Resource: Principles of Managerial Finance, Ch. 16Complete the following case study: Integrative Case Casa Diseno p. 681 .( Chapter 16)Only complete the YELLOW HIGHLIGHTED AREA. ONLY DO the probelm highlighted in question DI have copied and paste chapter 16 and highlighted my part of the assignment. remember it’s a team assignment.
16 Current Liabilities Management
LG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms.
LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals.
LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans.
LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans.
LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral.
LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral.
Why This Chapter Matters to You
In your professional life
ACCOUNTING You need to understand how to analyze supplier credit terms to decide whether the firm should take or give up cash discounts; you also need to understand the various types of short-term loans, both unsecured and secured, that you will be required to record and report.
INFORMATION SYSTEMS You need to understand what data the firm will need to process accounts payable, track accruals, and meet bank loans and other short-term debt obligations in a timely manner.
MANAGEMENT You need to know the sources of short-term loans so that, if short-term financing is needed, you will understand its availability and cost.
MARKETING You need to understand how accounts receivable and inventory can be used as loan collateral; the procedures used by the firm to secure short-term loans with such collateral could affect customer relationships.
OPERATIONS You need to understand the use of accounts payable as a form of short-term financing and the effect on one’s suppliers of stretching payables; you also need to understand the process by which a firm uses inventory as collateral.
In your personal life
Management of current liabilities is an important part of your financial strategy. It takes discipline to avoid viewing cash and credit purchases equally. You need to borrow for a purpose, not convenience. You need to repay credit purchases in a timely fashion. Excessive use of short-term credit, particularly with credit cards, can create personal liquidity problems and, at the extreme, personal bankruptcy.
FastPay Getting Cash into the Hands of Online Media Companies
Digital advertising revenues hit $36.6 billion in 2012, a 15 percent increase over 2011, which was itself a record-breaking year. Online ads are everywhere, from Google search pages to YouTube videos to your Facebook News Feed. A challenge for the publishers of online ads is collecting money for those ads. The industry standard calls for publishers of online ads to send invoices within 30 days after an ad campaign is complete, and the advertiser then has 30 days or more to pay for the ad. Thus, companies that sell online advertising can accumulate large receivables balances, and collecting cash can be a slow process.
That’s where the company FastPay comes in. FastPay makes loans to publishers, ad-tech companies, and other digital media businesses based on those firms’ accounts receivable. FastPay lends up to $5 million per borrower, with the terms of the loan based on the quality of the receivable. For example, if Pepsi were to enter into an agreement with YouTube to place online ads in videos, FastPay would grant a loan to YouTube on relatively favorable terms because it views Pepsi as a good credit risk. One area in which FastPay is expanding rapidly is in making loans to Facebook Preferred Marketing Developers, a network of small and mediumsized businesses that builds advertising apps on Facebook, manages ad campaigns, and helps Facebook develop new marketing strategies.
Firms rely on a wide array of short-term financing vehicles. In this chapter, you’ll learn about the ways companies can use short-term finance to help maximize the wealth of their shareholders.
16.1 Spontaneous Liabilities
Spontaneous liabilities arise from the normal course of business. For example, when a retailer orders goods for inventory, the manufacturer of those goods usually does not demand immediate payment but instead extends a short-term loan to the retailer that appears on the retailer’s balance sheet under accounts payable. The more goods the retailer orders, the greater will be the accounts payable balance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addition, both are forms of unsecured short-term financing, short-term financing obtained without pledging specific assets as collateral. The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible.
Financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals.
unsecured short-term financing
Short-term financing obtained without pledging specific assets as collateral.
ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are the major source of unsecured short-term financing for business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser.
Role in the Cash Conversion Cycle
The average payment period is the final component of the cash conversion cycle introduced in Chapter 15. The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In Chapter 15, we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is accounts payable management.
accounts payable management
Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier.
When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period.
In 2013, Brown-Forman Corporation (BF), manufacturer of alcoholic beverage brands such as Jack Daniels, had annual revenue of $3.8 billion, cost of revenue of $1.8 billion, and accounts payable of $468 million. BF had an average age of inventory (AAI) of 168 days, an average collection period (ACP) of 55 days, and an average payment period (APP) of 136 days (BF’s purchases were $1.3 billion). Thus, the cash conversion cycle for BF was 87 days (168 + 55 − 136).
The resources BF had invested in this cash conversion cycle (assuming a 365-day year) were
Based on BF’s APP and average accounts payable, the daily accounts payable generated by BF is about $3.5 million ($0.48 billion ÷ 136). If BF were to increase its average payment period by 5 days, its accounts payable would increase by about $17.5 million (5 × $3.5 million). As a result, BF’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $17.5 million. Clearly, if this action did not damage BF’s credit rating, it would be in the company’s best interest.
Analyzing Credit Terms
The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases. Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment.
Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date.
Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000 − (0.02 × $1,000)] by March 10, thereby saving $20.
Giving Up the Cash Discount If the firm chooses to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, when a firm gives up a discount, it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a loan, and the length of this loan is the number of additional days that the purchaser can delay payment to the seller. This cost can be illustrated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period).
cost of giving up a cash discount
The implied rate of interest paid to delay payment of an account payable for an additional number of days.
FIGURE 16.1 Payment Options
Payment options for Lawrence Industries
My Finance Lab Solution Video
In Example 16.2, we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must pay an extra $20, or $1,000 rather than $980. In other words, if the firm pays on March 30, it will pay $980 (what it could have paid on March 10) plus $20. The extra $20 is like interest on a loan, and in this case the $980 is like the loan principal. Lawrence Industries owes $980 to its supplier on March 10, but the supplier is willing to accept $980 plus $20 in interest on March 30. Figure 16.1 shows the payment options that are open to the company.
To calculate the implied interest rate associated with giving up the cash discount, we simply treat $980 as the loan principal, $20 as the interest, and 20 days (the time from March 10 to March 30) as the term of the loan. Again, the tradeoff that Lawrence faces is that it can pay $980 on March 10 or $980 plus $20 in interest 20 days later on March 30. Therefore, the interest rate that Lawrence is paying by giving up the discount is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The general expression for calculating the annual percentage cost of giving up a cash discount can be expressed as1
1. Equation 16.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each alternative.
Substituting the values for CD (2%) and N (20 days) into Equation 16.1 results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)].
A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 16.1:
The smaller the cash discount, the closer the approximation to the actual cost of giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% [2% × (365 ÷ 20)].
Using the Cost of Giving Up a Cash Discount in Decision Making The financial manager must determine whether it is advisable to take a cash discount. A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other institution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier.
Mason Products, a large building-supply company, has four possible suppliers, each offering different credit terms. Otherwise, their products and services are identical. Table 16.1 presents the credit terms offered by suppliers A, B, C, and D and the cost of giving up the cash discounts in each transaction. The approximation method of calculating the cost of giving up a cash discount (Equation 16.2) has been used. The cost of giving up the cash discount from supplier A is 36.5%; from supplier B, 4.9%; from supplier C, 21.9%; and from supplier D, 29.2%.
