CHAPTER 15

Working-Capital Management

CHAPTER ORIENTATION
In this chapter, we introduce working-capital management in terms of managing the firm’s
liquidity. Specifically, working capital is defined as the difference in current assets and current
liabilities. The hedging principle is offered as one approach to addressing the firm’s liquidity
problems. In addition, this chapter deals with the sources of short-term financing that must be
repaid within 1 year.

CHAPTER OUTLINE

I. Managing current assets

A. The firm’s investment in current assets (such as fixed assets) is determined by
the marginal benefits derived from investing in them compared with their
acquisition cost.
B. However, the current fixed-asset mix of the firm’s investment in assets is an
important determinant of the firm’s liquidity. That is, the greater the firm’s
investment in current assets, other things remaining the same, the greater the
firm’s liquidity. This is generally true, since current assets are usually more
easily converted into cash.
C. The firm can invest in marketable securities to increase its liquidity. However,
such a policy involves committing the firm’s funds to a relatively low-yielding
(in comparison to fixed assets) investment.

II. Managing the firm’s use of current liabilities

A. The greater the firm’s use of current liabilities, other things being the same, the
less will be the firm’s liquidity.
B. There are a number of advantages associated with the use of current liabilities
for financing the firm’s asset investments.
1. Flexibility. Current liabilities can be used to match the timing of a
firm’s short-term financing needs exactly.

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 2. Interest cost. Historically, the interest cost on short-term debt has been
lower than that on long-term debt.
C. Following are the disadvantages commonly associated with the use of short-
term debt:
1. Short-term debt exposes the firm to an increased risk of illiquidity
because short-term debt matures sooner and in greater frequency, by
definition, than does long-term debt.
2. Since short-term debt agreements must be renegotiated from year to
year, the interest cost of each year’s financing is uncertain.

III. Determining the appropriate level of working capital

A. Pragmatically, it is impossible to derive the "optimal" level of working capital
for the firm. Such a derivation would require estimation of the potential costs
of illiquidity which, to date, have eluded precise measurement.
B. However, the "hedging principle" provides the basis for the firm’s working-
capital decisions.
1. The hedging principle or rule of self-liquidating debt involves the
following: Those asset needs of the firm not financed by spontaneous
sources (i.e., payables and accruals) should be financed in accordance
with the following rule: Permanent asset investments are financed with
permanent sources and temporary investments are financed with
temporary sources, of financing.
2. A permanent investment in an asset is one which the firm expects to
hold for a period longer than one year. Such an investment may involve
current or fixed assets.
3. Temporary asset investments comprise the firm’s investment in current
assets that will be liquidated and not replaced during the year.
4. Spontaneous sources of financing include all those sources that are
available upon demand (e.g., trade credit—accounts payable) or that
arise naturally as a part of doing business (e.g., wages payable, interest
payable, taxes payable, etc.).
5. Temporary sources of financing include all forms of current or short-
term financing not categorized as spontaneous. Examples include bank
loans, commercial paper, and finance company loans.
6. Permanent sources of financing include all long-term sources such as
debt having a maturity longer than one year, preferred stock, and
common stock.
C. Although the hedging principle provides a useful guide to the firm’s working-
capital decisions, no firm will follow its tenets strictly. At times, a firm may
rely too much on temporary financing for its cash needs, or it may have excess
cash as a result of excessive use of permanent financing.

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IV. Determining the appropriate level of short-term financing
A. The hedging concept was presented as one basis for determining the firm’s use
of short-term debt.
B. Hedging involves attempting to match temporary needs for funds with short-
term sources of financing and permanent needs with long-term sources.

V. Selecting a source of short-term financing

A. In general, there are three basic factors that should be considered in selecting a
source of short-term financing:
1. The effective cost of the credit source
2. The availability of credit
3. The effect of the use of a particular source of credit on the cost and
availability of other sources
B. The basic procedure used in estimating the cost of short-term credit utilizes the
basic interest equation, i.e., interest = principal x rate x time.
C. The problem faced in assessing the cost of a source of short-term financing
involves estimating the annual percentage rate (APR) where the interest
amount, the principal sum, and the time for which financing will be needed is
known. Thus, the basic interest equation is "rearranged" as follows:
interest 1
APR = x
principal time
D. Compound interest was not considered in the simple APR calculation. To
consider compounding, the following relation is used:

 i M
APY = 1 +  - 1
 M
where APY is the annual percentage yield, i is the nominal rate of interest per
year, and M is the number of compounding periods within one year. The effect
of compounding is to raise the effective cost of short-term credit.

VII. Sources of short-term credit

A. The two basic sources of short-term credit are unsecured and secured credit.
1. Unsecured credit consists of all those sources that have as their security
only the lender’s faith in the ability of the borrower to repay the funds
when due.
2. Secured funds include additional security in the form of assets that are
pledged as collateral in the event the borrower defaults in payment of
principal or interest.

