Chapter 16

Chapter 16
Working Capital Policy and Short-Term Financing
CHAPTER 16
WORKING CAPITAL POLICY AND
SHORT-TERM FINANCING
ANSWERS TO QUESTIONS:
1. The need for working capital arises because the normal operating cycle of the firm requires
that expenditures for raw materials, labor, etc. be made prior to receipt of the funds from the sale
of the output. Funds must be invested during the operating cycle in the various short-term assets
that make up working capital--namely, cash, inventories, and accounts receivable.
2. The operating cycle represents the length of time involved in purchasing raw materials,
manufacturing the product, and distributing (selling) the product. The cash conversion cycle
represents the net time interval between the collection of cash receipts from sales and the cash
payments for the various resources used by the firm. The operating cycle is equal to the sum of
the inventory conversion period and the receivables conversion period. The cash conversion
cycle is equal to the operating cycle less the payables deferral period.
3. A relatively large investment in working capital results in lower expected profitability and
lower risk for the firm. The rate of return on current assets is normally less than the rate of
return on fixed assets and hence a relatively large investment in current assets lowers the overall
rate of return on the total assets of the firm. However, a relatively large investment in current
assets also increases the working capital position of the firm and hence lowers the risk of the
firm encountering financial difficulties. Similar reasoning also leads to the conclusion that a
relatively small investment in working capital results in higher expected profitability and higher
risk for the firm.
4. Permanent current assets are held to meet the company's long-term minimum needs (e.g.,
safety stocks of cash and inventories). Fluctuating current assets vary with seasonal or cyclical
changes in the company's sales.
5. The cost of long-term debt can exceed the cost of short-term debt, even when short-term
interest rates are higher than long-term rates, because of the reduced flexibility of long-term debt
compared with short-term debt. When the firm finances its assets with long-term debt it must
incur the interest costs even when it has no immediate need for the funds, such as during a
seasonal or cyclical downturn. In contrast, when the firm uses short-term debt to finance its
assets, it can avoid paying interest costs on unneeded funds by paying off (or not renewing) the
debt.
6. With the matching approach, the maturity structure of the firm's financing instruments is
"matched" (i.e., made to correspond) exactly to the maturity structure of its assets. Fixed and
permanent current assets are financed with long-term debt and equity funds and fluctuating
current assets are financed with short-term debt. The matching approach is difficult to
implement because of the uncertainty associated with the lives of individual assets.
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Chapter 16
7. The use of a relatively high proportion of long-term debt to finance its assets results in lower
expected profitability and lower risk for the firm. The cost of long-term debt is generally greater
than the cost of short-term debt and hence the use of a relatively high proportion of long-term
debt reduces the expected returns available to shareholders. However, a relatively high
proportion of long-term debt also reduces the risk of being unable to refund its short-term debt
and the risk associated with fluctuations in interest rates. Similar reasoning leads to the
conclusion that the use of a relatively high proportion of short-term debt results in higher
expected profitability and higher risk for the firm.
8. The smaller the difference between the costs of long-term and short-term debt, the lower will
be the additional expected returns associated with an aggressive financing plan compared with a
conservative plan. From a risk-return perspective, the aggressive plan would tend not to
generate enough additional expected returns to justify the additional risk. Hence, the
conservative financing plan would tend to become more attractive as the difference between the
costs of long-term and short-term debt decreases.
9. No one working capital investment and financing policy is necessarily optimal for all firms
since the policy that maximizes shareholder wealth is a function of many additional factors.
Some of these factors include the variability in the firm's sales and cash flows and the amount of
operating and financial leverage employed by the firm.
10. a, b. A policy of financing permanent current assets with short-term debt (policy (i)) will
subject the firm to greater risk and produce higher expected returns than a policy of financing
fluctuating current assets with long-term debt (policy (ii)). Policy (i) is an aggressive financial
policy similar to the one shown in Figure 16-5 in the chapter, whereas policy (ii) is a
conservative policy similar to the one shown in Figure 16-4.
11. Collateral protects the lender against default on a loan by the borrower. If the borrower
defaults on the loan or otherwise fails to honor the terms of the loan agreement, the lender can
seize and sell the collateral to recover the amount owed.
12. The annual financing cost is calculated by dividing the interest costs plus any fees by the
amount of usable funds from a short-term financing source; this result is annualized by
multiplying by the factor, 365/number of days. The annual financing cost does not consider
compounding and slightly understates the true annual percentage rate.
13. Spontaneous short-term credit arises in the normal purchasing (trade credit), production
(accrued expenses), and selling (deferred income) activities of the firm. They normally expand
and contract with the size of the firm's operations. Usually there are no explicit interest charges
associated with these forms of credit. Negotiated sources of credit require the firm to formally
apply to a commercial bank or other lending institution for the funds. Their use is normally
limited to firms that have proven cash generating ability (unsecured) or that can offer collateral
as security for the loan (secured). Explicit interest is normally charged on these forms of credit.
14. If the firm forgoes the cash discount (if one is offered) or if it "stretches" the payments
beyond the due date, then trade credit is not a "cost-free" source of funds.
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Chapter 16
15. a. Accrued expenses are liabilities for services rendered to the firm that have not yet been
paid by the firm.
b. Deferred income represents payments received by the firm for goods and services that are
to be delivered at some future date.
c. The prime rate historically was the lowest interest rate that large banks charge on loans
made to their most creditworthy (i.e., "prime") business customers. Recently, large,
very profitable firms have been able to borrow at rates below the prime rate.
d. A compensating balance provision requires the firm to keep a certain percentage of the
loan amount (usually between 5 and 20 percent) in its checking account at the bank.
e. A discounted loan is one in which the bank deducts the interest in advance, so that the
firm does not receive the full amount of the loan.
f. A commitment fee is a fee, usually in the range of 0.25 to 0.50 percent, paid to the bank
by the firm on the unused portion of funds under a revolving credit agreement.
16. A line of credit is an agreement permitting a company to borrow funds up to a