TABLE 16.1 Cash Discounts and Associated Costs for Mason Products
Approximate cost of giving up a cash discount
2/10 net 30 EOM
1/10 net 85 EOM
3/20 net 70 EOM
4/10 net 60 EOM
If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 6%, and if each of the suppliers is viewed separately, which (if any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier A, the firm takes the cash discount, because the cost of giving it up is 36.5%, and then borrows the funds it requires from its bank at 6% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of this action is less than the cost of borrowing money from the bank (4.9% versus 6%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the 6% cost of borrowing from the bank.
The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain bank borrowing costs. However, other factors relative to payment strategies may also need to be considered. For example, some firms, particularly small firms and poorly managed firms, routinely give up all discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions.
Effects of Stretching Accounts Payable
A strategy that is often employed by a firm is stretching accounts payable, that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduce the cost of giving up a cash discount.
stretching accounts payable
Paying bills as late as possible without damaging the firm’s credit rating.
Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of giving up the cash discount, assuming payment on the last day of the credit period, was approximately 36.5% [2% × (365 ÷ 20)]. If the firm were able to stretch its account payable to 70 days without damaging its credit rating, the cost of giving up the cash discount would be only 12.2% [2% × (365 ÷ 60)]. Stretching accounts payable reduces the implicit cost of giving up a cash discount.
Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases.
Personal Finance Example 16.6
Jack and Mary Nobel, a young married couple, are in the process of purchasing a 50-inch HD TV at a cost of $1,900. The electronics dealer currently has a special financing plan that would allow them to either (1) put $200 down and finance the balance of $1,700 at 3% annual interest over 24 months, resulting in payments of $73 per month; or (2) receive an immediate $150 cash rebate, thereby paying only $1,750 cash. The Nobels, who have saved enough to pay cash for the TV, can currently earn 5% annual interest on their savings. They wish to determine whether to borrow or to pay cash to purchase the TV.
The upfront outlay for the financing alternative is the $200 down payment, whereas the Nobels will pay out $1,750 up front under the cash purchase alternative. So, the cash purchase will require an initial outlay that is $1,550 ($1,750 − $200) greater than under the financing alternative. Assuming that they can earn a simple interest rate of 5% on savings, the cash purchase will cause the Nobels to give up an opportunity to earn $155 (2 years × 0.05 × $1,550) over the 2 years.
If they choose the financing alternative, the $1,550 would grow to $1,705 ($1,550 + $155) at the end of 2 years. But under the financing alternative, the Nobels will pay out a total of $1,752 (24 months × $73 per month) over the 2-year loan term. The cost of the financing alternative can be viewed as $1,752, and the cost of the cash payment (including forgone interest earnings) would be $1,705. Because it is less expensive, the Nobels should pay cash for the TV. The lower cost of the cash alternative is largely the result of the $150 cash rebate.
The second spontaneous source of short-term business financing is accruals. Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. Because taxes are payments to the government, their accrual cannot be manipulated by the firm. However, the accrual of wages can be manipulated to some extent by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work. The pay period for employees who earn an hourly rate is often governed by union regulations or by state or federal law. However, in other cases, the frequency of payment is at the discretion of the company’s management.
Liabilities for services received for which payment has yet to be made.
in practice focus on ETHICS: Accruals Management
On June 2, 2010, Diebold, Inc., agreed to pay a $25 million fine to settle accounting fraud charges brought by the U.S. Securities and Exchange Commission (SEC). According to the SEC, the management of the Ohio-based manufacturer of ATMs, bank security systems, and electronic voting machines regularly received reports comparing the company’s earnings to analyst forecasts. When earnings were below forecasts, management identified opportunities, some of which amounted to accounting fraud, to close the gap.
“Diebold’s financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company’s bottom line,” SEC Enforcement Director Robert Khuzami said in a statement. “When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences.”a
A number of the SEC’s claims focused on premature revenue recognition. For example, Diebold was charged with improper use of “bill and hold” transactions. Under generally accepted accounting principles, revenue is typically recognized after a product is shipped. However, in some cases, sellers can recognize revenue before shipment for certain bill and hold transactions. The SEC claimed that Diebold improperly used bill and hold accounting to record revenue prematurely.
The SEC also claimed that Diebold manipulated various accounting accruals. Diebold was accused of understating liabilities tied to its Long Term Incentive Plan, commissions to be paid to sales personnel, and incentives to be paid to service personnel. Diebold temporarily reduced a liability account set up for payment of customer rebates. The company was also accused of overstating the value of inventory and improper inventory write-ups.
Each of these activities allowed Diebold to inflate the company’s financial performance. According to the SEC’s complaint, Diebold’s fraudulent activities misstated reported pretax earnings by at least $127 million between 2002 and 2007. Two years prior to the settlement, Diebold restated earnings for the period covered by the charges.
The clawback provision of the 2002 Sarbanes-Oxley antifraud law requires executives to repay compensation they receive while their company misled shareholders. Diebold’s former CEO, Walden O’Dell, agreed to return $470,000 in cash, plus stock and options. The SEC is currently pursuing a lawsuit against two other former Diebold executives for their part in the matter.
Why might financial managers still be tempted to manage earnings when a clawback is a legitimate possibility?
Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 × $400,000).
What are the two major sources of spontaneous short-term financing for a firm? How do their balances behave relative to the firm’s sales?
Is there a cost associated with taking a cash discount? Is there any cost associated with giving up a cash discount? How do short-term borrowing costs affect the cash discount decision?
What is “stretching accounts payable”? What effect does this action have on the cost of giving up a cash discount?
16.2 Unsecured Sources of Short-Term Loans
Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are available to firms of all sizes; commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions.
Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is the short-term, self-liquidating loan. These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. In other words, the use to which the borrowed money is put provides the mechanism through which the loan is repaid, hence the term self-liquidating.
short-term, self-liquidating loan
An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid.
Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, through lines of credit, and through revolving credit agreements. Before we look at these types of loans, we consider loan interest rates.
Loan Interest Rates
The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often based on the prime rate of interest. The prime rate of interest (prime rate) is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent.
prime rate of interest (prime rate)
The lowest rate of interest charged by leading banks on business loans to their most important business borrowers.
Fixed- and Floating-Rate Loans Loans can have either fixed or floating interest rates. On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established, and the rate of interest is allowed to “float,” or vary, above prime as the prime rate varies until maturity. Generally, the increment above the prime rate will be lower on a floating-rate loan than on a fixed-rate loan of equivalent risk because the lender bears less risk with a floating-rate loan. Most short-term business loans are floating-rate loans.
A loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity.