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B. There are three major sources of unsecured short-term credit: trade credit,
unsecured bank loans, and commercial paper.
1. Trade credit provides one of the most flexible sources of financing
available to the firm. To arrange for credit, the firm need only place an
order with one of its suppliers. The supplier then checks the firm’s
credit and if the credit is good, the supplier sends the merchandise.
2. Commercial banks provide unsecured short-term credit in two basic
forms: lines of credit and transaction loans (notes payable). Maturities
of both types of loans are usually 1 year or less with rates of interest
depending on the credit-worthiness of the borrower and the level of
interest rates in the economy as a whole.
3. A line of credit is generally an informal agreement or understanding
between the borrower and the bank as to the maximum amount of credit
that the bank will provide the borrower at any one time. There is no
"legal" commitment on the part of the bank to provide the stated credit.
There is another variant of this form of financing referred to as a
revolving credit agreement whereby such a legal obligation is involved.
The line of credit generally covers a period of one year corresponding to
the borrower’s "fiscal" year.
4. Transaction loans are another form of unsecured short-term bank credit.
The transaction loan, in contrast to a line of credit, is made for a specific
purpose.
5. Only the largest and most creditworthy companies are able to use
commercial paper, which consists of unsecured promissory notes in the
money market.
a. The maturities of commercial paper are generally six months or
less with the interest rate slightly lower than the prime rate on
commercial bank loans. The new issues of commercial paper are
either directly placed or dealer placed.
b. There are a number of advantages that accrue to the user of
commercial paper: interest rates are generally lower than rates
on bank loans and comparable sources of short-term financing;
no minimum balance requirements are associated with
commercial paper; and commercial paper offers the firm with
very large credit needs a single source for all its short-term
financing needs. Since it is widely recognized that only the most
creditworthy borrowers have access to the commercial paper
market, its use signifies a firm’s credit status.
c. However, a very important "risk" is involved in using this source
of short-term financing; the commercial paper market is highly
impersonal and denies even the most creditworthy borrower any
flexibility in terms of repayment.

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B. Secured sources of short-term credit have certain assets of the firm, such as
accounts receivable or inventories, pledged as collateral to secure a loan. Upon
default of the loan agreement, the lender has first claim to the pledged assets.

1. Generally, a firm’s receivables are among its most liquid assets. Two
secured loan arrangements are generally made with accounts receivable
as collateral:

a. Under the arrangement of pledged accounts receivable, the

amount of the loan is stated as a percentage of the face value of
the receivables pledged.

b. Factoring accounts receivable involves the outright sale of a

firm’s accounts receivables to a factor.

2. Four secured loan arrangements are generally made with inventory as

collateral:

a. Under the floating lien agreement, the borrower gives the lender
a lien against all his or her inventories.

b. The chattel mortgage agreement involves having specific items

of inventory identified in the security agreement.

c. The field warehouse financing agreement means that the

inventories used as collateral are physically separated from the
firm’s other inventories and are placed under the control of a
third-party field warehousing firm.

d. Terminal warehouse agreements involve transporting the

inventories pledged as collateral to a public warehouse that is
physically removed from the borrower’s premises.

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 ANSWERS TO
END-OF-CHAPTER QUESTIONS

15-l. Working capital has traditionally been defined as the firm’s investment in current
assets. Current assets are comprised of all assets which the firm expects to convert into
cash within one year including: cash, marketable securities, accounts receivable, and
inventories.
Net working capital refers to the difference in the firm’s current assets and its current
liabilities (i.e., Net working capital = current assets - current liabilities).
15-2. The final composition of the firm’s current and fixed asset investments is an important
determinant of the firm’s liquidity since, other things remaining the same, the greater
the firm’s investment in current assets the greater its liquidity.
The firm may choose to invest additional funds in cash and/or marketable securities as
a means of increasing its liquidity. However, this type of action involves a tradeoff
between the risk of illiquidity and the firm’s return on invested funds. By increasing
its investment in cash and marketable securities, the firm reduces its risk of illiquidity.
However, the firm has increased its investment in assets which earn little or no return.
The firm can reduce its risk of illiquidity only by reducing its overall return on invested
funds and vice versa.
15-3. Advantages of Short-Term vs. Long-Term Debt:
(1) The interest rate is usually lower (i.e., the term structure of interest rates is
generally upward sloping).
(2) Funds are available only when they are needed.
Disadvantages:
(1) Short-term debts must be repaid sooner; thus, there is a greater risk of
illiquidity.
(2) Interest costs on short-term debts vary from year to year, whereas long-term
debt agreements "lock in" the cost of funds to the firm.
15-4. The use of current liabilities, or short-term debt as opposed to long-term debt, subjects
the firm to a greater risk of illiquidity. That is, short-term debt, by its very nature, must
be repaid or "rolled over" more often than long-term debt. Thus, the possibility that the
firm’s financial condition might deteriorate to a point where the needed funds might
not be available is increased where short-term debt is used.
15-5. The hedging principle involves matching the maturities of the sources of financing for
the firm’s assets with the useful lives of the assets. To implement the hedging
principle, the firm must fund all its permanent assets investments not financed by
spontaneous sources (payables) with long-term sources of funds and then finance all its
temporary asset investments not funded by spontaneous sources of financing with
short-term sources of funds.

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15-6. Definitions:
(l) A permanent asset investment in an asset is one which the firm expects to hold
for a period longer than one year.
(2) Temporary asset investments are comprised of the firm’s investments in current
assets which will be liquidated and not replaced within the current year.
(3) Permanent sources of financing include intermediate and long-term debt,
preferred stock, and common equity.
(4) Temporary financing consists of the various sources of short-term debt:
including secured and unsecured bank loans, commercial paper, loans secured
by accounts receivable, and loans secured by inventories.
(5) Spontaneous financing consists of the trade credit and other accounts payable
which arise "spontaneously" in the firm’s day-to-day operations. Examples
include wages and salaries payable, accrued interest, and accrued taxes.
15-7. Long-term sources of funds have maturities longer than five years. Intermediate-term
financing includes those sources of funds having maturities longer than one but less
than five years. Short-term financing must be repaid within one year.
15-8. The important factors in selecting a source of short-term credit are as follows:
(1) the effective cost of credit.
(2) the availability of credit.
(3) the effect of the use of particular source of credit on the cost and availability of
other sources of credit.
15-9. The procedure used in estimating the cost of short-term credit relies on the use of the
basic interest equation:
I = P x APR x T
The problem faced in assessing the cost of a source of short-term financing, however,
generally involves estimating the annual effective rate for which the interest amount,
the principal sum, and the time for which financing will be needed is known.
To find the effective rate of interest, we simply solve the interest equation for the rate
(APR), i.e.,
I 1
APR = ⋅
P T
15-10. Compound interest was not considered in the simple APR calculation. To consider the
influence of compounding, we can use the following relation:
APY = (1 + i/m)m -1
where i is the nominal rate of interest per year and m is the number of compounding
periods within a year. This cost of credit relationship is frequently referred to as the
Annual Percentage Yield or APY.

