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ANSWERS TO QUESTIONS
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1. Trade credit from suppliers is spontaneous because there is no formal negotiation for the funds. By merely purchasing merchandise on credit, funds are acquired.
2. The reasons trade credit from suppliers is used to finance temporary working capital are as follows:
a) Firms may be erroneously calculating the cost of this financing for, say, 60 days as the annual cost. Therefore,
"2/10, net 60" is calculated as only 2% rather than (2/98)(365/50) = 14.9%.
b) It may be that firms prefer the convenience of spontaneous funds.
c) Seasonal dating and stretching payables may reduce the financing cost to a level competitive with short-term bank loans.
3. Stretching payables creates problems for suppliers since their ability to forecast cash flows is substantially impaired. The more uncertain the cash projections, the higher the level of protective liquidity a firm must hold. Also, investors may perceive a higher degree of risk for the supplier, thus increasing the supplier's cost of capital. Methods of preventing the stretching of payables include severe penalties for late payment (such as a 10% late charge), friendly reminders to the customers, and other acceptable collection procedures.
4. The firm could expect its liquidity to be improved. The cost to the firm's customers of not taking cash discounts has risen drastically (from 9.3% to 37.2%). Thus, customers will tend to borrow money from banks and other sources in order to receive the cash discount. This will tend to increase the selling firm's turnover, and decrease the firm's investment in accounts receivable, thereby increasing the firm's liquidity. Of course the customer's position is exactly reversed.
5. There is far less ability to change the amount of financing provided by accrued expenses than there is with trade credit. The amount largely depends on the amount of wages and profits.
6. The rate on commercial paper is lower than the prime rate since the high quality borrower, who is able to issue commercial paper, can get the prime rate at the bank. Lenders can buy treasury bills;
therefore, to induce lenders to buy commercial paper, a higher rate must be paid. To induce borrowers to issue commercial paper, a rate lower than prime, but more than the T-bill rate, must be available.
7. The commercial paper market is not available to all firms. Also, the market is very impersonal compared to a bank.
8. For the most part, commercial paper is restricted to large, high quality industrial companies, finance companies, and utilities.
Whereas the purpose originally was to support seasonal borrowings,
and this still remains an important purpose, a good deal of the commercial paper issued today represents permanent financing. It is simply rolled over at maturity.
9. While both represent money-market, short-term instruments, a bankers' acceptance has a viable secondary market whereas commercial paper does not. Bankers' acceptances are associated with a specific shipment of goods or storage of goods. With this instrument, the acceptance of the draft by a bank substitutes the bank's credit for that of the parties involved. Similarly, if commercial paper is "bank supported," a bank provides a letter of credit guaranteeing the obligation. With "stand alone" commercial paper, the company often must have backup lines of credit from banks. Both instruments are rated as to quality by independent rating agencies.
10. A line of credit is an informal lending arrangement, usually for one year, where the bank expresses a willingness to lend up to some specified amount of funds at an interest rate related to the prime rate or to the bank's cost of funds. A revolving credit agreement is a legal commitment to extend credit up to some maximum amount anytime a company wishes to borrow. Usually the commitment is for multiple years, often three. Also, the company must satisfy certain restrictions (called protective covenants) specified in the agreement. If satisfied, however, the loan cannot be denied whereas it can be legally denied under a line of credit should the company evolve itself into financial difficulty.
11. Because interest is subtracted from the amount advanced, a discount note has a higher effective rate of interest than a note where interest is collected at the end (everything else being equal).
Therefore, a borrower will prefer a collect note and the lender a discount note, all other things the same.
12. The quality of the borrower and its cash flow ability to service debt largely determine whether a lender is willing to make an unsecured loan. If the lender does not have a very high degree of confidence in the ability of the borrower to repay, it will insist on some type of secured lending arrangement.
13. The percentage advanced depends on the marketability of the collateral, the synchronization of its life with that of the loan, and the basic riskiness of the collateral. With respect to the latter, the lender is concerned with fluctuations in market price.
14. The analysis should be on the basis of costs and benefits.
Typically, the factoring arrangement will be more costly as a method of financing. However, the sale of receivables eliminates clerical and credit costs the company would otherwise have to bear.