A loan with a rate of interest initially set at an increment above the prime rate and allowed to “float,” or vary, above prime as the prime rate varies until maturity.
Method of Computing Interest Once the nominal (or stated) annual rate is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to
Most bank loans to businesses require the interest payment at maturity.
When interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than is requested (and less than they must repay). Loans on which interest is paid in advance are called discount loans. The effective annual rate for a discount loan, assuming a 1-year period, is calculated as
Loan on which interest is paid in advance by being deducted from the amount borrowed.
Paying interest in advance raises the effective annual rate above the stated annual rate.
Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10,000 for the year. At the end of the year, Wooster will write a check to the lender for $11,000, consisting of the $1,000 interest as well as the return of the $10,000 principal. Substituting into Equation 16.3 reveals that the effective annual rate is therefore
If the money is borrowed at the same stated annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 − $1,000). The effective annual rate in this case is
In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).
A single-payment note can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.
A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period.
Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank B. The loans were incurred on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate was set at % above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at % (6% prime rate + % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × (, × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000).
Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate, or EAR, by using Equation 5.10. Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1:
The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.
Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000).
Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:
Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.
Personal Finance Example 16.10
Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.
Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable-rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:
60 days from today the prime rate will rise by 1%.
90 days from today the prime rate will rise another %.
150 days from today the prime rate will drop by 1%.
Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.
Fixed-Rate Loan: Total interest cost over 180 days
Variable-Rate Loan: The applicable interest rate would begin at 9% (8% + 1%) and remain there for 60 days. Then the applicable rate would rise to 10% (9% + 1%) for the next 30 days and then to 10.50% (10% + 0.50%) for the next 60 days. Finally, the applicable rate would drop to 9.50% (10.50% − 1%) for the final 30 days.
Total interest cost over 180 days
Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, Megan should take the variable-rate loan. By doing so, she will save about $38 ($1,480 − $1,442) in interest cost over the 180 days.
Lines of Credit
A line of credit is an agreement between a commercial bank and a business, specifying the amount of unsecured short-term borrowing that the bank will make available to the firm over a given period of time. It is similar to the agreement under which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is not a guaranteed loan; rather, it indicates that if the bank has sufficient funds available, it will allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is the maximum amount the firm can owe the bank at any point in time.
line of credit
An agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.
When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma balance sheet, and recent financial statements. If the bank finds the customer acceptable, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the creditworthiness of a customer each time it borrows money within the year.
Interest Rates The interest rate on a line of credit is normally stated as a floating rate: the prime rate plus a premium. If the prime rate changes, the interest rate charged on new as well as outstanding borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the premium (interest increment) above prime and vice versa.
Operating-Change Restrictions In a line-of-credit agreement, a bank may impose operating-change restrictions, which give it the right to revoke the line if any major changes occur in the firm’s financial condition or operations. The firm is usually required to submit up-to-date, and preferably audited, financial statements for periodic review. In addition, the bank typically needs to be informed of shifts in key managerial personnel or in the firm’s operations before changes take place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the proposed changes and the firm makes them anyway, the bank has the right to revoke the line of credit.
Contractual restrictions that a bank may impose on a firm’s financial condition or operations as part of a line-of-credit agreement.
Compensating Balances To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a compensating balance equal to a certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20 percent. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower.
A required checking account balance equal to a certain percentage of the amount borrowed from a bank under a line-of-credit or revolving credit agreement.
My Finance Lab Solution Video
Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of-credit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus, it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 × $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 ÷ $800,000), which is 2.5% more than the stated rate of 10%.
If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 ÷ $900,000). Thus, a compensating balance raises the cost of borrowing only if it is larger than the firm’s normal cash balance.
Annual Cleanups To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an annual cleanup. In these cases, the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period ensures that short-term loans do not turn into long-term loans.
The requirement that for a certain number of days during the year borrowers under a line of credit carry a zero loan balance (that is, owe the bank nothing).
All the characteristics of a line-of-credit agreement are negotiable to some extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of maintaining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce a line of credit that is suitable to both borrower and lender.
Revolving Credit Agreements
A revolving credit agreement is nothing more than a guaranteed line of credit. It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of credit. It is not uncommon for a revolving credit agreement to be for a period greater than 1 year.2 Because the bank guarantees the availability of funds, a commitment fee is normally charged on a revolving credit agreement. This fee often applies to the average unused balance of the borrower’s credit line. It is normally about 0.5 percent of the average unused portion of the line.
revolving credit agreement
A line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of money.
The fee that is normally charged on a revolving credit agreement; it often applies to the average unused portion of the borrower’s credit line.
REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on the average unused balance. Because the average unused portion of the committed funds was $500,000 ($2 million − $1.5 million), the commitment fee for the year was $2,500 (0.005 × $500,000). Of course, REH also had to pay interest on the actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 7.67% [($112,500 + $2,500) ÷ $1,500,000]. Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint because the availability of funds is guaranteed.
2. Many authors classify the revolving credit agreement as a form of intermediate-term financing, defined as having a maturity of 1 to 7 years, but we do not use the intermediate-term financing classification; only short-term and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-credit agreements.
Commercial paper is a form of financing that consists of short-term, unsecured promissory notes issued by firms with a high credit standing. Generally, only large firms of unquestionable financial soundness are able to issue commercial paper. Most commercial paper issues have maturities ranging from 3 to 270 days. Although there is no set denomination, such financing is generally issued in multiples of $100,000 or more. A large portion of the commercial paper today is issued by finance companies; manufacturing firms account for a smaller portion of this type of financing. Businesses often purchase commercial paper, which they hold as marketable securities, to provide an interest-earning reserve of liquidity. For further information on recent use of commercial paper, see the Focus on Practice box.
A form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing.
Interest on Commercial Paper
in practice focus on PRACTICE: The Ebb and Flow of Commercial Paper
The difficult economic and credit environment in the post–September 11 era, combined with historically low interest rates and a deep desire by corporate issuers to reduce exposure to refinancing risk, had a depressing effect on commercial paper volumes from 2001 through 2003. According to the Federal Reserve, U.S. nonfinancial commercial paper, for example, declined 68 percent over the 3-year period, from $315.8 billion outstanding at the beginning of 2001 to $101.4 billion by December 2003. In addition to lower volume, credit quality of commercial paper declined over the same period, with the ratio of downgrades outpacing upgrades 17 to 1 in 2002.
In 2004, signs emerged that the volume and rating contraction in commercial paper was finally coming to an end. The most encouraging of them was the pickup in economic growth, which spurs the need for short-term debt to finance corporate working capital. Although commercial paper is typically used to fund working capital, it is often boosted by a sudden surge of borrowing activity for other strategic activities, such as mergers and acquisitions and long-term capital investments. According to Federal Reserve Board data, at the end of July 2004, total U.S. commercial paper outstanding was $1.33 trillion.
