Chapter 16
Chapter 16
Chapter 16
Chapter 14
c.
277
CD
365
100% CD N
1%
365
Cost of giving up cash discount =
100% 1% 30
Cost of giving up cash discount = 0.0101 12.17 = 0.1229 = 12.29%
2%
365
2%
365
100% 2% 21
Cost of giving up cash discount = 0.0204 17.38 = 0.3646 = 36.46%
Cost of giving up cash discount =
1%
365
d. For the first three purchases the firm would be better off to borrow the funds and take the
discount. The annual cost of not taking the discount is less than the firms 8% cost of capital
in the last case.
P14-4. LG 1: Cash discount versus loan
Basic
Cost of giving up cash discount = (0.03 0.97) (365 35) = 32.25%
Since the cost of giving up the discount is higher than the cost of borrowing for a short-term loan,
Erica is correct; her boss is incorrect.
P14-5. LG 2: Personal finance: Borrow or pay cash for an asset
a.
b.
c.
3,000
10%
$ 300.00
$2,700.00
4%
24
23.0283
$ 117.25
$
$
$
$
3,000
200
2,800
(300)
2,500
278
d.
Earnings on savings
Years
Net initial cash outlay
Opportunity cost under the cash purchase option
5.20%
2
$ 2,500
$
260
e.
Opportunity cost
Net initial cash outlay
Cost of cash option
$
$
$
260
2,500
2,760
f.
$
$
2,814
2,760
Because it is less expensive, Bob and Carol should pay cash for the furniture. The lower cost of
the cash alternative is largely the result of the $300 cash rebate.
P14-6. LG 1, 2: Cash discount decisions
Intermediate
a.
c.
J
K
Borrow
Give up
Give up
Borrow
Decision
Prairie would have lower financing costs by giving up Ks and Ls discount since the cost of
forgoing the discount is lower than the 16% cost of borrowing.
Cost of giving up discount from Supplier M = (0.03 0.97) (365 75) = 15.05% In this
case the firm should give up the discount and pay at the end of the extended period.
c.
b.
Supplier
Chapter 14
279
First 60 days
6.5%
1.5%
8.0%
$45,000
$ 591.78
$45,591.78
Days 61 to 90
6.5&
2.0%
8.5%
$45,591.78
$318.52
$45,910.30
Days 91 to 180
6.5%
3.0%
9.5%
$45,910.30
$1,075.43
$46,985.73
The variable rate loan, which has an interest expense of $1,985.73, is less costly.
P14-11. LG 3: Effective annual rate of interest
Basic
Effective interest =
$10,000 0.10
= 14.29%
[$10,000 (1 0.10 0.20)]
= $800,000 11 %
= $88,000
$88,000
=
= 12.94%
$680,000
= $120,000 $70,000
= $50,000
$88,000
=
= 11.73%
$800,000 $50,000
= 11%
(None of the $800,000 borrowed is required to satisfy the compensating balance requirement.)
d. The lowest effective interest rate occurs in Situation (c), when Lincoln has $150,000 on
deposit. In Situations (a) and (b), the need to use a portion of the loan proceeds for
compensating balances raises the borrowing cost.
280
$150,000 0.09
$13,500
=
= 10.0%
$150,000 ($150,000 0.10) $135,000
This calculation assumes that Weathers does not maintain any normal account balances at
State Bank.
$150,000 0.09 6/12
$6,750
Frost finance interest =
=
= 4.71%
$150,000 ($150,000 0.09 6/12) $143,250
Effective annual rate = (1.0471)2 1 = 0.0964 = 9.46%
b. If Weathers became a regular customer of State Bank and kept its normal deposits at the bank,
then the additional deposit required for the compensating balance would be reduced and the
cost would be lowered.
P14-14. LG 3: Integrativecomparison of loan terms
Challenge
Chapter 14
281
$1,000,000 $978,000
= 2.25%
$978,000
Amount
D
E
F
H
J
K
Total collateral
$ 8,000
50,000
12,000
46,000
22,000
62,000
$200,000
282
Amount
A
E
F
G
H
Total Collateral
$20,000
2,000
12,000
27,000
19,000
$80,000
Interest cost =
$7,750
= 7.75% for 6 months
$100,000
Interest cost =
$4,875
= 4.88% for 3 months
$100,000
Chapter 14
283
P14-19. LG 5: Factoring
Intermediate
Holder Company
Factored Accounts
May 30
Accounts
Amount
Date Due
Status on
May 30
A
B
C
D
E
F
G
H
$200,000
90,000
110,000
85,000
120,000
180,000
90,000
30,000
5/30
5/30
5/30
6/15
5/30
6/15
5/15
6/30
C 5/15
U
U
C 5/30
C 5/27
C 5/30
U
C 5/30
Amount
Remitted
Date of
Remittance
$196,000
88,200
107,800
83,300
117,600
176,400
88,200
29,400
5/15
5/30
5/30
5/30
5/27
5/30
5/15
5/30
The factor purchases all acceptable accounts receivable on a nonrecourse basis, so remittance is
made on uncollected as well as collected accounts.