predetermined limit any time during the life of the agreement. While a bank usually feels
morally obligated to honor a line of credit agreement, it can choose not to make loans under the
agreement if the company's financial position has deteriorated or if the bank lacks sufficient
loanable funds to satisfy all its commitments.
A revolving credit agreement is a guaranteed line of credit in that the bank is legally
committed to making loans to the company up to the predetermined credit limit specified in the
agreement. Also, unlike a line of credit agreement, the company is normally required to pay a
commitment fee to the bank on the unused portion of the funds under a revolving credit
agreement. Finally, lines of credit usually are unsecured whereas revolving credit agreements
generally are secured with some form of collateral.
17. The major disadvantages of relying too heavily on commercial paper as a source of funds
are
a. Commercial paper financing is not always a reliable source of funds because the market is
very impersonal and a company faced with temporary financial difficulties may be unable
to sell new issues to replace its maturing issues.
b. The amount of loanable funds in the commercial paper market is limited to the amount of
excess liquidity of the various purchasers of commercial paper and, during periods of
tight money, there may not be enough funds available at reasonable rates to meet the
aggregate needs of corporate issuers of commercial paper.
c. Unlike bank loans that can be repaid prior to maturity, commercial paper usually cannot
be paid off until the issue matures and interest costs must be incurred even if the firm no
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Chapter 16
longer needs the funds.
18. When accounts receivable are pledged, the firm retains title to the receivables and continues
to carry them on its balance sheet. The firm also must assume the risk of default on the pledged
receivables. When accounts receivable are factored, title to the receivables is transferred to the
factor and the receivables no longer appear on the firm's balance sheet. Also, most factoring is
done on a non-recourse basis, meaning that the factor assumes the risk of default on the
receivables purchased.
19. Under a floating lien arrangement the lender receives a general claim on all the inventory of
the borrower. Under a trust receipts arrangement, specific, readily identifiable inventory is used
as collateral and, when the inventory is sold, the borrower is required to forward immediately the
sale proceeds to the lender.
20. The annual financing cost of secured credit is generally higher than that of unsecured credit
because of the added administrative costs (e.g., record keeping) of processing and monitoring the
collateral.
21. A "clean up" provision helps to assure the bank that the line of credit is being used to
finance the firm's temporary seasonal needs for funds and not to finance its permanent capital
requirements.
22. A firm that factors its receivables does not incur credit investigation and collection costs.
Also, if the receivables are factored on a non-recourse basis, the firm does not incur the losses on
uncollected accounts. Finally, the factor may be better able to control bad-debt losses because of
its greater experience in credit evaluation and collection methods.
23. a. A rise in the prime rate will increase the annual financing cost because the interest rate
charged the firm normally is directly related to the prime rate.
b. A lower compensating balance requirement will decrease the annual financing cost
because more usable funds will be available from the loan.
c. An increase in the firm's average bank balance will decrease the annual financing cost
because these funds can be used to offset the compensating balance requirement and more
usable funds will be available from the loan.
24. A firm might find it desirable to borrow funds from a bank or other lending institution in
order to take a cash discount if the interest cost of the loan is less than the cost of forgoing the
cash discount.
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Chapter 16
SOLUTIONS TO PROBLEMS:
1. a. Current Assets = Cash + Marketable Securities
+ Accounts Receivable + Inventories
= $3,810 + $2,700 + $27,480+ $41,295
= $75,285,000.
b. Working Capital Investment = Current Assets - Current

Liabilities
= Current Assets - (Accounts

Payable + Current Portion of LTD
+ Accrued Wages + Accrued Taxes
+ Other Current Liabilities)
= $75,285 - ($14,582 + $3,000

+ $1,200 + $3,600 + $2,200)
= $50,703,000.
c. Current Ratio = Current Assets/Current Liabilities
= ($3,810 + $2,700 + $27,480 + $41,295)/($14,582

+$3,000 + $1,200 + $3,600 + $2,200)
= 3.06
d. Return on Stockholders’ Equity = $10,000/($19,500 + $15,000

+ $30,753) = 15.3%
2.
Alternative Working Capital Investment
and Financing Policies
(millions of dollars)
Aggressive Moderate Conservative
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Chapter 16
Current Assets (C/A) $35 $40 $45

Fixed Assets (F/A) 30 30 30
Total Assets (T/A) $65 $70 $75
Current Liab. (C/L) (STD) $30 (8.5%) $20 (8%) $10 (7.5%)
Long-term Debt (LTD) 9 (10.5%) 22 (10%) 35 (9.5%)
Total Liab. (60% of T/A) $39 $42 $45
Common Equity 26 28 30
Total Liab. & Equity $65 $70 $75
Forecasted Sales $98 $100 $102