By 2006, commercial paper surged to $1.98 trillion, an increase of 21.5 percent over 2005 levels. However, after peaking at $2.22 trillion, the tide changed in response to the credit crisis that began in August 2007. According to Federal Reserve data, as of October 1, 2008, the commercial paper market had contracted to $1.6 trillion, a reduction of nearly 28 percent, and new issues virtually dried up for several weeks. With much of the commercial paper outstanding at the start of the credit crisis coming up for renewal, the Federal Reserve began operating the Commercial Paper Funding Facility (CPFF) on October 27, 2008. The CPFF was intended to provide a liquidity backstop to U.S. issuers of commercial paper and, thereby, increase the availability of credit in short-term capital markets. CPFF allowed for the Federal Reserve Bank of New York to finance the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers.
Even with the CPFF up and running, companies that were worried about their ability to roll over their outstanding commercial paper every few weeks turned to long-term debt to meet their liquidity needs. Merrill Lynch & Co. and Bloomberg data showed that to manage short-tem liability risk, companies were paying as much as $75 million in additional annual interest to swap long-term debt for $1 billion of 30-day commercial paper.
With the recession in the rearview mirror and short-term credit markets working again, the CPFF was closed on February 1, 2010. But three years later, the commercial paper market was still far smaller than it had been before the financial crisis. In March 2013, the Federal Reserve reported that the total amount of commercial paper outstanding was a little more than $1 trillion, about half the size of the market in 2007 before the crisis.
What factors contribute to an expansion of the commercial paper market? What factors cause a contraction in the commercial paper market?
Commercial paper is sold at a discount from its par, or face, value. The size of the discount and the length of time to maturity determine the interest paid by the issuer of commercial paper. The actual interest earned by the purchaser is determined by certain calculations, illustrated by the following example.
My Finance Lab Solution Video
Bertram Corporation, a large shipbuilder, has just issued $1 million worth of commercial paper that has a 90-day maturity and sells for $990,000. At the end of 90 days, the purchaser of this paper will receive $1 million for its $990,000 investment. The interest paid on the financing is therefore $10,000 on a principal of $990,000. The effective 90-day rate on the paper is 1.01% ($10,000 ÷ $990,000). Assuming that the paper is rolled over each 90 days throughout the year (that is, 365 ÷ 90 = 4.06 times per year), the effective annual rate for Bertram’s commercial paper, found by using Equation 5.10, is 4.16% [(1 + 0.0101)4.06 − 1].
An interesting characteristic of commercial paper is that its interest cost is normally 2 percent to 4 percent below the prime rate. In other words, firms are able to raise funds more cheaply by selling commercial paper than by borrowing from a commercial bank. The reason is that many suppliers of short-term funds do not have the option, as banks do, of making low-risk business loans at the prime rate. They can invest safely only in marketable securities such as Treasury bills and commercial paper.
Although the stated interest cost of borrowing through the sale of commercial paper is normally lower than the prime rate, the overall cost of commercial paper may not be less than that of a bank loan. Additional costs include various fees and flotation costs. Also, even if it is slightly more expensive to borrow from a commercial bank, it may at times be advisable to do so to establish a good working relationship with a bank. This strategy ensures that when money is tight, funds can be obtained promptly and at a reasonable interest rate.
Matter of fact
Commercial banks are legally prohibited from lending amounts in excess of 15 percent (plus an additional 10 percent for loans secured by readily marketable collateral) of the bank’s unim-paired capital and surplus to any one borrower. This restriction is intended to protect depositors by forcing the commercial bank to spread its risk across a number of borrowers. In addition, smaller commercial banks do not have many opportunities to lend to large, high-quality business borrowers.
In some ways, arranging short-term financing for international trade is no different from financing purely domestic operations. In both cases, producers must finance production and inventory and then continue to finance accounts receivable before collecting any cash payments from sales. In other ways, however, the short-term financing of international sales and purchases is fundamentally different from that of strictly domestic trade.
The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to exchange rate risk. A U.S.-based company that exports goods and has accounts receivable denominated in a foreign currency faces the risk that the U.S. dollar will appreciate in value relative to the foreign currency. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar will depreciate. Although exchange rate risk can often be hedged by using currency forward, futures, or options markets, doing so is costly and is not possible for all foreign currencies.
Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms.
Financing International Trade
Several specialized techniques have evolved for financing international trade. Perhaps the most important financing vehicle is the letter of credit, a letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country.
letter of credit
A letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met.
Firms that do business in foreign countries on an ongoing basis often finance their operations, at least in part, in the local market. A company that has an assembly plant in Mexico, for example, might choose to finance its purchases of Mexican goods and services with peso funds borrowed from a Mexican bank. This practice not only minimizes exchange rate risk but also improves the company’s business ties to the host community. Multinational companies, however, sometimes finance their international transactions through dollar-denominated loans from international banks. The Eurocurrency loan markets allow creditworthy borrowers to obtain financing on attractive terms.
Transactions between Subsidiaries
Much international trade involves transactions between corporate subsidiaries. A U.S. company might, for example, manufacture one part in an Asian plant and another part in the United States, assemble the product in Brazil, and sell it in Europe. The shipment of goods back and forth between subsidiaries creates accounts receivable and accounts payable, but the parent company has considerable discretion about how and when payments are made. In particular, the parent can minimize foreign exchange fees and other transaction costs by “netting” what affiliates owe each other and paying only the net amount due rather than having both subsidiaries pay each other the gross amounts due.
How is the prime rate of interest relevant to the cost of short-term bank borrowing? What is a floating-rate loan?
How does the effective annual rate differ between a loan requiring interest payments at maturity and another, similar loan requiring interest in advance?
What are the basic terms and characteristics of a single-payment note? How is the effective annual rate on such a note found?
What is a line of credit? Describe each of the following features that are often included in these agreements: (a) operating-change restrictions, (b) compensating balance, and (c) annual cleanup.
What is a revolving credit agreement? How does this arrangement differ from the line-of-credit agreement? What is a commitment fee?
How do firms use commercial paper to raise short-term funds? Who can issue commercial paper? Who buys commercial paper?
What is the important difference between international and domestic transactions? How is a letter of credit used in financing international trade transactions? How is “netting” used in transactions between subsidiaries?
16.3 Secured Sources of Short-Term Loans
When a firm has exhausted its sources of unsecured short-term financing, it may be able to obtain additional short-term loans on a secured basis. Secured short-term financing has specific assets pledged as collateral. The collateral commonly takes the form of an asset, such as accounts receivable or inventory. The lender obtains a security interest in the collateral through the execution of a security agreement with the borrower that specifies the collateral held against the loan. In addition, the terms of the loan against which the security is held form part of the security agreement. A copy of the security agreement is filed in a public office within the state, usually a county or state court. Filing provides subsequent lenders with information about which assets of a prospective borrower are unavailable for use as collateral. The filing requirement protects the lender by legally establishing the lender’s security interest.
secured short-term financing
Short-term financing (loan) that has specific assets pledged as collateral.