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15-11. The three major sources of unsecured short-term credit are trade credit, unsecured bank
loans, and commercial paper.
To arrange for trade credit, the firm need only place an order with one of its suppliers.
The supplier then checks the firm’s credit and, if it is good, sends the merchandise.
The purchasing firm then pays for the goods in accordance with supplier’s credit terms.
The advantages of trade credit are that it is easily and conveniently obtained as a
normal part of the firm’s operations. No formal agreements are generally involved in
extending credit. Furthermore, the amount of credit extended expands and contracts
with the needs of the firm. This latter advantage of trade credit as a source of financing
underlies the reason for its earlier classification as a spontaneous source of financing.
Commercial banks provide unsecured short-term credit in two basic forms: lines of
credit and transaction loans (notes payable). Maturities of both types of loans are
usually one year or less with rates of interest depending on the creditworthiness of the
borrower and the level of interest rates in the economy as a whole.
A line of credit is generally an informal agreement or understanding between the
borrower and the bank as to the maximum amount of credit which the bank will
provide the borrower at any one time. Under this type of agreement, there is no "legal"
commitment on the part of the bank to provide the stated credit.
Lines of credit usually do not involve fixed rates of interest but state that credit will be
extended "at 1/2 percent over prime" or some other spread over the bank’s prime rate.
The agreement generally does not "spell out" the specific use which will be made of
the funds beyond some general statement such as "for working-capital purposes."
Lines of credit usually require that the borrower maintain a minimum balance in the
bank throughout the loan period.
Transaction loans are made for a specific purpose. Unsecured transaction loans are
very similar to a line of credit with regard to their cost, term to maturity, and
compensating balance requirements. This type of loan is the one that most individuals
associate with bank credit. The loan is obtained by signing a promissory note.
In order to obtain a transaction loan, commercial banks often require that the borrower
"clean up" its short-term loans for a 30- to 45-day period during the year. This is also
often a requirement of a line of credit.
Only the largest and most creditworthy companies are able to use commercial paper.
Commercial paper consists of unsecured promissory notes sold in the money market.
The maturity of this credit source is generally six months or less with some issues
carrying 270-day maturities. The interest rate on commercial paper is generally
slightly lower (one-half of one percent) than the prime rate on commercial bank loans.
There are a number of advantages which accrue to the user of commercial paper:
(1) Interest rate. Commercial paper rates are generally lower than rates on bank
loans and comparable sources of short-term financing.
(2) Compensating balance requirement. No minimum balance requirements are
associated with commercial paper.
(3) Amount of credit. Commercial paper offers the firm with very large credit
needs a single source for all its short-term financing needs.

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 (4) Prestige. Since it is widely recognized that only the most credit worthy
borrowers have access to the commercial paper market, its use signifies a firm’s
credit status.
15-12. The trade credit term "2/10, net 30" means that a 2% discount is offered for payment
within 10 days, or the full amount is due in 30 days: "4/20, net 60"—4% discount
within 20 days, full amount 60 days; “3/15, net 45”—3% within 15 days, full amount
45 days.
15-13. A line of credit is generally an informal agreement or understanding between the
borrower and the banks as to the maximum amount of credit which the bank will
provide the borrower at any one time.
Commercial paper consists of unsecured promissory notes of firms that are sold in the
money market.
Compensation balance is a minimum balance that a borrower must maintain in a bank
throughout a loan period.
The prime rate of interest represents that rate which a bank charges its most
creditworthy borrowers on short-term loans.
15-14. The four advantages of commercial paper are:
(1) Interest rate. Commercial paper rates are generally lower than rates on bank
loans and comparable sources of short-term financing.
(2) Compensating balance requirements. No minimum balance requirements are
associated with commercial paper.
(3) Amount of credit. Commercial paper offers the firm with very large credit
needs a single source for all its short-term financing needs.
(4) Prestige. Since it is widely recognized that only the most credit-worthy
borrowers have access to the commercial paper market, its use signifies a firm’s
credit status.
15-15. The "risk" involved with the firm’s use of commercial paper as a source of short-term
debt relates to the fact that the commercial paper market is highly impersonal and
denies even the most creditworthy borrower any flexibility in terms of repayment.
15-16. There are two basic procedures which can be used in arranging for financing on
receivables—pledging and factoring.
Under pledging, the borrower simply offers his accounts receivable as collateral for a
loan obtained from either a commercial bank or finance company. The amount of the
loan is stated as a percent of the face value of receivables pledged.
The primary advantage of pledging as a source of short-term credit relates to the
flexibility it provides the borrower. Financing is available on a continuous basis.
Furthermore, the lender may provide credit services which eliminate or reduce the need
for similar services within the firm.
Factoring receivables involves the outright sale of a firm’s accounts to a factor. The
factor, in turn, bears the risk of collection and services the accounts for a fee. In
addition, the factor provides advances or loans to the borrower on which interest is
charged for the term of the advance.