Expected EBIT 9.8 10 10.2
Less: Interest STD 2.55 1.6 .75
LTD 0.945 2.2 3.325
3.495 3.8 4.075
Earnings before taxes 6.305 6.2 6.125

Less: Income Taxes (40%) 2.522 2.48 2.45
Earnings After Taxes $ 3.783 $3.72 $3.675
Rate of Return on Common

Equity 14.55% 13.29% 12.25%
3. a. Inventory conversion period = $12 / ($60/365) = 73.0 days
b. Receivables conversion period = $14 / ($100/365) = 51.1 days
c. Operating cycle = 73.0 days + 51.1 days = 124.1 days
d. Payables deferral period = ($10)/[($60)/365] =60.8 days (using equation 16.4) or 54.75
days using the equation in Footnote #4.
e. Cash conversion cycle = 124.1 days – 60.8 days = 63.3 days (or 69.35 days using the
equation in Footnote #4)
f. The cash conversion cycle, 63.3 days (or 69.35 days – see above), is the net time interval
between the collection of cash receipts from product sales and the cash payments for the
company’s various resource purchases.
4. a.
Alternative Working Capital
Investment Policies
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Chapter 16
Current Liab. (C/L) $18 $18 $18

Expected EBIT $5.9 $6.0 $6.1
(i) Rate of Return on
Total Assets 12.29% 12.0% 11.73%
(ii) Net Working Cap.

Position $10 $12 $14
(iii) Current Ratio 1.56 1.67 1.78
b. Expected profitability (rate of return on total assets) and risk (as measured by net working
capital position or current ratio) are lowest under the conservative policy and highest under the
aggressive policy. In other words, the firm that desires to increase its expected returns through
reduced investment in working capital subjects itself to a higher risk of incurring financial
difficulties.
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Chapter 16
5. a.
Alternative Financing Policies

Total Liabilities $25 $25 $25
Equity 40 40 40

Expected EBIT $6.0 $6.0 $6.0
Less: Interest STD 1.32 .90 .54
LTD .085 1.405 .56 1.46 .975 1.515
Earnings before taxes 4.595 4.54 4.485
Earnings After Taxes $2.757 $2.724 $2.691
(i) Rate of Return on Equity 6.89% 6.81% 6.73%

Position $6 $12 $18
b. Expected profitability (rate of return on equity) and risk are lowest

under the conservative policy and highest under the aggressive policy.
In other words, the firm that seeks to increase its expected returns
through the use of a large amount of STD financing subjects itself to a higher risk of
incurring financial difficulties.
6. a. Alternative Working Capital Investment

and Financing Policies
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Chapter 16

Total Liab. (50% of T/A) $48 $50 $52
Common Equity 48 50 52

Expected EBIT $11.8 $12.0 $12.2
Less: Interest STD 3.12 2.16 1.32
LTD 0 3.12 1.26 3.42 2.38 3.70
Taxable Income 8.68 8.58 8.50
Net Income After Taxes $ 5.208 $ 5.148 $ 5.10
(i) Rate of Return on Equity 10.85% 10.30% 9.81%

Position $8 $24 $40
b. Expected profitability and risk are lowest under the conservative
policy and highest under the aggressive policy. Thus, the firm that
seeks to increase its expected shareholder returns through the use of
relatively small amounts of working capital and relatively large
amounts of STD financing, subjects itself to greater risks.
7. a. (millions of dollars)
Total
Equity
(30 + Total Debt
Total Net Net Requirements
Current Assets Add. Add. (Total Assets
Year Quarter Assets Assets (F/A+C/A) to R/E to R/E) -Total Equity)
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Chapter 16
2016 1 $36 $20 $56 $0 $30 $26

2 36 24 60 0 30 30
3 36 30 66 1 31 35
4 36 24 60 1 32 28
2017 1 38 24 62 0 32 30
2 38 28 66 0 32 34
3 38 36 74 1 33 41
4 38 28 66 2 35 31
2018 1 40 28 68 0 35 33
2 40 32 72 0 35 37
3 40 38 78 1 36 42
4 40 30 70 2 38 32
b.
2016 2017 2018
c. i., ii.
Total Debt Short-term Cost of Cost of

Requirements Long-term Debt (Total LTD (.02 STD
Year Quarter (From Part a) Debt Debt - LTD) x LTD) (.015x STD)
2016 1 $26 $26 $0 $ .52 $0.00

2 30 28 2 .56 0.03
3 35 28 7 .56 0.105
4 28 28 0 .56 0.00
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Chapter 16
2017 1 30 30 0 .60 0.00

2 34 31 3 .62 0.045
3 41 31 10 .62 0.15
4 31 31 0 .62 0.00
2018 1 33 32 1 .64 0.015
2 37 32 5 .64 0.075
3 42 32 10 .64 0.15
4 32 32 0 .64 0.00
Total $7.22 $0.57
Total Interest Costs = $7.22 + $0.57 = $7.79 (million)
d. i., ii. (In millions of dollars)
Interest
Excess Earnings on
Total Debt Long- Funds Cost of Excess Funds
Requirement term (LTD-Total LTD (.02 (.010 x Exc.
Year Quarter (From Part a) Debt Debt Req ) x LTD) Funds)
2016 1 $26 $35 $9 $ .70 $.09
2 30 35 5 .70 .05
3 35 35 0 .70 0.00
4 28 35 7 .70 .07
2017 1 30 41 11 .82 .11
2 34 41 7 .82 .07
3 41 41 0 .82 0.00
4 31 41 10 .82 .10
2018 1 33 42 9 .84 .09
2 37 42 5 .84 .05
3 42 42 0 .84 0.00
4 32 42 10 .84 .10
Total $9.44 $0.73
Total Interest Costs = $9.44 - $0.73 = $8.71 (million)
e. i., ii. (In millions of dollars)
Total Debt Short-term Cost of Cost of