The agreement between the borrower and the lender that specifies the collateral held against a secured loan.
CHARACTERISTICS OF SECURED SHORT-TERM LOANS
Although many people believe that holding collateral as security reduces the risk that a loan will default, lenders do not usually view loans in this way. Lenders recognize that holding collateral can reduce losses if the borrower defaults, but the presence of collateral has no impact on the risk of default. A lender requires collateral to ensure recovery of some portion of the loan in the event of default. What the lender wants above all, however, is to be repaid as scheduled. In general, lenders prefer to make less risky loans at lower rates of interest than to be in a position in which they must liquidate collateral.
Collateral and Terms
Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.
Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral.
The percentage of the book value of the collateral that constitutes the principal of a secured loan.
The interest rate that is charged on secured short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both.
Institutions Extending Secured Short-Term Loans
The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. Commercial finance companies are lending institutions that make only secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits.
commercial finance companies
Lending institutions that make only secured loans—both short-term and long-term—to businesses.
Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services.
USE OF ACCOUNTS RECEIVABLE AS COLLATERAL
Two commonly used means of obtaining short-term financing with accounts receivable are pledging accounts receivable and factoring accounts receivable. Actually, only a pledge of accounts receivable creates a secured short-term loan; factoring really entails the sale of accounts receivable at a discount. Although factoring is not actually a form of secured short-term borrowing, it does involve the use of accounts receivable to obtain needed short-term funds.
Pledging Accounts Receivable
A pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral.
pledge of accounts receivable
The use of a firm’s accounts receivable as security, or collateral, to obtain a short-term loan.
The Pledging Process When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral.
After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage.
Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a lien, which is a publicly disclosed legal claim on the collateral.
A publicly disclosed legal claim on loan collateral.
Notification Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a notification basis, the customer is notified to remit payment directly to the lender.
The basis on which a borrower, having pledged an account receivable, continues to collect the account payments without notifying the account customer.
The basis on which an account customer whose account has been pledged (or factored) is notified to remit payment directly to the lender (or factor).
Matter of fact
Founded in 2007, the Receivables Exchange is an online marketplace where organizations such as hedge funds and commercial banks looking for short-term investments can bid on receivables pledged by small, medium-sized, and large companies from a wide range of industries. Companies that need cash put their receivables up for auction on the Receivables Exchange, and investors bid on them. In its first few years of operation, the Receivables Exchange provided funding of more than $1 billion to companies selling their receivables. The Receivables Exchange attracted the attention of the NYSE Euronext, which purchased a minority stake in the company in 2011.
Pledging Cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing.
Factoring Accounts Receivable
Factoring accounts receivable involves selling them outright, at a discount, to a financial institution. A factor is a financial institution that specializes in purchasing accounts receivable from businesses. Although it is not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with accounts receivable as collateral.
factoring accounts receivable
The outright sale of accounts receivable at a discount to a factor or other financial institution.
A financial institution that specializes in purchasing accounts receivable from businesses.
Factoring Agreement A factoring agreement normally states the exact conditions and procedures for the purchase of an account. The factor, like a lender against a pledge of accounts receivable, chooses accounts for purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to be on a continuing basis, the factor will actually make the firm’s credit decisions because this will guarantee the acceptability of accounts. Factoring is normally done on a notification basis, and the factor receives payment of the account directly from the customer. In addition, most sales of accounts receivable to a factor are made on a nonrecourse basis, meaning that the factor agrees to accept all credit risks. Thus, if a purchased account turns out to be uncollectible, the factor must absorb the loss.
The basis on which accounts receivable are sold to a factor with the understanding that the factor accepts all credit risks on the purchased accounts.
Matter of fact
The use of credit cards such as MasterCard, Visa, and Discover by consumers has some similarity to factoring because the vendor that accepts the card is reimbursed at a discount for purchases made with the card. The difference between factoring and credit cards is that cards are nothing more than a line of credit extended by the issuer, which charges the vendors a fee for accepting the cards. In factoring, the factor does not analyze credit until after the sale has been made; in many cases (except when factoring is done on a continuing basis), the initial credit decision is the responsibility of the vendor, not the factor that purchases the account.
Typically, the factor is not required to pay the firm until the account is collected or until the last day of the credit period, whichever occurs first. The factor sets up an account similar to a bank deposit account for each customer. As payment is received or as due dates arrive, the factor deposits money into the seller’s account, from which the seller is free to make withdrawals as needed.
In many cases, if the firm leaves the money in the account, a surplus will exist on which the factor will pay interest. In other instances, the factor may make advances to the firm against uncollected accounts that are not yet due. These advances represent a negative balance in the firm’s account, on which interest is charged.
Factoring Cost Factoring costs include commissions, interest levied on advances, and interest earned on surpluses. The factor deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the commissions. The commissions are typically stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The interest levied on advances is generally 2 to 4 percent above the prime rate. It is levied on the actual amount advanced. The interest paid on surpluses is generally between 0.2 and 0.5 percent per month.
Although its costs may seem high, factoring has certain advantages that make it attractive to many firms. One is the ability it gives the firm to turn accounts receivable immediately into cash without having to worry about repayment. Another advantage is that it ensures a known pattern of cash flows. In addition, if factoring is undertaken on a continuing basis, the firm can eliminate its credit and collection departments.
USE OF INVENTORY AS COLLATERAL
Inventory is generally second to accounts receivable in desirability as short-term loan collateral. Inventory normally has a market value that is greater than its book value, which is used to establish its value as collateral. A lender whose loan is secured with inventory will probably be able to sell that inventory for at least book value if the borrower defaults on its obligations.
The most important characteristic of inventory being evaluated as loan collateral is marketability. A warehouse of perishable items, such as fresh peaches, may be quite marketable, but if the cost of storing and selling the peaches is high, they may not be desirable collateral. Specialized items, such as moon-roving vehicles, are also not desirable collateral because finding a buyer for them could be difficult. When evaluating inventory as possible loan collateral, the lender looks for items with very stable market prices that have ready markets and that lack undesirable physical properties.
Floating Inventory Liens
A lender may be willing to secure a loan under a floating inventory lien, which is a claim on inventory in general. This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. Inventories of items such as auto tires, screws and bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. The interest charge on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often require floating liens as extra security on what would otherwise be an unsecured loan. Floating-lien inventory loans may also be available from commercial finance companies.
floating inventory lien
A secured short-term loan against inventory under which the lender’s claim is on the borrower’s inventory in general.
