strategies that follow:
Strategy 1”Aggressive: Finance seasonal needs with short-term funds and
permanent needs with long-term funds.
Strategy 2”Conservative: Finance an amount equal to the peak need with
long-term funds and use short-term funds only in an emergency.
Strategy 3”Tradeoff: Finance $3,000,000 with long-term funds and finance
the remaining funds requirements with short-term funds.
Using the data on the firm™s total funds requirements, Morton estimated the
average annual short-term and long-term financing requirements for each strat-
egy in the coming year, as shown in the following table.
558 PART 5 Short-Term Financial Decisions


Average annual financing
Strategy 1 Strategy 2 Strategy 3
Type of financing (aggressive) (conservative) (tradeoff)

Short-term $2,500,000 $ 0 $1,666,667
Long-term 1,000,000 7,000,000 3,000,000


To ensure that, along with spontaneous financing from accounts payable
and accruals, adequate short-term financing will be available, Morton plans to
establish an unsecured short-term borrowing arrangement with its local bank,
Third National. The bank has offered either a line-of-credit agreement or a
revolving credit agreement. Third National™s terms for a line of credit are an
interest rate of 2.50% above the prime rate, and the borrowing must be reduced
to zero for a 30-day period during the year. On an equivalent revolving credit
agreement, the interest rate would be 3.00% above prime with a commitment fee
of 0.50% on the average unused balance. Under both loans, a compensating bal-
ance equal to 20% of the amount borrowed would be required. The prime rate is
currently 7%. Both the line-of-credit agreement and the revolving credit agree-
ment would have borrowing limits of $1,000,000. For purposes of his analysis,
Morton estimates that Kanton will borrow $600,000 on the average during the
year, regardless which financing strategy and loan arrangement it chooses.

Required
a. Determine the total annual cost of each of the three possible financing strate-
gies.
b. Assuming that the firm expects its current assets to total $4 million through-
out the year, determine the average amount of net working capital under
each financing strategy. (Hint: Current liabilities equal average short-term
financing.)
c. Using the net working capital found in part b as a measure of risk, discuss the
profitability“risk tradeoff associated with each financing strategy. Which
strategy would you recommend to Morton Mercado for Kanton Company?
Why?
d. Find the effective annual rate under:
(1) The line-of-credit agreement.
(2) The revolving credit agreement. (Hint: Find the ratio of the dollars that
the firm will pay in interest and commitment fees to the dollars that the
firm will effectively have use of.)
e. If the firm does expect to borrow an average of $600,000, which borrowing
arrangement would you recommend to Kanton? Explain why.


WEB EXERCISE Go to the Web site www.21stfinancialsolutions.com.
WW
W
1. Click on What Is Factoring? What are factoring™s advantages?
2. In the left-hand navigation bar, click on Is factoring for You? What are the
additional benefits, and what types of companies can use factoring to their
advantage?
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CHAPTER 14 Current Liabilities Management


3. Using the information in How factoring works, summarize the factoring
process.
Next, go to the Web site www.wellsfargo.com.
4. On the top navigation bar, click on commercial services. Under Business
Lending and Leasing, click on commercial loans.
a. What types of loans does the bank offer businesses?
b. Click on each of the four categories and summarize the type of loan and
its uses.
5. At the top of the page, click on the link for factoring services.
a. Describe the two types of factoring services.
b. Click on Wells Fargo Business Credit. What features does Wells Fargo
offer its factoring customers?




Remember to check the book™s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.

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