Requirements Long-term Debt (Total LTD (.02 STD (.015
Year Quarter (From Part a) Debt Debt - LTD) x LTD) x STD)
2016 1 $26 $13 $13 $.26 $.195

2 30 13 17 .26 .255
3 35 13 22 .26 .330
4 28 13 15 .26 .225
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Chapter 16
2017 1 30 15 15 .30 .225

2 34 15 19 .30 .285
3 41 15 26 .30 .390
4 31 15 16 .30 .240
2018 1 33 16 17 .32 .255
2 37 16 21 .32 .315
3 42 16 26 .32 .390
4 32 16 16 .32 .240
Total $3.52 $3.345

Total Interest Costs = $3.52 + $3.345 = $6.865 (million)
8. a. (In thousands of dollars)

Working Long-term Debt Marketable Securities
Capital (Cost = 1.0%.Mo) (Return = .667%/Mo)
Month Requirements Amt. Cost Amt. Return
Jan 7,500 9,500 95 2,000 13.3333
Feb 6,000 9,500 95 3,500 23.3333
Mar 3,000 9,500 95 6,500 43.3333
Apr 2,500 9,500 95 7,000 46.6666
May 3,500 9,500 95 6,000 40.0200
Jun 4,500 9,500 95 5,000 33.3333
Jul 6,000 9,500 95 3,500 23.3333
Aug 7,500 9,500 95 2,000 13.3333
Sep 8,500 9,500 95 1,000 6.6666
Oct 9,000 9,500 95 500 3.3333
Nov 9,500 9,500 95 0 0
Dec 9,000 9,500 95 500 3.3333
1140 250.0200
Net cost = $1,140 - $250.0200 = $889.98 (or $889,980)
b. (In thousands of dollars)
Working Long-term Debt Short-term Debt

Capital (Cost = 1.0%./Mo) (Cost = 0.833%/Mo)
Month Requirements Amt. Cost Amt. Cost
Jan 7,500 0 0 7,500 62.5000
Feb 6,000 0 0 6,000 50.0000
Mar 3,000 0 0 3,000 25.0000
Apr 2,500 0 0 2,500 20.8333
May 3,500 0 0 3,500 29.1666
Jun 4,500 0 0 4,500 37.5000
Jul 6,000 0 0 6,000 50.0000
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Chapter 16
Aug 7,500 0 0 7,500 62.5000
Sep 8,500 0 0 8,500 70.8333
Oct 9,000 0 0 9,000 75.0000
Nov 9,500 0 0 9,500 79.1666
Dec 9,000 0 0 9,000 75.0000
0 637.5000
Net cost = 0 + $637.50000 = $637.500 (or $637,500)
c. Financing working capital requirements with all short-term debt
(part (b)) results in a lower interest cost than using all long-term
debt (part (a)). However there is a greater risk with the short-term
debt alternative than with the long-term financing method.
9. a.
Policy A Policy B
Current Assets 65% X Sales 40% X Sales
Long-term Debt (LTD) 70% X Tot. Debt 40% X Tot. Debt
Short-term Debt (STD) 30% X Tot. Debt 60% X Tot. Debt
Total Debt 50% X Tot. Assets 50% X Tot. Assets
Equity 50% X Tot. Assets 50% X Tot. Assets
EBIT 15% X Sales 15% X Sales
Inc. Taxes 40% X EBT 40% X EBT
Interest (STD) 12% X STD 12% X STD
Interest (LTD) 15% X LTD 15% X LTD
Forecasted Sales $20,000,000 $20,000,000
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Chapter 16
Fixed Assets $10,000,000 $10,000,000
Current Assets $13,000,000 $ 8,000,000
Total Assets 23,000,000 18,000,000
Total Equity 11,500,000 9,000,000
Total Debt 11,500,000 9,000,000
Short-term Debt 3,450,000 5,400,000
Long-term Debt 8,050,000 3,600,000
EBIT 3,000,000 3,000,000

Interest STD 414,000 1,621,500 648,000 1,188,000
LTD 1,207,500 540,000
EBT (EBIT-Interest) 1,378,500 1,812,000
Taxes 551,400 724,800
EAT $ 827,100 $1,087,200
Rate of Return (EAT/

Tot. Equity) 7.19% 12.08%
Net Working Capital

(Cur. Assets - STD) $9,550,000 $2,600,000
Current Ratio
(Cur. Assets/STD) 3.77 1.48
b. Policy B is riskier than Policy A. Although both policies use the
same proportion of total debt (50%) to finance the company's
assets, Policy B uses a much higher proportion of short-term debt.
Likewise Policy B holds a much smaller proportion of the company's
total assets in the form of current assets. The result is less net
working capital and a lower current ratio under Policy B than under
Policy A.
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Chapter 16
10. a. Inventory conversion period = $800 / ($1,500/365) = 194.7 days
Receivables conversion period = $1,300 / ($6,500/365) = 73.0 days
Operating cycle = 194.7 days + 73.0 days = 267.7 days
Payables deferral period = ($900 + $300)/[($1,500

