Management consultancy by cabrera chapter 17 answer

MANAGEMENT CONSULTANCY - Solutions Manual CHAPTER 17 SHORT-TERM CREDIT FOR FINANCING CURRENT ASSETS I Questions It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of foregoing the discount If it cost us 36 percent to miss a discount, we would be much better off finding an alternate source of funds for to 10 percent The prime rate is the rate that a bank charges its most creditworthy customers The average customer can expect to pay one or two percent (or more) above prime The stated interest rate is the percentage rate unadjusted for time or method of repayment The effective interest rate is the true rate and considers all these variables A percent stated rate for 90 days provides a 20 percent effective rate The financial manager should recognize the effective rate as the true cost of borrowing The effective rate is also referred to as the APR (Annual Percentage Rate) Commercial paper can be either purchased or issued by a corporation To the extent one corporation purchases another corporation’s commercial paper as a short-term investment, it is a current asset Conversely, if a corporation issues its own commercial paper, it is a current liability Pledging accounts receivable means receivables are used as collateral for a loan; factoring account receivables means they are sold outright to a finance company Three types of lender control used in inventory financing are a Blanket inventory lien-general claim against inventory or collateral No specific items are marked or designated b Trust receipt-borrower holds the inventory in trust for the lender Each item is marked and has a serial number When the inventory 17-1 Chapter 17 Short-term Credit for Financing Current Assets is sold, the trust receipt is canceled and the funds go into the lender’s account c Warehousing the inventory is physically identified, segregated, and stored under the direction of an independent warehouse company that controls the movement of the goods If done on the premises of the warehousing firm, it is termed public warehousing An alternate arrangement is field warehousing whereby the same procedures are conducted on the borrower’s property II Multiple Choice A B D B D 16 17 18 19 20 10 C A D B D 21 22 23 24 25 11 12 13 14 15 A A B C B 26 27 28 29 30 B A C D D D C D C D D A B B D 31 32 33 34 35 D A A A C 36 37 38 39 40 D C D B C 41 42 43 44 45 D D C C D 46 D 47 A Supporting computations: P1,080,000 / 360 = P3,000 in purchases per day Typically, there will be P3,000 (40) = P120,000 of accounts payable on the books at any given time Of this, P3,000 (10) is “free” credit, while P3,000 (30) = P90,000 is “non-free” credit Approx cost = = Discount % 100 - Discount % 2% x 100% - 2% 17-2 360 x Days credit is Discount outstanding − period 360= 40 - 10 2x 98 360 30 Short-term Credit for Financing Current Assets Chapter 17 =24.5% = = Effective rate on the discount loan Interest = 0.1111 = 11.11% Face value − Interest = (P2,400,000) (0.10) Credit terms are 2/10, net 40, but delaying payments 30 additional days P2,400,000 − penalty, (P2,400,000) (0.10) is the equivalent of 2/10, net 70 Assuming no the approximate cost is as follows: P240,000 P2,160,000 Discount % 360 Approx cost = x Days credit is Discount 100 - Discount % outstanding − period 2% 360 360 = x = x 100% - 2% 70 - 10 98 60 =12.24% Therefore, the loan cost is 1.13 percentage points less than trade credit = = = 11.1% Approximate effective rate = Effective rate = P1,000 / P5,000 = 20.0% P10,000 (0.10) P10,000 − P10,000 (0.10) 10 17-3 = P1,000 13.3% P9,000 Chapter 17 Short-term Credit for Financing Current Assets = P13,333, since 0.15 (P13,333) = P2,00010% is required for the compensating balance, required for the immediate Effectiveand rate0.10 (P13,333) =− P1,333 0.15 − is0.10 interest payment 21 The effective rate is equal to net interest expense divided by proceeds received not proceeds borrowed P10,000 − 0.15 − 0.10 = million + P125,000 = 12.67% P10 180 / 360 P200 million − P125,000 − P10 million 24 = 8.67% 26 Interest Proceeds 120,000 − (0.06 x 100,000) = 1,000,000 − 100,000 = = 0959 (P1,000,000 − 980,000 + 1,200) x 1,000,000 − 20,000 − 1,200 III Problems Interest 07 COMPANY) 07 PROBLEM (CAMATCHILE SALES Proceeds 73 [1.00 (.93) − 20] The discounted interest cost of the commercial paper issue is calculated as follows: Interest expense million = 10 x P200 million x 180 / 360 The effective cost of credit can now be calculated as follows: RATE = x 17-4 = P10 Short-term Credit for Financing Current Assets = Chapter 17 46% PROBLEM (JAN MFG CO.) a Interest for two months = = = = RATE = = 14 x − x P500,000 P11,667 P500,000 − (.2 x P500,000 + P11,667) P383,333 x 030043 x = 18026, or 18.026% Note that Jan would actually have to borrow more than the needed P500,000 in order to cover the compensating balance requirement However, as we demonstrated earlier, the effective cost of credit