FINANCIAL MANAGEMENT

SOURCES OF SHORT-TERM FUNDS / CURRENT LIABILITIES MANAGEMENT PROBLEMS – SOLUTION

Spontaneous Liabilities
PROBLEMS
1. Wood Corp. is offered by its supplier a trade credit term of 3/15, n/45. Wood Corp. does not take advantage of
the discount instead pay the account affect 67 days. Use 365 days per year. What is Wood Corp.’s nominal
annual cost of not taking the discount? 21.71%

Note:
• 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.
• When a firm gives up a discount, it pays a higher cost for the goods that it orders
• The discount (3%) is divided with the 97% (which is the discounted amount of the good) and further
multiplied with the number of times the company pays beyond the discount date (15th day) for a year to
annualize the computed rate.
 2. Calculate the approximate and effective annual cost of foregoing the cash discount for both of the suppliers of
Mouse Corp.
Supplier CAT 4/10, n/50
Supplier DOG 3/10, n/60
Assuming the firm needs short-term financing, recommend whether it would be better to give up the cash
discount or take the discount and borrow from a bank at 25% annual interest. Evaluate each supplier separately.
Use 360 days per year. Supplier CAT: 37.5%, borrow money and take discount; Supplier DOG: 22.27%, Forgo
the discount

Note:
• The financial manager must determine whether it is advisable to take a cash discount. 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.
• The cost of forgoing the discount for each supplier is computed respectively. These costs are compared with
the cost of borrowing an amount from the bank. Whichever has the lower cost or percentage will be the
better option or decision.
• The Mouse Corp. can be better off borrow in the bank at a rate of 25% and pay its payable to Supplier CAT
until the last day of discount date than forgoing the discount and pay on the 50th day, the last day of the
credit term, because it is more expensive to forgo the discount (25% < 37.5%).
• It will be more advantageous to forgo the discount of supplier DOG than borrowing at the bank to have a cash
that will be used to pay at the discount date (25% > 22.27%)
Unsecured Sources of Short-Term Loans
Installment loans
Golem Inc. borrowed an amount of P1,000,000 from a bank. The bank charges a 12% stated rate in an add-on
arrangement, payable in 12 equal monthly instalment. What is the estimated effective interest rate on this installment
loan? 22.15%

Note:
• The average loan for the year is the sum of the first balance of the loan (1,000,000) and the last balance of the
loan before it will be paid off completely (1,000,000/12 = 83,333.33) divided by 2.
• Effective Annual Rate for installment loan (estimates) is the interest to be paid (1,000,000 * 12) divided by the
average balance of the loan for the year.
Discounting of Loans
1. Panda Co. plans to borrow P10,000 from BDI Bank which offers to lend Panda Co. the funds needed at 10%
nominal or stated rate for a one-year loan.
a. What is the effective rate if the loan is a discounted loan? 11.11%
b. Assuming the loan is good only for 6 months, what is the effective rate if the loan is a discounted loan?
10.53%

Note:
• Recalling the formula that is used to compute for the interest rate, the amount of interest is divided by the
principal. E.g. Principal = 5,000, Interest = 500, interest rate =? Divide: (500/5,000) = 10% as the interest rate.
• The interest is the cost of obtaining the principal or the amount of proceeds that we can use.
• If the loan is discounted, the fund or the proceed we can get is the Principal less that interest from the loan.
The (Principal – Interest) of a discounted loan is the proceed that is usable by the company. In other words,
the Effective annual rate of a discount loan is the percentage of the interest or the cost of obtaining the loan
divided by the amount of proceeds that is usable by the company.
• In letter (a), 10,000*10% is the interest earned by the bank or the cost of obtaining the loan, and the
denominator [10,000 – (10,000*10%)] = 9,000 which is the proceed or the amount usable by the company.
And dividing such will get the “Effective” Annual Rate.
• In letter (b), since the loan is good only for less than a year, it is appropriate to get the portion of the 6
months only: multiplying the interest earned by 6/12 and further multiplying the whole term with 12/6 to
annualize the rate (since 12/6 = 2; there is 2 “6-months period” during the year).
 2. Matte Corp. plans to borrow P250,000 for one year at 12% from Balita Bank. There is a 20% compensating
balance requirement.
a. What is the effective rate of interest? 15%
b. What is the effective rate of interest assuming Matte Corp. keeps a minimum transaction balance of
P10,000? 14.29%