P14-20. LG 1, 6: Inventory financing
Challenge
a.
City-Wide Bank:
[$75,000 (0.12 12)] +(0.0025 $100,000) = $1,000
Sun State Bank:
$100,000 (0.13 12) = $1,083
Citizens Bank and Trust: [$60,000 (0.15 12)] + (0.005 $60,000) = $1,050
b. City-Wide Bank is the best alternative, since it has the lowest cost.
c.
284
correct amount of nontaxable revenue, which is usually not directly available from the companys
financial statements.
Chapter 14
285
Case
Strategy IAggressive
a. Amount required: $2,500,000 short-term and $1,000,000 long-term
b. Cost: (10% $2,500,000) + (14% $1,000,000) = $390,000
Strategy 2Conservative
a. Amount required: $7,000,000 long-term and $0 short-term
b. Cost: (14% $7,000,000) = $980,000
Strategy 3Tradeoff
a. Calculation of short-term requirements
Month
January
February
March
April
May
June
July
August
September
October
November
December
(1)
Total Funds
Requirements
(2)
Permanent
Requirements
$1,000,000
1,000,000
2,000,000
3,000,000
5,000,000
7,000,000
6,000,000
5,000,000
5,000,000
4,000,000
2,000,000
1,000,000
$3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
3,000,000
Seasonal
Requirements
0
0
0
0
2,000,000
4,000,000
3,000,000
2,000,000
2,000,000
1,000,000
0
0
286
3.
The three strategies differ in terms of profitability and risk. The aggressive strategy is the most
profitableit has the lowest cost, $390,000because it uses the largest amount of the less-expensive
short-term financing. It also pays interest only on needed financing. The aggressive strategy is also
the most risky, relying heavily on short-term financing, which may have more limited availability.
Net working capital is lowest, also increasing risk.
Because the conservative strategy funds the highest amount in any month for the whole year with
more-expensive long-term financing, it is the most expensive ($980,000) and the least profitable. It is
the lowest-risk strategy, however, reserving short-term financing for emergencies. The high level of
working capital also reduces risk.
The tradeoff strategy falls between the two extremes in terms of both profitability and risk. The cost
($536,667) is higher than the aggressive strategy because the permanent funds requirement of
$3,000,000 is financed with more costly long-term funds. In five months (January, February, March,
November, and December), the company pays interest on unneeded funds. The risk is less than with
the aggressive strategy; some short-term borrowing capacity is preserved for emergencies. Because a
portion of short-term requirements is financed with long-term funds, the firms ability to obtain shortterm financing is good.
Mr. Mercado should consider implementing the tradeoff strategy. The wide swings in monthly funds
requirements make the cost of the conservative strategy very high in comparison to the reduced risk.
For the same reason, the aggressive strategy is quite risky, requiring the firm to raise short-term funds
ranging from $1,000,000 to $6,000,000. If it should become difficult to arrange short-term financing,
Kanton Company would be in trouble.
Note: Other recommendations are possible, depending on the students risk preference. Of course, the
student should present sound reasons for his or her choice of strategy.
4.
5.
The line of credit arrangement seems better, since its annual cost of 11.88% is less than the 12.92%
cost of the revolving loan arrangement. Kanton will save about 1% in terms of annual interest cost
(11.88% versus 12.92%) by using the line of credit. The only negative is that if Third National lacks
loanable funds, Kanton may not be able to borrow the needed funds. Under the revolving credit
agreement, funds availability would be guaranteed.
Chapter 14
287
Spreadsheet Exercise
The answer to Chapter 14s comparison of borrowing from First American or First Citizen spreadsheet
problem is located in the Instructors Resource Center at www.prenhall.com/irc.
A series of chapter-relevant assignments requiring Internet access can be found at the books Companion
Website at http://www.prenhall.com/gitman. In the course of completing the assignments students access
information about a firm, its industry, and the macro economy, and conduct analyses consistent with those
found in each respective chapter.