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 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

15-1. First, we calculate the interest expense for the 3-month loan as follows:
Interest = .12 x $100,000 x 3/12 = $3,000.
Assuming that Paymaster has to leave 10% of the loan idle in a compensating balance,
the effective cost of credit can be calculated as follows:
APR = [$3,000/($100,000 - 10,000 - 3,000)] x (12/3) = 13.79%
If the company already has sufficient funds in the bank to satisfy the compensating
balance requirement, then the cost of credit drops to 12.37%.
15-2. Interest expense for the commercial paper issue is calculated as follows:
Interest = .11 x $20 million x (270/360) = $1,650,000
The effective rate of interest to Burlington Western (including the issue fee of
$200,000) is calculated as follows:
APR = [($1,650,000 + 200,000)/($20 million - 1,650,000 - 200,000)] x (360/270) =
13.59%
Note that both the interest expense and the issue fee are prepaid.
0.02 1
15-3. a. x = 0.36734 or 36.73%
0.98 20 / 360
0.03 1
b. x = 0.74226 or 74.23%
0.97 15 / 360
0.03 1
c. x = 0.37113 or 37.11%
0.97 30 / 360
0.02 1
d. x = 0.16327 or 16.33%
0.98 45 / 360
15-4. Instructor’s Note: This problem can be easily solved using the exponent function (yx)
on a hand calculator. Simply let y = (1+r/m) and x = m, then solve for yx. Finally,
subtract "1" to obtain the effective cost of credit with compounding of interest.
APY = (1 + i/m)m - 1
i = Nominal interest rate
m = # of compounding periods in a year
0.3673 18
a. APY = (1 + ) -1
18
= 1.4385 - 1
= .4385 or 43.85%

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 0.7423 24
b. APY = (1+ ) -1
24
= 2.0773 - 1
= 1.0773 or 107.73%
0.3711 12
c. APY = (1 + ) -1
12
= 1.4412 - 1
= .4412 or 44.12%
0.1633 8
d. APY = (1 + ) -1
8
= 1.1755 - 1
= .17555 or 17.55%
15-5. a. Bank Loan Alternative. Since interest on the bank loan is discounted, we must
first determine how much R. Morin will have to borrow in order that the firm
receive the needed $100,000. This involves solving for B (the amount to be
borrowed) such that
B - .14B = $100,000
That is, B is that amount which must be borrowed such that the proceeds to the
firm, after interest at a rate of 14% for one year has been deducted, will equal
the needed $100,000.
Thus, .86 B = $100,000
B = $100,000/.86
B = $116,279.07
Interest = .14 x $116,279.07
= $16,279.07
Therefore, the effective rate of interest on the loan is calculated as follows:
$16,279.07 1
APR = x
$116,279.07 − 16,279.07 360 / 360
= .1628 or 16.28%
Dealer Financing Alternative
$16,300 1
APR = x
$100,000 360 / 360
= .163 or 16.3%
Analysis. The costs of the two sources of financing are identical for practical
purposes. The final choice can now be made based upon other nonquantitative
factors. For example, the firm may find that using dealer financing is less time
consuming and allows the firm to leave its credit line with the bank unchanged.
Since bank credit can be used for a much wider array of financing needs than
dealer financing, R. Morin would find that using dealer financing leaves the
firm with greater flexibility in raising funds for its future needs.

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 b. If the compensating balance becomes binding, then the bank loan alternative
will require that R. Morin borrow

B - .14B - .15B = $100,000

.71B = $100,000
B = $100,000/.71
= $140,845.07
Interest = .14 x $140,845.07
= $19,718.31
Compensating Balance = .15 x $140,845.07
= $21,126.76
$19,718.31 1
APR = x
$140,845.07 − 19,718.31 − 21,126.76 360 / 360
= .197 or 19.7%
Thus, where the 15% compensating balance requirement is binding on R.
Morin, the cost of the bank loan rises to 19.7%. In this case, dealer financing is
clearly less costly.
Note that equipment dealers will frequently price their merchandise so as to
compensate them for offering "below market" rates of interest for financing. This may
well be the case here such that R. Morin should use the dealer financing unless it can
negotiate a price concession equal to the value of "bargain financing."

15-6. 100,000
x 0.13
$13,000
$1083/month—interest
$20,000—compensating balance
$13,000 1
a. APR = x = 0.13 or 13%
$100,000 360 / 360
$13,000 1
b. APR = x = 0.1625 or 16.25%
$80,000 360 / 360
Interest expense for the loan is
360
($100,000) (0.13) = $13,000
360
However, the firm gets the use of only .8 x $100,000 = $80,000.

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 interest 1
15-7. a. APR = x
principal time
$25,625 * +12,000 1
APR = x
$500,000 − 12,000 − 25,625 180 / 360
= .1627 = 16.27%
*Interest = .1025 x $500,000 x 180/360
b. The risk involved with the issue of commercial paper should be considered.
This risk relates to the fact that the commercial paper market is highly
impersonal and denies even the most creditworthy borrower any flexibility in
terms of when repayment is made.
In addition, commercial paper is a viable source of credit to only the most
creditworthy borrowers. Thus, it may simply not be available to the firm.

$39,000 * +24,000 * * 1
15-8. a. APR = x = .21 or 21%
$300,000 360 / 360

* ($400,000 x 0.13 x .75) = $39,000

** (200,000 x .01 x 12) = $24,000

b. $300,000 x .15 = $45,000 (compensating balance)

Since Johnson normally maintains a balance of $80,000 with the bank, the
compensating balance requirement will not increase the effective cost of credit.