+ $2,500)/365]
= 109.5 days
Cash conversion cycle = 267.7 days -109.5 days =158.2 days
(Note: This solution uses the equation in Footnote #4)
b. The cash conversion cycle, 158.2 days, is the net time interval between the collection of
cash receipts from product sales and the cash payments for the company’s various resource
purchases.
11. a.
Policy A Policy B
Current assets $15,000,000 $12,000,000
Total assets 45,000,000 42,000,000
Total equity 22,500,000 21,000,000
Total debt 22,500,000 21,000,000
Short-term debt 9,000,000 10,500,000
Long-term debt 13,500,000 10,500,000
EBIT $7,500,000 $7,500,000

Interest
STD (9%) $810,000 $945,000
LTD (12%) 1,620,000 1,260,000
$2,430,000 $2,205,000
EBT $5,070,000 $5,295,000
Taxes (@ 40%) 2,028,000 2,118,000
EAT $3,042,000 $3,177,000
Return on equity 13.5% 15.1%
b. Net working capital $6,000,000 $1,500,000

Current ratio 1.67 1.14
Policy B is riskier than Policy A. Although both policies use the same proportion (50%) of total
16-15
Chapter 16
debt to finance the company’s assets, Policy B uses a higher proportion of short-term debt.
Likewise, Policy B holds a smaller proportion of the company’s assets in the form of current
assets. The result is less net working capital and a lower current ratio under Policy B than under
Policy A.
12. a. Inventory conversion period = $1,827 / ($9,890/365) = 67.4 days
Receivables conversion period = $1,138 / ($13,644/365) = 30.4 days
Payables deferral period = ($1,166 + $536)/[($9,890

+ $2,264)/365]
= 51.1 days
Cash conversion cycle = 97.8 days - 51.1 days = 46.7 days
b. Receivables conversion period = $1,138/[($13,644)(0.75)/365)]

= 40.6 days
Operating cycle = 67.4 days + 40.6 days = 108 days
c. Receivables conversion period = $1,138/[($13,644)(0.50)/365)]

= 60.9 days
(Note: This solution uses the equation in Footnote #4)
13. a. Current trade credit (Accounts payable) = Average purchases per
day x Credit period
=$22,000/day x 30 days
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Chapter 16
= $660,000
b. Trade credit (Next year) = $25,000/day x 40 days = $1,000,000
Additional trade credit = $1,000,000 - $660,000 = $340,000
14. a. AFC = ($6,000/$100,000) x (365/182) = 12.03%
b. APR = [ 1 + ($6,000/$100,000)]365/182 - 1 = 12.40%
c. The AFC does not consider compounding effects.
15. a. Annual financing cost = [Percent discount/(100 - Percent discount)] x
365/(Credit period - Discount period)] = (2/98) x (365/50)
= 14.90%
b. Annual financing cost = (1.5/98.5) x (365/50) = 11.12%
c. Annual financing cost = (2/98) x (365/30) = 24.83%
d. Annual financing cost = (5/95) x (365/92) = 20.88%
e. Annual financing cost = (1/99) x (365/20) = 18.43%
16. a. APR = [ 1 + (2/98)]365/50 - 1 = 15.89%
b. APR = [ 1 + (2/98)]365/20 - 1 = 44.59%
17. Annual financing cost = (1/99) x (365/40) = 9.22%
18. Annual interest costs = $10,000 x .095 = $950
Amount of funds received (usable funds) = 10,000 - 950 = $9,050
AFC= ($950/$9050) x (365/365) x 100 = 10.50%
19.
Interest costs = $100,000 x 0.08 = $8,000 (assuming a 365 day
borrowing period)
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Chapter 16
a. Additional compensating balance = $100,000 x .15 - $7,000
= $8,000
Usable funds = $100,000 - $8,000 = $92,000
Annual financing cost = ($8,000/$92,000) x (365/365) x 100 = 8.70%
b. Additional compensating balance = $100,000 x .15 = $15,000
Usable funds = $100,000 - $15,000 = $85,000
Annual financing cost = ($8,000/$85,000) x (365/365) x 100 = 9.41%
20. Interest costs = $20,000 x 0.10 x 182/365 = $997.26
Usable funds = $20,000 - $997 = $19,003
AFC = ($997/$19,003) x (365/182) x 100 = 10.52%
21.
Assume a 365-day borrowing period
a. Annual financing cost = (Interest costs + Commitment fee)/
(Usable funds) x (365/number of days) x 100
Interest costs = $250,000 x .09 = $22,500
Commitment fee = ($1,000,000 - $250,000) x .005 = $3,750
Usable funds = $250,000 x (1 - .10) = $225,000

Annual financing cost = [($22,500+$3,750)/$225,000]x(365/365) x100
= 11.67%
b. Interest costs = $500,000 x 0.09 = $45,000
Commitment fee = ($1,000,000 - $500,000) x 0.005 = $2,500
Usable funds = $500,000 x (1 - 0.10) = $450,000
Annual financing cost = [($45,000+$2,500)/$450,000] x (365/365) x 100
= 10.56%
c. Interest costs = $1,000,000 x 0.09 = $90,000
Commitment fee = ($1,000,000 - $1,000,000) x 0.005 = $0
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Chapter 16
Usable funds = $1,000,000 x (1 - 0.10) = $900,000
Annual financing cost = ($90,000/$900,000) x (365/365) x 100
= 10.00%
22. Annual financing cost = [(Interest costs + Placement fee)/(Usable
funds)] x (365/number of days) x 100
Interest costs = $5,000,000 x (0.085) x (182/365) = $211,918
Placement fee = $8,000
Usable funds = Amount of C.P. issue - Interest - Placement fee