will not be affected by adjusting the loan amount for interest expense Loan accordingly proceeds changes (for P500,000 loan) b The estimation of the cost of forgoing trade discounts is generally quite straightforward; however, in this case the firm actually stretches its trade credit for purchases P11,667 made during 12July beyond the due date by an additional 30 days.P388,333 If it is able to this without penalty, then the firm effectively forgoes a percent discount for not paying within 15 days and does not pay for an additional 45 days (60 days less the discount period of 15 days) Thus, for the July trade credit, Jan’s cost is calculated as follows: RATE = (.03 / 97) x (360 / 45) = 24.74% However, for the August trade credit the firm actually pays at the end of the credit period (the 30th day), so that the cost of trade credit becomes RATE = (.03 / 97) x (360 / 15) = 17-5 74.22% Chapter 17 Short-term Credit for Financing Current Assets c .16 x P200,000 = 12 x x P500,000 P200,000 − 20 x P200,000 = P10,000 Pledging fee = 1 = 005 x P750,000 P3,750 14 x P200,000 RATE = P200,000 − 14 x P200,000 −x x P200,000 1 = 0275 x = 165, or 16.5% PROBLEM (JELO MFG COMPANY) a 12 Interest for two months RATE = x = 18, or 18% b RATE = P10,000 + P3,750 P500,000 12 x = 20, or 20% c RATE = x = 21212, or 21.212% 18 x P200,000 Alternative (a) offers the lower-cost P200,000 service of 1financing, although it carries the highest stated rate of interest The reason for this, of course, its that there is no compensating balance requirement nor is interest discounted for this alternative 17-6 Short-term Credit for Financing Current Assets PROBLEM (KIWI CORPORATION) P5,500 P300,000 = = Chapter 17 360 60 x 2% 98% x = 360 (70 − 10) 2.04% x = 16.32% Effective rate of interest with a 20% compensating balance requirement: = = = Interest rate / (1 − C) 14% / (1 − 2) P300,000 P300,000 14% / (.8) = 17.5% (1 − C) (1 − 20) P300,000 80 The effective cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.32% Kiwi Corporation should continue to pay in 55 days and pass up the discount P6,850 360 PROBLEM (READY FLASHLIGHTS, INC.) 60 P375,000 − P75,000 a Effective rate of interest = x P6,850 Cost of not taking Discount % 360 =P300,000 1.83% x = 10.98% a cash discount Final due date100% − Disc.% Discount period b Cost of lost discount = x 2% 360 = − 10)2.04% x = 12.24% 98% (55 c Yes, because the cost of borrowing is less than the cost of losing the discount d = = = P375,000 amount needed to be borrowed e Effective interest rate = x 17-7 Chapter 17 Short-term Credit for Financing Current Assets = = x = 2.28% x 13.68% 12 x P9,000balance of 20 percent since the No, not borrow with2a xcompensating − the P10,000) (12 taking + 1) the cash discount effective rate is(P100,000 greater than savingsx from PROBLEM (SUMMIT RECORD COMPANY) a Trust Bank Effective interest rate = = P72,000 / P355,000 = 20.28% Northeast Bank Effective interest rate = = P216,000 / P1,170,000 = 18.46% Choose Northeast Bank since it has the lowest effective interest rate b The numerators stay the same as in part (a) but the denominator increases to reflect the use of more money because compensating balances are already maintained at both banks Trust Bank Effective interest rate = = P72,000 / (P100,000 − P9,000) x P72,000 / P455,000 = 15.82% x x P9,000 Northeast Bank (P100,000 − P20,000 − P9,000) x (4 + 1) Effective interest rate = P216,000 / (P100,000 x 13) = P216,000 / P1,300,000 = 16.62% 17-8 Short-term Credit for Financing Current Assets Chapter 17 c Yes If compensating balancesCosts are maintained at both banks in the incurred by using commercial paper normal course of business, then Trust Bank should be chosen over Net funds available from commercial paper Northeast Bank The effective cost of its loan will be less PROBLEM (ATBP., INC.) a 11.73% b 12.09% c 18% PROBLEM (FAMILIA, INC.) a Cost of commercial paper = Cost of commercial paper in the first quarter Cost of issuing commercial paper: = Interest (P4,000,000 x 0775 x ¼) Placement fee (P4,000,000 x 00125) First quarter cost P P Funds available for use: Funds raised Less: Compensating balance P400,000 Less: Interest and placement 82,500 Net funds available in first quarter Cost of commercial paper in the first quarter P4,000,000 482,500 P3,517,500 P 82,500 P3,517,500 = Cost of issuing commercial paper per quarter: Interest (P4,000,000 x 0775 x ¼) Funds available for use: 17-9 77,500 5,000 82,500 2.345% P 77,500 Chapter 17 Short-term Credit for Financing Current Assets Funds raised Less: Compensating balance P4,000,000 P400,000 77,500 Net funds available per quarter Cost of commercial paper per quarter 477,500 P3,522,500 P 77,500 P3,522,500 = 2.20% Total annual effective cost of commercial paper Effective cost = = = = = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.) 