Trust Receipt Inventory Loans
A trust receipt inventory loan often can be made against relatively expensive automotive, consumer durable, and industrial goods that can be identified by serial number. Under this agreement, the borrower keeps the inventory, and the lender may advance 80 to 100 percent of its cost. The lender files a lien on all the items financed. The borrower is free to sell the merchandise but is trusted to remit the amount lent, along with accrued interest, to the lender immediately after the sale. The lender then releases the lien on the item. The lender makes periodic checks of the borrower’s inventory to make sure that the required collateral remains in the hands of the borrower. The interest charge to the borrower is normally 2 percent or more above the prime rate.
trust receipt inventory loan
A secured short-term loan against inventory under which the lender advances 80 to 100 percent of the cost of the borrower’s relatively expensive inventory items in exchange for the borrower’s promise to repay the lender, with accrued interest, immediately after the sale of each item of collateral.
Trust receipt loans are often made by manufacturers’ wholly owned financing subsidiaries, known as captive finance companies, to their customers. Captive finance companies are especially popular in industries that manufacture consumer durable goods because they provide the manufacturer with a useful sales tool. For example, General Motors Acceptance Corporation, the financing subsidiary of General Motors, grants these types of loans to its dealers. Trust receipt loans are also available through commercial banks and commercial finance companies.
Warehouse Receipt Loans
A warehouse receipt loan is an arrangement whereby the lender, which may be a commercial bank or finance company, receives control of the pledged inventory collateral, which is stored by a designated agent on the lender’s behalf. After selecting acceptable collateral, the lender hires a warehousing company to act as its agent and take possession of the inventory.
warehouse receipt loan
A secured short-term loan against inventory under which the lender receives control of the pledged inventory collateral, which is stored by a designated warehousing company on the lender’s behalf.
Two types of warehousing arrangements are possible. A terminal warehouse is a central warehouse that is used to store the merchandise of various customers. The lender normally uses such a warehouse when the inventory is easily transported and can be delivered to the warehouse relatively inexpensively. Under a field warehouse arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged collateral. Regardless of the type of warehouse, the warehousing company places a guard over the inventory. Only on written approval of the lender can any portion of the secured inventory be released by the warehousing company.
The actual lending agreement specifically states the requirements for the release of inventory. As with other secured loans, the lender accepts only collateral that it believes to be readily marketable and advances only a portion—generally 75 to 90 percent—of the collateral’s value. The specific costs of warehouse receipt loans are generally higher than those of any other secured lending arrangements because of the need to hire and pay a warehousing company to guard and supervise the collateral. The basic interest charged on warehouse receipt loans is higher than that charged on unsecured loans, generally ranging from 3 to 5 percent above the prime rate. In addition to the interest charge, the borrower must absorb the costs of warehousing by paying the warehouse fee, which is generally between 1 and 3 percent of the amount of the loan. The borrower is normally also required to pay the insurance costs on the warehoused merchandise.
Are secured short-term loans viewed as more risky or less risky than unsecured short-term loans? Why?
In general, what interest rates and fees are levied on secured short-term loans? Why are these rates generally higher than the rates on unsecured short-term loans?
Describe and compare the basic features of the following methods of using accounts receivable to obtain short-term financing: (a) pledging accounts receivable and (b) factoring accounts receivable. Be sure to mention the institutions that offer each of them.
For the following methods of using inventory as short-term loan collateral, describe the basic features of each, and compare their use: (a) floating lien, (b) trust receipt loan, and (c) warehouse receipt loan.
FOCUS ON VALUE
Current liabilities represent an important and generally inexpensive source of financing for a firm. The level of short-term (current liabilities) financing employed by a firm affects its profitability and risk. Accounts payable and accruals are spontaneous liabilities that should be carefully managed because they represent free financing. Notes payable, which represent negotiated short-term financing, should be obtained at the lowest cost under the best possible terms. Large, well-known firms can obtain unsecured short-term financing through the sale of commercial paper. On a secured basis, the firm can obtain loans from banks or commercial finance companies, using either accounts receivable or inventory as collateral.
The financial manager must obtain the right quantity and form of current liabilities financing to provide the lowest-cost funds with the least risk. Such a strategy should positively contribute to the firm’s goal of maximizing the stock price.
REVIEW OF LEARNING GOALS
LG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms. The major spontaneous source of short-term financing is accounts payable. They are the primary source of short-term funds. Credit terms may differ with respect to the credit period, cash discount, cash discount period, and beginning of the credit period. Cash discounts should be given up only when a firm in need of short-term funds must pay an interest rate on borrowing that is greater than the cost of giving up the cash discount.
LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals. Stretching accounts payable can lower the cost of giving up a cash discount. Accruals, which result primarily from wage and tax obligations, are virtually free.
LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans. Banks are the major source of unsecured short-term loans to businesses. The interest rate on these loans is tied to the prime rate of interest by a risk premium and may be fixed or floating. It should be evaluated by using the effective annual rate. Whether interest is paid when the loan matures or in advance affects the rate. Bank loans may take the form of a single-payment note, a line of credit, or a revolving credit agreement.
LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans. Commercial paper is an unsecured IOU issued by firms with a high credit standing. International sales and purchases expose firms to exchange rate risk. Such transactions are larger and of longer maturity than domestic transactions, and they can be financed by using a letter of credit, by borrowing in the local market, or through dollar-denominated loans from international banks. On transactions between subsidiaries, “netting” can be used to minimize foreign exchange fees and other transaction costs.
LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral. Secured short-term loans are those for which the lender requires collateral, which are usually current assets such as accounts receivable or inventory. Only a percentage of the book value of acceptable collateral is advanced by the lender. These loans are more expensive than unsecured loans. Commercial banks and commercial finance companies make secured short-term loans. Both pledging and factoring involve the use of accounts receivable to obtain needed short-term funds.
LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral. Inventory can be used as short-term-loan collateral under a floating lien, a trust receipt arrangement, or a warehouse receipt loan.
In the chapter opener, you learned about FastPay, a company that lends to online ad publishers based on advertising receivables. Suppose that you are running a business that relies on online ad revenues. It typically takes 60 days to collect from your customers and convert receivables into cash. FastPay offers you $150,000 in cash in exchange for the right to collect $155,000 in receivables from a particular customer. You have a bank line of credit that allows you to borrow on a short-term basis at an annual interest rate of 7 percent. Should you borrow on the credit line or accept the offer from FastPay?
(Solutions in Appendix)
LG 1 LG 2
Cash discount decisions The credit terms for each of three suppliers are shown in the following table. (Note: Assume a 365-day year.)
1/10 net 55 EOM
2/10 net 30 EOM
2/20 net 60 EOM
a. Determine the approximate cost of giving up the cash discount from each supplier.
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.
c. Now assume that the firm could stretch its accounts payable (net period only) by 20 days from supplier Z. What impact, if any, would that have on your answer in part b relative to this supplier?
All problems are available in MyFinanceLab.
Lyman Nurseries purchased seeds costing $25,000 with terms of 3/15 net 30 EOM on January 12. How much will the firm pay if it takes the cash discount? What is the approximate cost of giving up the cash discount, using the simplified formula?