= $5,000,000 - $211,918 - $8,000 = $4,780,082
Annual financing cost = [($211,918+$8,000)/$4,780,082] x (365/182)
x 100 = 9.23%
23. Annual financing cost = [(Interest costs + Fees)/(Usable funds)]
x (365/number of days) x 100
A: Interest cost = $8,000,000 x 0.085 x (90/365) = $167,671
Usable funds = $8,000,000 - $167,671 - $12,000 = $7,820,329
AFC = [($167,671 + $12,000)/$7,820,329] x (365/90) x 100
= 9.32%
B: Interest cost = $10,000,000 x 0.0875 x (120/365) = $287,671
Usable funds = $10,000,000 - $287,671 - $15,000 = $9,697,329
AFC = [($287,671 + $15,000)/$9,697,329] x (365/120) x 100
= 9.49%
Therefore, choose dealer A.
24. Usable funds (pledged receivables) = 0.75 x $5,000,000 = $3,750,000
Interest costs = $3,750,000 x 0.135 x (50/365) = $69,349
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Chapter 16
Service fee = $5,000,000 x 0.01 = $50,000
AFC = [($69,349 + $50,000) / $3,750,000] x (365/50) = 23.23%
25. Calculation of usable funds:
Average level of receivables $2,500,000
Less: Factoring commission
(0.025 x $2,500,000) -62,500
Less: Reserve for returns

(0.10 x $2,500,000) -250,000
Equals: Amount of advance before deducting
interest $2,187,500
Less: Interest on advance
[0.12 x $2,187,500 x (60/365)] 43,151
Equals: Usable funds (amount advanced by factor) $2,144,349
a. AFC (before cost savings and bad-debt loss savings):
= [ ($43,151 + $62,500)/$2,144,349] x (365/60) x 100
= 29.97%
b. Average bad-debt losses per 60-day period $30,000
Credit department savings, per 60 day period 8,000
$38,000
AFC (after cost savings and bad-debt loss savings):
= [ ($43,151 + $62,500 - $38,000)/$2,144,349]
x (365/60) x 100 = 19.19%
16-20
Chapter 16
26. Pay- Balance Amount Lost Stretching

Month Purchases ments Due Past-due Discount Penalties
1 $100,000 $0 $100,000 $0 $2,000* --

2 100,000 0 200,000 100,000 2,000 $1,500
3† 100,000 50,000 250,000 150,000 2,000 2,250**
4 100,000 100,000 250,000 150,000 2,000 2,250
5 100,000 100,000 250,000 150,000 2,000 2,250
6 100,000 100,000 250,000 150,000 2,000 2,250
. . . . . . .
. . . . . . .
. . . . . .
a. *Cash discounts lost per month = .02 x $100,000 = $2,000
Cash discounts lost per year = 12 x $2,000 = $24,000
b. **Stretching penalties per month = $150,000 x .015 = $2,250
Stretching penalties per year = 12 x $2,250 = $27,000
c. Annual financing cost =
[(Lost discounts + Stretching penalties)/
Funds raised from stretching A/P] x (365/# of days) x 100 =
[($24,000 + $27,000)/($250,000)]x(365/365) x (100) = 20.4%

†
Note: The $250,000 in needed funds (i.e., equilibrium) is not obtained from
stretching payables until the third month.
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Chapter 16
27. Alternative (c) is preferred since it offers the greatest discount (2%) and the longest deferral
period in those cases where the discount is not taken.
28. a. Field warehousing fee $16,000
Interest cost (0.10 x $300,000) 30,000
Interest cost + fee $46,000

Annual financing cost =
[(Interest cost + fees)/Usable funds] x (365/# of days) x 100
= ($46,000/$300,000) x (365/365) x 100 = 15.3%
b. Field warehousing fee $16,000
Interest cost (0.10 x $250,000) 25,000
Interest cost + fee $41,000
Annual financing cost =
($41,000/$250,000) x (365/365) x 100 = 16.4%
29. Pay- Balance Amount Lost Stretching

Month Purchases ments Due Past-due Discount Penalties
1 $125,000 $0 $125,000 $0 $3,750* --
2 125,000 0 250,000 125,000 3,750 $1,250
3† 125,000 75,000 300,000 175,000 3,750 1,750**
4 125,000 125,000 300,000 175,000 3,750 1,750
a. *Cash discounts lost per month = .03 x 125,000 = $3,750
Cash discounts lost per year = 12 x 3,750 = $45,000
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Chapter 16
b. **Stretching penalties per month = 175,000 x .01 = $1,750
Stretching penalties per year = 12 x 1,750 = $21,000
c. Annual financing cost =
[(Lost discounts + Stretching penalties)/
Funds raised from stretching A/P] x (365/# of days) x 100 =
[($45,000 + $21,000)/($300,000)] x (365/365) x (100) = 22%
† Note: The $300,000 in needed funds (i.e., equilibrium) is not
obtained from stretching payables until the third month.
30. a. Interest costs = $1,500,000 x 0.105 = $157,500
Additional compensating balance = $1,500,000 x 0.10 - $100,000
= $50,000
Usable funds = $1,500,000 - $50,000 = $1,450,000
Annual financing cost = ($157,500/$1,450,000) x (365/365) x 100
= 10.86%
b. Additional compensating balance = $1,500,000 x 0.10 = $150,000
Usable funds = $1,500,000 - $150,000 = $1,350,000
Annual financing cost = ($157,500/$1,350,000) x (365/365) x 100