$42,000 1
x = 0.14 or 14%
$300,000 360 / 360

Interest = $300,000 x .14 = $42,000.

c. Choose the line of credit since the effective interest is considerably lower.
Note, however, that the pledging arrangement may involve credit services to
Johnson which would reduce Johnson’s credit department expense. If this were
the case, then these savings would reduce the effective cost of that financing
arrangement.

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15-9. a. Maximum Advance
Face Value of Receivables
(2 months credit sales) $ 800,000
Less: Factoring Fee (1%) (8,000)
Reserve (9%) (72,000)
Interest (60 days) * (21,600)
Loan Advance (less discount interest) $ 698,400
*Interest is calculated on the 90% of the factored accounts that can be
borrowed, (.90 x $800,000 x .015 x 2 months) = $21,600 or ($800,000 - 8,000
- 72,000) x .015 x 2 months = $21,600.
Thus, the effective cost of credit to MDM is calculated as follows:
$21,600 + 8,000 − 3,000 * * 1
APR = x
$698, 400 (60 / 360)
= .2285 or 22.85%
**Credit department savings for 60 days equals 2 x $1500.
b. Of particular concern here is the presence of any "stigma" associated with
factoring. In some industries, factoring simply is not used unless the firm’s
financial condition is critical. This would appear to be the case here, given the
relatively high effective rate of interest on borrowing.
15-10. a. Pledged Receivables (A/R):
0.80 A/R = $500,000 loan
A/R = $500,000/.80 = $625,000
Fee = (0.01) ($625,000) = $6,250
Interest Cost = (0.11) ($500,000) x 1/4 = $13,750
 $13,750 + 6, 250  1 
Effective Rate =   
 $500,000  90 / 360 
= .16 or 16%
b. Warehousing cost = $2,000 x 3 months = $6,000
Interest cost = 0.09 x $500,000 x 1/4 = $11,250
 $6,000 + 11,250  1 
Effective Rate =   
 $500,000  90 / 360 
= .138 or 13.8%
The inventory loan would be preferred, since its cost is lowest under the
conditions presented to S-J.

477
15-11. a. Interest = $20,000 x .10 x 1/2
= $1,000
$1,000 1
APR = x
$20,000 (180 / 360)
= .10 or 10%

b. The net proceeds from the loan are now $20,000 - (.15 x $20,000) or $17,000.
Thus, the effective cost of credit is
$1,000 1
APR = x
$17,000 180 / 360
= .1176 or 11.76%
We would have gotten the same answer by assuming that you borrow the
necessary compensating balance. In that case, the amount borrowed (B) is
found as follows:
B - .15B = $20,000
.85B = $20,000
B = $20,000/.85
= $23,529.41
Interest = .10 x 1/2 x $23,529.41
= $1,176.47
$1,176.47 1
APR = x
$20,000 180 / 360
= .1176 or 11.76%

c. In this case we assess the impact of discounted interest and the 15%
compensating balance. As in part b, the discounted interest serves to reduce the
loan proceeds:
$1,000 1
APR = x
$20,000 − 3,000 − 1,000 (180 / 360)
= .125 or 12.5%

478
 If you borrowed enough to cover both the compensating balance requirement
and discounted interest, then you would borrow (B) such that
B - .15B - (.10 x ½ )B = $20,000
.8B = $20,000
B = $25,000
Interest = .10 x 1/2 x $25,000
= $1,250
Compensating Balance = .15 x $25,000
= $3,750
Thus,
$1,250 1
APR = x
$25,000 − 1,250 − 3,750 180 / 360
= .125 or 12.5%
The cost of the bank loan rises once again in part c due to the reduction in funds
available to you from the loan as a result (this time) of discounted interest.

15-12. Calculation of the Maximum Advance

Face Amount of Receivables Factored $300,000
Less: Fee (.02 x $300,000) (6,000)
Reserve (.20 x $300,000) (60,000)
Interest (.01 x $234,000 x 3 months) (7,020)
Maximum Advance $226,980
Calculation of the cost of credit
$7,020 + 6,000 − 6,000 12
APR = x
$226,980 3
= .0309 x 4 = .1237 or 12.37%

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15-13.
a. Given:
Loan amount $240,000.00
Loan period 3 months
Loan rate 8%
Compensating balance 20%
Current bank balance $ 4,000.00

Analysis
Interest cost $ 4,800.00
Added compensating balance $ 44,000.00
Cost of credit 9.80%

b. Cost of credit 8.79%

15-14. Cash Conversion Cycle

DATA Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Sales –Net 2,873 3,475 5,296 7,759 12,327
Receivables-Total 411 538 726 903 1,486
Accounts Payable 283 447 466 1,040 1,643
Inventories-Total 220 293 429 251 233

a. Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Days-sales-outstanding-in-receivables 52.22 56.51 50.04 42.48 44.00
Days-sales-in-inventory* 27.95 30.78 29.57 11.81 6.90
Days-sales-in-inventory** 39.93 43.97 42.24 16.87 9.86
Days-payables-outstanding 35.95 46.95 32.12 48.92 48.65

*Note that days sales in inventory should be calculated using cost of goods sold which is not known in this
problem. Consequently, we use sales instead.

**Assuming the firm’s cost of goods sold equals 70% of sales.

From the calculations above it is apparent that Simms has successfully increased the efficiency
of its management of both accounts receivable and inventory.

b. Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Cash conversion cycle* 44.21 40.33 47.49 5.36 2.25
Cash conversion cycle** 56.19 53.52 60.16 10.42 5.21

*Uses sales instead of COGS to calculate the days inventory outstanding.