Cleaner’s, Inc., is switching to paying employees every 2 weeks rather than weekly and will therefore “skip” 1 week’s pay. The firm has 25 employees who work a 60-hour week and earn an average wage of $12.50 per hour. Using a 10% rate of interest, how much will this change save the firm annually?
Jasmine Scents has been given two competing offers for short-term financing. Both offers are for borrowing $15,000 for 1 year. The first offer is a discount loan at 8%, and the second offer is for interest to be paid at maturity at a stated interest rate of 9%. Calculate the effective annual rates for each loan, and indicate which loan offers the better terms.
Jackson Industries has borrowed $125,000 under a line-of-credit agreement. Although the company normally maintains a checking account balance of $15,000 in the lending bank, this credit line requires a 20% compensating balance. The stated interest rate on the borrowed funds is 10%. What is the effective annual rate of interest on the line of credit?
Horizon Telecom sold $300,000 worth of 120-day commercial paper for $298,000. What is the dollar amount of interest paid on the commercial paper? What is the effective 120-day rate on the paper?
All problems are available in MyFinanceLab.
Payment dates Determine when a firm must pay for purchases made and invoices dated on November 25 under each of the following credit terms:
a. net 30 date of invoice
b. net 30 EOM
c. net 45 date of invoice
d. net 60 EOM
Cost of giving up cash discounts Determine the cost of giving up the cash discount under each of the following terms of sale. (Note: Assume a 365-day year.)
a. 2/10 net 30
b. 1/10 net 30
c. 1/10 net 45
d. 3/10 net 90
e. 1/10 net 60
f. 3/10 net 30
g. 4/10 net 180
Credit terms Purchases made on credit are due in full by the end of the billing period. Many firms extend a discount for payment made in the first part of the billing period. The original invoice contains a type of shorthand notation that explains the credit terms that apply. (Note: Assume a 365-day year.)
a. Write the shorthand expression of credit terms for each of the following:
Cash discount period
Beginning of credit period
date of invoice
end of month
date of invoice
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?
Cash discount versus loan Joanne Germano works in an accounts payable department of a major retailer. She has attempted to convince her boss to take the discount on the 1/15 net 65 credit terms most suppliers offer, but her boss argues that giving up the 1% discount is less costly than a short-term loan at 7%. Prove to whoever is wrong that the other is correct. (Note: Assume a 365-day year.)
Personal Finance Problem
Borrow or pay cash for an asset Bob and Carol Gibbs are set to move into their first apartment. They visited Furniture R’Us, looking for a dining room table and buffet. Dining room sets are typically one of the more expensive home furnishing items, and the store offers financing arrangements to customers. Bob and Carol have the cash to pay for the furniture, but it would definitely deplete their savings, so they want to look at all their options.
The dining room set costs $3,000, and Furniture R’Us offers a financing plan that would allow them to either (1) put 10% down and finance the balance at 4% annual interest over 24 months or (2) receive an immediate $200 cash rebate, thereby paying only $2,800 cash to buy the furniture.
Bob and Carol currently earn 5.2% annual interest on their savings.
a. Calculate the cash down payment for the loan.
b. Calculate the monthly payment on the available loan. (Hint: Treat the current loan as an annuity and solve for the monthly payment.)
c. Calculate the initial cash outlay under the cash purchase option.
d. Assuming that they can earn a simple interest rate of 5.2% on savings, what will Bob and Carol give up (opportunity cost) over the 2 years if they pay cash?
e. What is the cost of the cash alternative at the end of 2 years?
f. Should Bob and Carol choose the financing or the cash alternative?
Cash discount decisions Prairie Manufacturing has four possible suppliers, all of which 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. (Note: Assume a 365-day year.)
LG 1 LG 2
1/5 net 30 EOM
2/20 net 80 EOM
1/15 net 60 EOM
3/10 net 90 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 9%, 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. Now assume that the firm could stretch by 30 days its accounts payable (net period only) from supplier M. What impact, if any, would that have on your answer in part b relative to this supplier?
Changing payment cycle On accepting the position of chief executive officer and chairman of Muse, Inc., Dominic Howard changed the firm’s weekly payday from Monday afternoon to the following Friday afternoon. The firm’s weekly payroll was $100 million, and the cost of short-term funds was 5%. If the effect of this change was to delay check clearing by 1 week, what annual savings, if any, were realized?
Spontaneous sources of funds, accruals When Tallman Haberdashery, Inc., merged with Meyers Men’s Suits, Inc., Tallman’s employees were switched from a weekly to a biweekly 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?
Cost of bank loan Data Back-Up Systems has obtained a $10,000, 90-day bank loan at an annual interest rate of 15%, payable at maturity. (Note: Assume a 365-day year.)
a. How much interest (in dollars) will the firm pay on the 90-day loan?
b. Find the 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.
Personal Finance Problem
Unsecured sources of short-term loans John Savage has obtained a short-term loan from First Carolina Bank. The loan matures in 180 days and is in the amount of $45,000. John needs the money to cover start-up costs in a new business. He hopes to have sufficient backing from other investors in 6 months. First Carolina Bank offers John two financing options for the $45,000 loan: a fixed-rate loan at 2.5% above prime rate or a variable-rate loan at 1.5% above prime.
Currently, the prime rate of interest is 6.5%, and the consensus interest rate forecast of a group of economists is as follows: Sixty days from today the prime rate will rise by 0.5%; 90 days from today the prime rate will rise another 1%; 180 days from today the prime rate will drop by 0.5%.
Using the forecast prime rate changes, answer the following questions.
a. Calculate the total interest cost over 180 days for a fixed-rate loan.
b. Calculate the total interest cost over 180 days for a variable-rate loan.
c. Which is the lower-interest-cost loan for the next 180 days?
Effective annual rate A financial institution made a $4 million, 1-year discount loan at 6% interest, requiring a compensating balance equal to 5% of the face value of the loan. Determine the effective annual rate associated with this loan. (Note: Assume that the firm currently maintains $0 on deposit in the financial institution.)
Compensating balances and effective annual rates Lincoln Industries has a line 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.
a. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains no deposit balances at Bank Two.
b. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains $70,000 in deposit balances at Bank Two.
c. Calculate the effective annual rate on the firm’s borrowing if 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.
Compensating balance versus discount loan Weathers Catering Supply, Inc., needs 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. (Note: Weathers currently maintains $0 on deposit in State Bank.) 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?
Integrative: Comparison of loan terms Cumberland Furniture wishes to establish a prearranged borrowing agreement with a 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 compensating balance is equal to 20% of the amount borrowed. (Note: Cumberland currently maintains $0 on deposit at the bank.) The prime rate is currently 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.
Cost of commercial paper Commercial paper is usually sold at a discount. Fan 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. (Note: Assume a 365-day year.)