= 11.67%
31. a. Annual financing cost = [(Interest costs + Commitment fee)/(Usable funds)] x
(365/number of days) x 100
Interest costs = $1,000,000 x 0.10 = $100,000
Commitment fee = ($5,000,000 - $1,000,000) x 0.004 = $16,000
Usable funds = $1,000,000 x (1 - 0.10) = $900,000
Annual financing cost = [($100,000 + $16,000)/$900,000]
x (365/365) x 100
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Chapter 16
= 12.89%
b. Interest costs = $4,000,000 x 0.10 = $400,000
Commitment fee = ($5,000,000 - $4,000,000) x 0.004 = $4,000
Usable funds = $4,000,000 x (1 - 0.10) = $3,600,000
Annual financing cost = [($400,000 + $4,000)/$3,600,00 x (365/365) x 100 =
11.22%
32. Usable funds = 0.8 x $2,000,000 = $1,600,000
Interest costs = $1,600,000 x 0.12 x (45/365) = $23,671
Service fee = $2,000,000 x 0.015 = $30,000
Annual financing cost = [($23,671+ $30,000)/$1,600,000] x 365/45 x 100
= 27.21%
16-24
Chapter 16
33. Calculation of usable funds:
Average level of receivables $1,500,000
Less: Factoring commission
(0.02 x $1,500,000) -30,000
Less: Reserve for returns
(0.10 x $1,500,000) -150,000
Amount of advance before deducting

interest $1,320,000
Less: Interest on advance
[0.12 x $1,320,000 x (45/365)] -19,529
Usable funds $1,300,471
Calculation of net factoring cost:
Interest costs $19,529
Factoring commission or fee 30,000
Interest costs and fees per 45 days $49,529
Less: Credit department savings per 45 days

[$4,000 x (45/30)] -$6,000
Less: Average bad debt losses per 45 days
[$8,000 x (45/30)] -$12,000
Net factoring cost per 45 days $31,529
Annual financing cost
($31,529/$1,300,471)(365/45) x 100 19.66%
16-25
Chapter 16
34. a. Field warehousing fee $35,000
Interest cost (0.12 x $750,000) 90,000
Total fees and interest $125,000
Annual financing cost = [(Fees + Interest cost)/Usable funds] x
(365/number of days) x 100
= ($125,000/$750,000)x(365/365) x 100
= 16.67%
b. Field warehousing fee $35,000
Interest cost (0.12 x $500,000) 60,000
Total fees and interest $95,000
Annual financing cost = ($95,000/$500,000) x (365/365) x 100
= 19.0%
16-26
Chapter 16
SOLUTION TO INTEGRATIVE CASE PROBLEM:

WORKING CAPITAL MANAGEMENT
1. Current cash balance (Dec. 31, 2015) = $3,690,000
Minimum required cash balance = -3,000,000
Funds released for investment in F/A = $ 690,000
2. Current A/R investment (Dec. 31, 2015) = $15,000,000
Industry average collection period = 58.803 days
Reduced A/R investment = Average daily sales x Industry average
collection period
= ($75,000,000/365) x 58.803 = $12,082,808
Funds released for investment in F/A = Current A/R investment
- Reduced A/R investment
= $15,000,000 - $12,082,808
= $2,917,192
3. Current inventory investment (Dec. 31, 2015) = $20,250,000
Inventory turnover ratio (industry average) = 3.5
Reduced inventory investment = Cost of goods sold/Inventory
turnover ratio
= $60,750,000/3.5 = $17,357,143
16-27
Chapter 16
Funds released for investment in F/A = Current inventory investment
- Reduced inventory investment
= $20,250,000 - $17,357,143 = $2,892,857
4. Current A/P balance (Dec. 31, 2015) = $3,000,000
No. of days A/P outstanding = 30 + 10 = 40 days
Increased A/P balance = Average daily purchases x No. of days A/P
outstanding = ($3,000,000/30) x 40
= $4,000,000
Additional funds for investment in F/A = Increased A/P balance
- Current A/P balance
= $4,000,000 - $3,000,000
= $1,000,000
5. Pro forma Balance Sheet Year Ending 12/31/16
($000) (%)
Assets
Cash $ 3,000 5.2%
Receivables, net 12,083 20.8
Inventories 17,357 29.9
Total current assets $32,440 55.9%
Net fixed assets 25,560 44.1%
Total assets $58,000 100.0%
16-28
Chapter 16
Liabilities & Stockholders' Equity
Accounts payable $ 4,000 6.9%
Notes payable (8%) 3,750 6.5
Total current liabilities $ 7,750 13.4%
Long-term debt 18,000 31.0
Stockholders' equity 32,250 55.6
Total liabilities & S.E. $58,000 100.0%
6. Pro forma Income Statement Year Ending 12/31/16
($000) (%)
Net sales $87,000 100.0%
Cost of sales (.81 x 87,000) 70,470 81.0
Gross profit $16,530 19.0
Selling & adm. exp. (.10 x 87,000) 8,700 10.0
Earnings before interest & tax $ 7,830 9.0
Interest expense 2,100 2.4