**Uses COGS = 70% of sales to calculate days inventory outstanding.

Simms has made dramatic improvements to its working capital management by making more
than a 10 fold reduction in the firm’s cash conversion cycle.

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 ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS

15-1A. (Estimating the Cost of Bank Credit) Dee’s Christmas Trees, Inc., is evaluating options
for financing its seasonal working-capital needs. A short-term loan from Liberty Bank
would carry a 14% annual interest rate, with interest paid in advance (discounted). If
this option is chosen, Dee’s would also have to maintain a minimum demand deposit
equal to 10 percent of the loan balance, throughout the term of the loan. If Dee’s needs
to borrow $125,000 for the upcoming three months before Christmas, what is the
effective cost of the loan?
15-2A. (Estimating the Cost of Commercial Paper) Duro Auto Parts would like to exploit a
production opportunity overseas, and is seeking additional capital to finance this
expansion. The company plans a commercial paper issue of $15 million on February 3,
2000. The firm has never issued commercial paper before, but has been assured by the
investment banker placing the issue that it will have no difficulty raising the funds, and
that this method of financing is the least expensive option, even after the $150,000
placement fee. The issue will carry a 270-day maturity and will require interest based
on an annual rate of 12%. What is the effective cost of the commercial paper issue to
Duro?
15-3A. (Cost of Trade Credit) Calculate the effective cost of the following trade credit terms
where payment is made on the net due date.
a. 3/10, net 30
b. 2/15, net 30
c. 2/15, net 45
d. 3/15, net 60
15-4A. (Annual Percentage Yield) Compute the cost of the trade credit terms in problem 15-
3A using the compounding formula, or annual percentage yield.
15-5A. (Cost of Short-Term Financing) Vitra Glass Company needs to borrow $150,000 to
help finance the cost of a new $225,000 kiln to be used in the production of glass
bottles. The kiln will pay for itself in one year and the firm is considering the following
alternatives for financing its purchase:
Alternative A—The firm’s bank has agreed to lend the $150,000 for one year at a rate
of 15%. Interest would be discounted, and a 16% compensating balance would be
required. However, the compensating balance requirement would not be binding on
Vitra, because the firm normally maintains a minimum demand deposit (checking
account) balance of $25,000 in the bank.
Alternative B—The kiln dealer has agreed to finance the equipment with a one-year
loan. The $150,000 loan would require payment of principal and interest totaling
$163,000.
a. Which alternative should Vitra select?

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 b. If the bank’s compensating balance requirement were to necessitate idle demand
deposits equal to 16% of the loan, what effect would this have on the cost of the
bank loan alternative?
15-6A. (Cost of Short-Term Bank Loan) Lola’s Ice Cream recently arranged for a line of credit
with the Longhorn State Bank of Dallas. The terms of the agreement called for a
$100,000 maximum loan with interest set at 2.0% over prime. In addition, Lola’s must
maintain a 15% compensating balance in its demand deposit throughout the year. The
prime rate is currently 12%.
a. If Lola’s normally maintains a $15,000-$25,000 balance in its checking account
with LSB of Dallas, what is the effective cost of credit through the line-of-
credit agreement where the maximum loan amount is used for a full year?
b. Recompute the effective cost of credit to Lola’s Ice Cream if the firm has to
borrow the compensating balance and it borrows the maximum possible under
the loan agreement. Again, assume the full amount of the loan is outstanding
for a whole year.
15-7A. (Cost of Commercial Paper) Luft, Inc. recently acquired production rights to an
innovative sailboard design but needs funds to pay for the first production run, which is
expected to sell briskly. The firm plans to issue $450,000 in 180-day maturity notes.
The paper will carry an 11% rate with discounted interest and will cost Luft $13,000
(paid in advance) to issue.
a. What is the effective cost of credit to Luft?
b. What other factors should the company consider in analyzing whether to issue
the commercial paper?
15-8A. (Cost of Accounts Receivable) TLC Enterprises, Inc. is a wholesaler of toys and curios.
The firm needs $400,000 to finance an anticipated expansion in receivables. TLC’s
credit terms are net 60, and its average monthly credit sales are $250,000. In general,
the TLC’s customers pay within the credit period; thus, the firm’s average accounts
receivable balance is $500,000.
Kelly Leaky, TLC’s comptroller, approached the firm’s bank with a request for a loan
for the $400,000, using the firm’s accounts receivable as collateral. The bank offered to
make the loan at a rate of 2% over prime plus a 1% processing charge on all
receivables pledged ($250,000 per month). Furthermore, the bank agreed to lend up to
80% of the face value of the receivables pledged.
a. Estimate the cost of the receivables loan to TLC where the firm borrows the
$400,00. The prime rate is currently 11%.
b. Leaky also requested a line of credit for $400,000 from the bank. The bank
agreed to grant the necessary line of credit at a rate of 3% over prime and
required a 15% compensating balance. TLC currently maintains an average
demand deposit of $100,000. Estimate the cost of the line of credit.
c. Which source of credit should TLC select? Why?