Note:
• To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—require the
borrower to maintain a compensating balance equal to a certain percentage of the amount borrowed.
• The formula uses in this problem is the computation of EAR when there is a presence of a compensating
balance and a minimum transaction balance.
• The reason why the compensating balance is deducted from the principal is that the “usable amount” of cash
that the company can used (which should be the principal) is further deducted by an amount that is restricted
for use. Hence, the compensating balance arises from the incurrence of the loan is now unusable.
“Effectively” the only usable amount from the incurrence of the loan is the principal less the compensating
balance.
• To get the EAR in letter (a), the interest earned by the bank or the cost of the loan in the perspective of Matte
Corp. is divided by the “usable amount” arising from the loan (principal – compensating balance).
• In letter (b), Matte Corp. keeps a minimum transaction balance of P10,000. The minimum transaction balance
is added on the denominator because it increases the usable amount of cash as a result of incurrence of the
loan.
Line of Credit
1. Excel Corp. received a P300,000 line of credit at an interest rate of 12% from Metro Bank and drew down the
enter amount on February 1. The line of credit requires that an amount equal to 15% of the loan be deposited
into a compensating balance account. What is the effective annual cost of credit for this loan agreement?
14.12%

Note:
• The formula used here is just the same with the formula in computing the EAR if there is a presence of
compensating balance.
 2. Spanish Bank offers Phil Trading a P2,000,000 line of credit with an interest rate of 2.25% per month. The credit
line also requires that 2% of the unused portion of the credit line be deposited in a non-interest bearing account
as an compensating balance. Phil Trading’s short-term investments are paying 1% per month. Any funds
borrowed and invested are computed using compound interest.
a. What is the effective annual interest rate on this agreement if the line of credit goes unused all year?
12.68%
b. What is the effective annual interest rate on the line of credit if Phil Trading borrows the entire
P2,000,000 for one year? 30.60%

Note:
• In letter (a), all the funds are not used. The short-term investments that pays 1% per month will be used for
the portion of the line of credit unused for the year.
• In letter (b), all the funds are used. Hence, interest rate of 2.25% per month will be used in the formula.
Revolving Credit Agreement
Disney Cola arrange a revolving credit agreement amounting to P10,000,000 with a group of small banks. The firm paid
an annual commitment fee of ½% of the unused balance of the loan commitment. On the used portion of the loan,
Disney Cola paid 1.5% above prime for the funds actually borrowed on an annual simple interest basis. The prime rate
was 9% for the year.
a. If Disney Cola borrowed P10,000,000 immediately after the agreement was signed and repaid at the end of one
year, what was the total peso cost of the loan agreement for one year? 1,050,000
b. If Disney Cola borrowed P6,000,000 immediately after the agreement was signed and repaid at the end of one
year, what was the total peso cost of the loan agreement for one year? 650,000
c. If Disney Cola does not borrow at all, what was the total peso cost of the loan agreement for one year? 50,000

Note:
• It is necessary to get the percentage or the rate that the company will pay if they use and if they do not use
the amount in the revolving credit agreement. There is nothing free as we observe, even if the revolving
credit agreement amount is not used, the company still obliged to pay ½%.
• Separate the portion of the amount used and unused by the company from the revolving credit agreement
amount apply the corresponding rates.
Commercial Paper
James Inc. issues P5,000,000 of commercial paper with a maturity of 3 months at an annual interest rate of 8%.
a. How much is the proceeds? 4,901,960.78
b. How much should James Inc. pay at the end of the 3-month period? 5,000,000

Note:
• The proceeds from the issuance of a commercial paper is its discounted amount.
• In letter (a), the face value is discounted to get the proceeds.
• In letter (b), the amount to be paid by James, Inc. is the Face value of the commercial paper, which is the
return of the proceeds or the usable amount the company got from the issuance of commercial paper and the
interest.