02345 + 3(.02200) 02345 + 06600 08945 8.95% Familia Inc should choose commercial paper because the cost of bank financing (10.4 percent) exceeds the cost of commercial paper (8.95 percent) by greater than percent b The characteristics Familia Inc should possess in order to deal regularly in the commercial paper market include: Have a prestigious reputation, be financially strong, and have a high credit rating Have flexibility to arrange for large amounts of funds through regular banking channels Have a large and frequently recurring short-term or seasonal needs for funds Have the ability to deal in large denominations of funds for periods of one to nine months and be willing to accept the fact that commercial paper cannot be paid prior to maturity PROBLEM (CANADA COMPANY) = a The expected monthly cost of bank financing is the sum of the interest cost, processing cost, bad debt expense, and credit department cost The calculations are as follows: 17-10 Short-term Credit for Financing Current Assets Interest 15 / 12 x P180,000 Processing 02 x P180,000 / 75 Credit department Bad debt expense 0175 x x P900,000 Expected monthly cost of bank financing Chapter 17 = P 2,250 = 4,800 = 2,500 = 11,025 P20,575 b The expected monthly cost of factoring is the sum of the interest cost and the factor cost The calculations are as follows: Interest 015 x P180,000 Factor 025 x x P900,000 Expected monthly cost of factoring = P 2,700 = 15,750 P18,450 c The following are possible advantages of factoring: Using a factor eliminates the need to carry a credit department Factoring is a flexible source of financing because as sales increase, the amount of readily available financing increases Factors specialize in evaluating and diversifying credit risks d The following are possible disadvantages of factoring: The administrative costs may be excessive when invoices are numerous and relatively small in peso amount Factoring removes one of the most liquid of the firm’s assets and weakens the position of creditors It may mar their credit rating and increase the cost of other borrowing arrangements Customers could react unfavorably to a firm’s factoring their accounts receivable e Based upon the calculations in Parts a and b, the factoring arrangement should be continued The disadvantages of factoring are relatively unimportant in this case, especially since Canada Company has been using the factor in the past Before arriving at a final decision, the other services offered by the factor and bank would have to be evaluated, as well as the margin of error inherent in the estimation of the source data used in the calculations for Parts a and b The additional borrowing capacity needed by Canada Company is irrelevant because the firm only needs P180,000 and the bank will loan P472,500 (P900,000 x 70 x 75) and the factor will lend P567,000 (P900,000 x 70 x 90) 17-11 Chapter 17 Short-term Credit for Financing Current Assets PROBLEM 10 (BILLY MADISON CORPORATION) Discount 360 days – Discount Creditcompany’s period – Discount period is a The annual 1.00 percentage cost of each credit terms calculated as follows: Cost = x The cost of each supplier must be weighted by the proportion of the total provided by the supplier Supplier Fort Co Jester Co Jam Co Smitt & Co Total Annual Percentage Cost (1) 367 242 172 Weight (2) 30 25 35 10 1.00 Weighted Average Cost (1) x (2) 110 061 017 188 Average effective annual interest rate is 18.8 percent b No, the average effective annual interest rate does not indicate whether they should borrow funds to take advantage of the terms on a specific account The borrowing decision should be based on the effective annual interest rate of each supplier’s credit terms Money should be borrowed to pay within the discount period only when the cost of borrowing is less than the effective annual interest rate of the credit terms For instance, Fort Co has an effective annual interest rate of 36.7% and should be paid on day 10 only if the cost of borrowing is less than 36.7% c A line of credit is a loan agreement in which the borrower has, with certain specified limitations, control over the amount borrowed (up to some maximum) and when the funds are repaid 17-12 Short-term Credit for Financing Current Assets Chapter 17 Yes, a line of credit would be appropriate for Billy Madison if the company needs to borrow short-term money to take advantage of the cash discounts 17-13 ... P90,000 is “non-free” credit Approx cost = = Discount % 100 - Discount % 2% x 100% - 2% 1 7- 2 360 x Days credit is Discount outstanding − period 360= 40 - 10 2x 98 360 30 Short-term Credit for... P3, 517, 500 P 82,500 P3, 517, 500 = Cost of issuing commercial paper per quarter: Interest (P4,000,000 x 0775 x ¼) Funds available for use: 1 7- 9 77,500 5,000 82,500 2.345% P 77,500 Chapter 17 Short-term... P216,000 / P1,300,000 = 16.62% 1 7- 8 Short-term Credit for Financing Current Assets Chapter 17 c Yes If compensating balancesCosts are maintained at both banks in the incurred by using commercial paper