For the small company, these can be significant on a relative basis and more than offset the difference in financing costs. Also, because of economies of scale, the factor may be able to do a better job of credit analysis and record keeping.
15. No answer suggested.
16. a) Industries whose products are relatively standard, easily disposed of, and physically suitable for storage are often financed by terminal or field warehousing.
b) Smaller, undercapitalized firms frequently resort to accounts receivable assignment or to factoring, depending upon their ability to, and the relative costs of, maintaining an independent credit analysis department.
c) Due to capital market restrictions, international companies may seek to raise funds outside their domestic countries.
Eurodollar loans may be an attractive source for such companies.
d) Trust receipt loans are used frequently in the automotive industry because it relieves the dealer of extensive inventory carrying costs, and affords the manufacturer greater product exposure.
17. In determining an appropriate composition of short-term financing, such things as the relative cost of funds, the availability of different types of financing, whether or not the type of financing requires security, the timing of the borrowing in the money market or from a private lender, and the flexibility associated with the various types of potential financing should be considered. All of these things can change over time with changing financial market conditions.
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SOLUTIONS TO PROBLEMS
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1. a) Mr. Blunder is confusing the percentage cost of using funds for five days with the cost of using funds for a year. These costs are clearly not comparable. One must be converted to the time scale of the other.
b) (2/98)(365/5) = 149.0%
c) Assuming the firm has made the decision not to take the cash discount, it makes no sense to pay before the due date. In this case, payment 30 days after purchases are received rather than 15 would reduce the annual interest cost to 36.7%.
2. Alt. #1: Discount in $ or Alt. #2: Discount as % ──────────────────────────────── ───────────────────────
a) ($5/$495)(365/10) = 36.9% (1/99)(365/10) = 36.9%
b) ($20/$980)(365/30) = 24.8% (2/98)(365/30) = 24.8%
c) ($2/$98)(365/5) = 149.0% (2/98)(365/5) = 149.0%
d) ($7.50/$242.50)(365/20) = 56.4% (3/97)(365/20) = 56.4%
3. No. Assume credit terms of "2/10, net 30." For a $100 invoice, the annual interest cost would be:
($2/$98)(365/20) = 37.2%
For a $500 invoice, the annual cost would be the same:
($10/$490)(365/20) = 37.2%
4. Alt. #1: Discount in $ or Alt. #2: Discount as % ──────────────────────────────── ───────────────────────
a) ($5/$495)(365/20) = 18.4% (1/99)(365/20) = 18.4%
b) ($20/$980)(365/40) = 18.6% (2/98)(365/40) = 18.6%
c) ($2/$98)(365/15) = 49.7% (2/98)(365/15) = 49.7%
d) ($7.50/$242.50)(365/30) = 37.6% (3/97)(365/30) = 37.6%
■ The major advantage of stretching is the substantial reduction effected in annual interest cost.
■ The major disadvantages of stretching are the cost of the cash discount foregone and the possible deterioration in credit rating.
5. i) ($5,000,000)(.60)(.10) = $300,000 in interest
($5,000,000)(.40)(.005) = 10,000 in commitment fees ────────
$310,000 in annual dollar cost ii) $310,000 in annual dollar cost
────────────────────────────── = 10.33%
$3,000,000 in useable funds
iii) With 20 percent utilization we have:
($5,000,000)(.20)(.10) = $100,000 in interest
($5,000,000)(.80)(.005) = 20,000 in commitment fees ────────
$120,000 in annual dollar cost $120,000 in annual dollar cost
────────────────────────────── = 12%
$1,000,000 in useable funds
The annual dollar cost goes down, while the annual percentage cost goes up as less of the total revolving credit agreement is utilized. Declining interest costs, rising commitment fees, and declining useable funds combine to produce this result.
6. a) ($100,000 x .08) in interest
────────────────────────────────────────────── = 11.1%
($100,000 - $8,000 - $10,000) in useable funds
b) ($100,000 x .09) in interest
────────────────────────────────────────────── = 11.1%
($100,000 - $9,000 - $10,000) in useable funds
c) ($100,000 x .105) in interest
───────────────────────────── = 10.50%
$100,000 in useable funds
Alternative (c) is best because it has the lowest effective interest cost.