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?
Accounts receivable as collateral Kansas City Castings (KCC) is attempting to 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 the customer’s average payment period are as shown in the following table.
Average age of account
Average payment period of customer
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?
Accounts receivable as collateral Springer Products wishes to borrow $80,000 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.
Average age of account
Average payment period of customer
a. Calculate the dollar amount of acceptable accounts receivable collateral held by Springer Products.
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?
Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed 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 plus 3% and a 2% commission charge. The prime rate currently is 8.5%.
LG 3 LG 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 maximum 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? (Note: Assume a 365-day year and a prime rate that remains at 8.5% during the life of the loan.)
Factoring Blair Finance factors the accounts of the Holder Company. All eight 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.
Status on May 30
Collected May 15
Collected May 30
Collected May 27
Collected May 30
Collected May 30
Inventory financing Raymond Manufacturing faces a liquidity crisis: It needs a loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, 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. (Note: Assume a 365-day year.)
LG 1 LG 6
(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.
(2) Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month 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 outstanding 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?
ETHICS PROBLEM Rancco, Inc., reported total sales of $73 million last year, including $13 million in revenue (labor, sales to tax-exempt entities) exempt from sales tax. The company collects sales tax at a rate of 5%. In reviewing its information as part of its loan application, you notice that Rancco’s sales tax payments show a total of $2 million in payments over the same time period. What are your conclusions regarding the financial statements that you are reviewing? How might you verify any discrepancies?
Your company is considering manufacturing protective cases for a popular new smart-phone. Management decides to borrow $200,000 from each of two banks, First American and First Citizen. On the day that you visit both banks, the quoted prime interest rate is 7%. Each loan is similar in that each involves a 60-day note, with interest to be paid at the end of 60 days.
The interest rate was set at 2% above the prime rate on First American’s fixed-rate note. Over the 60-day period, the rate of interest on this note will remain at the 2% premium over the prime rate regardless of fluctuations in the prime rate.
First Citizen sets its interest rate at 1.5% above the prime rate on its floating-rate note. The rate charged over the 60 days will vary directly with the prime rate.
Create a spreadsheet to calculate and analyze the following for the First American loan:
a. Calculate the total dollar interest cost on the loan. Assume a 365-day year.
b. Calculate the 60-day rate on the loan.
c. Assume that the loan is rolled over each 60 days throughout the year under identical conditions and terms. Calculate the effective annual rate of interest on the fixed-rate, 60-day First American note.
Next, create a spreadsheet to calculate the following for the First Citizen loan:
d. Calculate the initial interest rate.
e. Assuming that the prime rate immediately jumps to 7.5% and after 30 days it drops to 7.25%, calculate the interest rate for the first 30 days and the second 30 days of the loan.
f. Calculate the total dollar interest cost.
g. Calculate the 60-day rate of interest.
h. Assume that the loan is rolled over each 60 days throughout the year under the same conditions and terms. Calculate the effective annual rate of interest.
i. Which loan would you choose, and why?
My Finance Lab
Visit www.myfinancelab.com for Chapter Case: Selecting Kanton Company’s Financing Strategy and Unsecured Short-Term Borrowing Arrangement, Group Exercises, and numerous online resources.
Integrative Case 7 Casa de Diseño
In January 2015, Teresa Leal was named treasurer of Casa de Diseño. She decided that she could best orient herself by systematically examining each area of the company’s financial operations. She began by studying the firm’s short-term financial activities.
Casa de Diseño, located in southern California, specializes in a furniture line called “Ligne Moderna.” Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Moderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores. Casa de Diseño’s manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.
Casa de Diseño entered the plastic-furniture market in late 2007. The company markets its plastic-furniture products as indoor–outdoor items under the brand name “Futuro.” Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firm’s sales and profits in 2014. Casa de Diseño anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.
Leal has decided to study the firm’s cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseño purchases all its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseño usually receives credit terms of net 30. An analysis of Casa de Diseño’s accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39 days.
Next, Leal studied the production cycle and inventory policies. Casa de Diseño tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done by Furniture Age, the trade association journal, was 83 days.
Casa de Diseño sells to all its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days. Investigation of the trade association’s and California manufacturers’ averages showed that the same collection period existed where net-60 credit terms were given. Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseño were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.
Casa de Diseño was spending an estimated $26,500,000 per year on operating-cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2015. Her concern was whether the firm’s cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseño’s cash conversion cycle. (Note: Assume a 365-day year, and assume that the operating-cycle investment per dollar of payables, inventory, and receivables is the same.)
a. Assuming a constant rate for purchases, production, and sales throughout the year, what are Casa de Diseño’s existing operating cycle (OC), cash conversion cycle (CCC), and resource investment need?
b. If Leal can optimize Casa de Diseño’s operations according to industry standards, what will Casa de Diseño’s operating cycle (OC), cash conversion cycle (CCC), and resource investment need to be under these more efficient conditions?
c. In terms of resource investment requirements, what is the cost of Casa de Diseño’s operational inefficiency?
(1) If in addition to achieving industry standards for payables and inventory the firm can reduce the average collection period by offering credit terms of 3/10 net 60, what additional savings in resource investment costs will result from the shortened cash conversion cycle, assuming that the level of sales remains constant?
(2) If the firm’s sales (all on credit) are $40,000,000 and 45% of the customers are expected to take the cash discount, by how much will the firm’s annual revenues be reduced as a result of the discount?
(3) If the firm’s variable cost of the $40,000,000 in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment, assuming that sales remain constant.
(4) If the firm’s bad-debts expenses decline from 2% to 1.5% of sales, what annual savings will result, assuming that sales remain constant?
(5) Use your findings in parts (2) through (4) to assess whether offering the cash discount can be justified financially. Explain why or why not.
e. On the basis of your analysis in parts a through d, what recommendations would you offer Teresa Leal?
f. Review for Teresa Leal the key sources of short-term financing, other than accounts payable, that she may consider for financing Casa de Diseño’s resource investment need calculated in part b. Be sure to mention both unsecured and secured sources.
Delivering a high-quality product at a reasonable price is not enough anymore.
That’s why we have developed 5 beneficial guarantees that will make your experience with our service enjoyable, easy, and safe.
You have to be 100% sure of the quality of your product to give a money-back guarantee. This describes us perfectly. Make sure that this guarantee is totally transparent.Read more
Each paper is composed from scratch, according to your instructions. It is then checked by our plagiarism-detection software. There is no gap where plagiarism could squeeze in.Read more
Thanks to our free revisions, there is no way for you to be unsatisfied. We will work on your paper until you are completely happy with the result.Read more
Your email is safe, as we store it according to international data protection rules. Your bank details are secure, as we use only reliable payment systems.Read more
By sending us your money, you buy the service we provide. Check out our terms and conditions if you prefer business talks to be laid out in official language.Read more