Earnings before taxes $ 5,730 6.6
Income taxes (45.16%) 2,588 3.0
Earnings after taxes $ 3,142 3.6%
16-29
Chapter 16
7. Current ratio = Current assets/Current liabilities
= $32,440,000/$7,750,000 = 4.19
Quick ratio = (Cash + receivables)/Current liabilities
= ($3,000,000 +$12,083,000)/$7,750,000 = 1.95
Times interest earned = EBIT/Interest =$7,830,000/$2,100,000= 3.73
Rate of return on equity = (EAT/Stockholders' Equity) x 100%
= ($3,142,000/$32,250,000) x 100% = 9.74%
Industry
Actual 2015 Forecasted 2016 Average
Current ratio 5.76 4.19 3.5
Quick ratio 2.77 1.95 1.6
Times interest earned 3.2 3.73 4.7
Rate of return on equity 7.9 % 9.74% 7.9%
The firm's current and quick ratios would decline substantially if short term sources of funds are
used to finance the plant expansion. However, both ratios would still be well above the industry
average. The times interest earned ratio would improve; however, it would still be below the
industry average. Anderson's forecasted rate of return on equity would increase substantially as
a result of the expansion and would be well above the industry average.
8. The attitudes toward risk of Anderson and White may lead them to disagree about the
desirability of the proposed financing plan. With a sizable personal investment in the firm, Mr.
Anderson's primary concern may be to protect his investment from losses. He will tend to favor
policies that minimize the risk of the firm encountering financial difficulties. Historically, the
firm has followed this approach with its relatively large (compared with the industry average)
investment in working capital and its high current and quick ratios. Hence, Anderson may
consider the use of short-term sources of funds (and the subsequent reduction in working capital)
to finance long-term assets to be unacceptable, even though it is expected to lead to a substantial
increase in the firm's profitability. White, on the other hand, may be less concerned about
minimizing risk because she presumably does not have a large personal investment in the firm.
She may feel that the additional risk to the firm of this financing plan is minimal, particularly in
view of the fact that the firm's current and quick ratios would still be above the industry
16-30
Chapter 16
averages. Being less concerned about risk, White may feel that the additional profits far
outweigh any additional risk that the firm might incur in financing the plant expansion.
9. Other possible sources of financing include receivable loans (pledging or factoring) and
inventory loans.
16-31

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Working Capital Policy and Short-Term Financing

16. A line of credit is an agreement permitting a company to borrow funds up to a

= $3,810 + $2,700 + $27,480+ $41,295

b. Working Capital Investment = Current Assets - Current

= Current Assets - (Accounts

= $75,285 - ($14,582 + $3,000

c. Current Ratio = Current Assets/Current Liabilities

= ($3,810 + $2,700 + $27,480 + $41,295)/($14,582

d. Return on Stockholders’ Equity = $10,000/($19,500 + $15,000

Aggressive Moderate Conservative

Current Assets (C/A) $35 $40 $45

Forecasted Sales $98 $100 $102

Earnings before taxes 6.305 6.2 6.125

Rate of Return on Common

3. a. Inventory conversion period = $12 / ($60/365) = 73.0 days

b. Receivables conversion period = $14 / ($100/365) = 51.1 days

c. Operating cycle = 73.0 days + 51.1 days = 124.1 days

Aggressive Moderate Conservative

Current Assets (C/A) $28 $30 $32

Current Liab. (C/L) $18 $18 $18

Forecasted Sales $59 $60 $61

(ii) Net Working Cap.

(iii) Current Ratio 1.56 1.67 1.78

Aggressive Moderate Conservative

Current Assets (C/A) $30 $30 $30

Forecasted Sales $60 $60 $60

(i) Rate of Return on Equity 6.89% 6.81% 6.73%

(ii) Net Working Cap.

(iii) Current Ratio 1.25 1.67 2.50

b. Expected profitability (rate of return on equity) and risk are lowest

incurring financial difficulties.

6. a. Alternative Working Capital Investment

Aggressive Moderate Conservative

Current Assets (C/A) $56 $60 $64

Forecasted Sales $118 $120 $122

(i) Rate of Return on Equity 10.85% 10.30% 9.81%

(ii) Net Working Cap.

(iii) Current Ratio 1.17 1.67 2.67

b. Expected profitability and risk are lowest under the conservative

seeks to increase its expected shareholder returns through the use of

relatively small amounts of working capital and relatively large

amounts of STD financing, subjects itself to greater risks.

2016 1 $36 $20 $56 $0 $30 $26

2016 2017 2018

Total Debt Short-term Cost of Cost of

2016 1 $26 $26 $0 $ .52 $0.00

2017 1 30 30 0 .60 0.00

e. i., ii. (In millions of dollars)

Total Debt Short-term Cost of Cost of

2016 1 $26 $13 $13 $.26 $.195

2017 1 30 15 15 .30 .225

Total $3.52 $3.345

8. a. (In thousands of dollars)

Net cost = $1,140 - $250.0200 = $889.98 (or $889,980)

b. (In thousands of dollars)

Working Long-term Debt Short-term Debt

Net cost = 0 + $637.50000 = $637.500 (or $637,500)

c. Financing working capital requirements with all short-term debt

debt alternative than with the long-term financing method.