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15-9A. (Cost of Factoring) To increase profitability, a management consultant has suggested to the
Dal Molle Fruit Company that it consider factoring its receivables. The firm has credit sales
of $300,000 per month and has an average receivables balance of $600,000 with 60-day
credit terms. The factor has offered to extend credit equal to 90% of the receivables factored
less interest on the loan at a rate of 1½% per month. The 10% difference in the advance and
the face value of all receivables factored consists of a 1% factoring fee plus a 9% reserve,
which the factor maintains. In addition, if Dal Molle decides to factor its receivables, it will
sell them all, so that it can reduce its credit department costs by $1,400 a month.
a. What is the cost of borrowing the maximum amount of credit available to Dal Molle,
through the factoring agreement?
b. What considerations other than cost should be accounted for by Dal Molle in
determining whether or not to enter the factoring agreement?
15-10A. (Cost of Secured Short-Term Credit) DST, Inc., a producer of inflatable river rafts, needs
$400,000 for the three-month summer season, ending September 30, 2000. The firm has
explored two possible sources of credit.
1. DST has arranged with its bank for a $400,000 loan secured by accounts receivable.
The bank has agreed to advance DST 80% of the value of its pledged receivables at a
rate of 11% plus a 1% fee based on all receivables pledged. DST’s receivables
average a total of $1 million year-round.
2. An insurance company has agreed to lend the $400,000 at a rate of 9% per annum,
using a loan secured by DST’s inventory. A field warehouse agreement would be
used, which would cost DST $2,000 a month.
Which source of credit would DST select? Explain.
15-11A. (Cost of Secured Short-Term Financing) You are considering a loan of $25,000 to finance
inventories for a janitorial supply store that you plan to open. The bank offers to lend you
the money at 11% annual interest for the six months the funds will be needed.
a. Calculate the effective rate of interest on the loan.
b. In addition, the bank requires you to maintain a 15% compensating balance in the
bank. Because you are just opening your business, you do not have a demand deposit
at the bank that can be used to meet the compensating balance requirement. This
means that you will have to put 15% of the loan amount from your own personal
money (which you had planned to use to help finance the business) in a checking
account. What is the cost of the loan now?
c. In addition to the compensating balance requirement in b, you are told that interest
will be discounted. What is the effective rate of interest on the loan now?
15-12A. (Cost of Financing) Tanglewood Roofing Supply, Inc. has agreed to borrow working capital
from a factor on the following terms: Tanglewood’s receivables average $150,000 per
month and have a 90-day average collection period (note that the firm offers 90-day credit
terms and its accounts receivable average $450,000 because of the 90-day collection
period). The factor will charge 13% interest on any advance (1.08% per month paid in
advance), will charge a 2% processing fee on all receivables factored, and will maintain a
15% reserve. If Tanglewood undertakes the loan, it will reduce its own credit department
expenses by $2,000 per month. What is the annual effective rate of interest to Tanglewood
on the factoring agreement? Assume that the maximum advance is taken.

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SOLUTIONS TO ALTERNATIVE PROBLEMS

15-1A.First we calculate the interest expense for the three-month loan as follows:
Interest = .14 x $125,000 x 3/12 = $4,375.
Assuming that Dee has to leave 10% of the loan idle in a compensating balance, the
effective cost of credit can be calculated as follows:
APR = [$4,375/($125,000 - 12,500 - 4,375)] x (12/3) = 16.18%
If the company already has sufficient funds in the bank to satisfy the compensating
balance requirement, then the cost of credit drops to 14.51%.
15-2A.Interest expense for the commercial paper issue is calculated as follows:
Interest = .12 x $15 million x (270/360) = $1,350,000
The effective rate of interest to Burlington Western (including the issue fee of
$150,000) is calculated as follows:
APR = [($1,350,000 + 150,000)/($15 million - 1,350,000 - 150,000)] x (360/270) =
14.81%
Note that both the interest expense and the issue fee are prepaid.
0.03 1
15-3A. a. x = 0.5567 or 55.67%
0.97 20 / 360
0.02 1
b. x = 0.4898 or 48.98%
0.98 15 / 360
0.02 1
c. x = 0.2449 or 24.49%
0.98 30 / 360
0.03 1
d. x = 0.2474 or 24.74%
0.97 45 / 360
15-4A.Instructor’s Note: This problem can be easily solved using the exponent function (yx)
on a hand calculator. Simply let y = (1+i/m) and x = m, then solve for yx. Finally,
subtract "1" to obtain the effective cost of credit with compounding of interest.
APY = (1 + i/m)m - 1
i = Nominal interest rate
m = # of compounding periods in a year
18
 0.5567 
a. APY = 1 +  −1
 18 
= 1.7302 - 1
= .7302 or 73.02%

484
 24
 0.4898 
b. APY = 1 +  −1
 24 
= 1.6240 - 1
= .6240 or 62.40%
12
 0.2424 
c. APY = 1 +  −1
 12 
= 1.2759 - 1
= .2759 or 27.59%
8
 0.1633 
d. APY = 1 +  −1
 8 
= 1.1755 - 1
= .17555 or 17.55%
15-5A. a. Bank Loan Alternative. Since interest on the bank loan is discounted, we must
first determine how much Vitra will have to borrow in order that the firm
receive the needed $150,000. This involves solving for B (the amount to be
borrowed) such that
B - .15B = $150,000
That is, B is that amount which must be borrowed such that the proceeds to the
firm, after interest at a rate of 15% for one year has been deducted, will equal
the needed $150,000.
Thus,
.85 B = $150,000
B = $150,000/.85
B = $176,470.59
Interest = .15 x $176,470.59
= $26,470.59
Therefore, the effective rate of interest on the loan is calculated as follows:
$26,470.59 1
APR = x
$176,470.59 − 26,470.59 360 / 360
= .1765 or 17.65%
Dealer Financing Alternative
$13,000 1
APR = x
$150,000 360 / 360
= .0867 or 8.67%
In this case, dealer financing is definitely preferred.