7. a) Interest cost ($200,000 x .10)(90/365) = $ 4,932 Warehousing cost = 3,000 Efficiency cost = 4,000 ───────
Total 90-day cost $11,932
b) Interest cost ($200,000 x .23)(90/365) = $11,342
Alternative (b), the floating lien loan, is preferred.
8. Factoring costs (monthly):
■ Purchase of receivables
(.02)(.70)($500,000) = $7,000
■ Lending arrangement
(.015)($100,000) = 1,500 $8,500
Banking financing costs (monthly):
Interest (.15/12)($100,000) = $1,250 Processing (.02)($100,000) = 2,000 Credit department expense = 2,000 Bad-debt expense (.01)(.70)($500,000) = 3,500 $8,750
The firm should continue its factoring arrangement -- it's cheaper.
9. Differential interest cost (Finance company minus Bank) =
7.5 percent - 2.5 percent = 5 percent. Quarterly differential = 5 percent/4 = 1.25 percent.
Interest cost savings:
Quarter Inventories Inventories x 1.25%
1 $1,600,000 $ 20,000 2 2,100,000 26,250 3 1,500,000 18,750 4 3,200,000 40,000 Annual savings $105,000
Annual servicing costs of the trust receipt loan =
$20,000 x 4 = $80,000. As the savings exceed the increased costs, the company should utilize the trust receipt financing arrangement.
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SOLUTIONS TO SELF-CORRECTION PROBLEMS
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1. a. 1/10, net/30 (1/99)(365/20) = 18.4%
b. 2/10, net/30 (2/98)(365/20) = 37.2%
c. 3/10, net/30 (3/97)(365/20) = 56.4%
d. 10/30, net/60 (10/90)(365/30) = 135.2%
e. 3/10, net/60 (3/97)(365/50) = 22.6%
f. 2/10, net/90 (2/98)(365/80) = 9.3%
g. 3/10, net/90 (3/97)(365/80) = 14.1%
h. 5/10, net/100 (5/95)(365/90) = 21.3%
2. Annualized costs are as follows:
a. Trade credit: (3/97)(365/20) = 56.47%
b. Bank financing: ($5,000,000 x .15)/($4,400,000) = 17.05%
c. Commercial paper: ($300,000/$4,400,000) x 2 = 13.64%
The bank financing is approximately 3.4 percent more expensive than the commercial paper; therefore, commercial paper should be issued.
3. Annualized costs are as follows:
a. Trade credit: If discounts are not taken, up to $97,000 (i.e., 97% x $50,000 per month x 2 months) can be raised after the second month. The cost would be
(3/97)(365/60) = 18.8%
b. Bank loan: Assuming that the compensating balance would not otherwise be maintained, the cost would be
($106,000 x .13)/($106,000 x .90) = 14.4%
c. Factoring: Factor fee for the year would be
2% x ($150,000 x 12) = $36,000. The savings effected, however, would be $30,000, giving a net factoring cost of
$6,000. Borrowing $95,000 on the receivables would thus cost approximately
([.12 x $95,000] + $6,000)/$95,000 = 18.3%
Bank borrowing would thus be the cheapest source of funds.
4. a. 12% of 80 percent of $400,000 for 6 months $19,200 Terminal warehousing cost for 6 months 7,000 Six-month cost of cash discount foregone to extend
payables from 10 days to 40 days:
(2/98)(365/30)($80,000)(1/2 year)
= .2483 x $80,000 x .5 9,932 Total six-month cost $36,132 b. $400,000 x 20% x 1/2 year $40,000 c. 10% of 70 percent of $400,000 for 6 months $14,000 Field warehousing cost for 6 months 10,000 Six-month cost of cash discount forgone to extend
payables from 10 days to 40 days:
(2/98)(365/30)($120,000)(1/2 year)
= .2483 x $120,000 x .5 14,898 Total six-month cost $38,898
The terminal warehouse receipt loan results in the lowest cost.