485
 b. If the compensating balance becomes binding, then the bank loan alternative
will require that Vitra borrow
B - .16B - .15B = $150,000
.69B = $150,000
B = $150,000/.69
= $217,391.30
Interest = .15 x $217,391.30
= $32,608.70
Compensating Balance = .16 x $217,391.31
= $34,782.61
$32,608.71 1
APR = x
$217,391.30 − 32,608.71 − 34,782.61 360 / 360
= .2174 or 21.74%
Thus, where the 16% compensating balance requirement is binding on Vitra,
the cost of the bank loan rises to 21.74%. However, dealer financing is much
less costly.
Note that equipment dealers will frequently price their merchandise so as to
compensate them for offering "below market" rates of interest for financing.
This may well be the case here such that Vitra should use the dealer financing
unless it can negotiate a price concession equal to the value of "bargain
financing."
15-6A. 100,000
x 0.14
$14,000 —Interest
$15,000 —compensating balance
$14,000 1
a. APR = x = 0.14 or 14%
$100,000 360 / 360
$14,000 1
b. APR = x = .1647 or 16.47%
$85,000 360 / 360
Interest expense for the loan is
360
($100,000) (0.14) = $14,000
360
However, the firm gets the use of only .85 x $100,000 = $85,000.

486
 interest 1
15-7A. a. APR = x
principal time
$24,750 * +13,000 1
APR = x
$450,000 − 13,000 − 24,750 180 / 360
= .1831 or 18.31%
*Interest = .11 x $450,000 x 1/2
b. The risk involved with the issue of commercial paper should be considered.
This risk relates to the fact that the commercial paper market is highly
impersonal and denies even the most creditworthy borrower any flexibility in
terms of when repayment is made.
In addition, commercial paper is a viable source of credit to only the most
creditworthy borrowers. Thus, it may simply not be available to the firm.
$52,000 * +30,000 * * 1
15-8A. a. APR = x = .205 or 20.5%
$400,000 360 / 360
*($500,000 x 0.13 x .80) = $52,000
**(250,000 x .01 x 12) = $30,000
b. $400,000 x .15 = $60,000 (compensating balance)
Since the firm normally maintains a balance of $100,000 with the bank, the
compensating balance requirement will not increase the effective cost of credit.
$56,000 1
x = 0.14 or 14%
$400,000 360 / 360
Interest = $400,000 x .14 = $56,000
c. Choose the line of credit since, the effective interest is considerably lower.
Note, however, that the pledging arrangement may involve credit services to the
firm which would reduce its credit department expense. If this were the case
then these savings would reduce the effective cost of that financing
arrangement.
15-9A. a. Maximum Advance
Face Value of Receivables
(2 months credit sales) $ 600,000
Less: Factoring Fee (1%) (6,000)
Reserve (9%) (54,000)
Interest (1 1/2% per month
for 60 days)* (16,200)
Loan Advance (less discount interest) $ 523,800
*Interest is calculated on the 90% of the factored accounts that can be
borrowed, (.90 x $600,000 x .015 x 2 months) = $16,200 or ($600,000 - 6,000
- 54,000) x .015 x 2 months = $16,200.

487
 Thus, the effective cost of credit to Dal Molle is calculated as follows:
$16, 200 + 6,000 − 2,800 * * 1
APR = x
$523,800 (60 / 360)
= .2222 or 22.22%
**Credit department savings for 60 days equals 2 x $1400.
b. Of particular concern here is the presence of any "stigma" associated with
factoring. In some industries, factoring simply is not used unless the firm’s
financial condition is critical. This would appear to be the case here, given the
relatively high effective rate of interest on borrowing.

15-10A. Pledged Receivables (A/R):

0.80 A/R = $400,000 loan
A/R = $400,000/.80 = $500,000
Fee = (0.01) ($500,000) = $5,000
Interest Cost = (0.11) ($400,000) x 1/4 = $11,000
 $11,000 + 5,000  1 
Effective Rate =   
 $400,000  90 / 360 
= .16 or 16%

Inventory Loan:

Warehousing cost = $2,000 x 3 months = $6,000

Interest cost = 0.09 x $400,000 x 1/4 = $9,000

 $6,000 + 9,000  1 
Effective Rate =   
 $400,000  90 / 360 

= .15 or 15%

The inventory loan would be preferred, since its cost is lowest under the
conditions presented.

15-11A.a. Interest = $25,000 x .11 x 1/2

= $1,375

$1,375 1
APR = x
$25,000 (180 / 360)

= .11 or 11%

488
 b. The net proceeds from the loan are now $25,000 - (.15 x $25,000) or $21,250.
Thus, the effective cost of credit is
$1,375 1
APR = X
$21,250 180 / 360
= .1294 or 12.94%
We would have gotten the same answer by assuming that you borrow the
necessary compensating balance. In that case, the amount borrowed (B) is
found as follows:
B - .15B = $25,000
.85B = $25,000
B = $25,000/.85
= $29,411.76
Interest = .11 x 1/2 x $29,411.76
= $1,617.65
$1,617.65 1
APR = x
$25,000 180 / 360
= .1394 or 12.94%

c. In this case, we assess the impact of discounted interest and the 15%
compensating balance. As in part b the discounted interest serves to reduce the
loan proceeds:

$1,375 1
APR = x
$25,000 − 3,750 − 1,375 (180 / 360)

= .1383 or 13.83%

15-12A. Calculation of the Maximum Advance

Face Amount of Receivables Factored $450,000
Less: Fee (.02 x $450,000) (9,000)
Reserve (.15 x $450,000) (67,500)
Interest (.0108 x $373,500 x 3 months) (12,101)
Maximum Advance $361,399
Calculation of the cost of credit
$12,101 + 9,000 − 6,000 12
APR = x
$361,399 3
= .1671 or 16.71%

489