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Chapter 15:Curent Liabilities Management

1. Principles of Managerial Finance Solution Lawrence J. Gitman Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui393 CHAPTER 15 Curent…
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  • 1. Principles of Managerial Finance Solution Lawrence J. Gitman Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui393 CHAPTER 15 Curent Liabilities Management Instructor’s RESOURCES Overview This chapter introduces the fundamentals and describes the interrelationship of net working capital, profitability, and risk in managing the firm's current liability accounts. The management of current liabilities requires choosing appropriate levels of financing and involves trade-offs between risk and profitability. This chapter also reviews sources of secured and unsecured short-term financing, including the role of international loans. Spontaneous sources, such as accounts payable and accruals, are differentiated from negotiated bank sources, such as lines of credit. The cash discount offered on accounts payable and the costs of forgoing the discount are described. Secured sources include bank and commercial finance company loans backed by collateral such as inventory or accounts receivable. PMF DISK This chapter's topics are not covered on the PMF Tutor or the PMF Problem-Solver. PMF Templates The following spreadsheet template is provided: Problem Topic 15-8 Cost of bank loan
  • 2. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui394 Study Guide The following Study Guide examples are suggested for classroom presentation: Example Topic 1 Loss of loan discounts 4 Accounts receivable as collateral
  • 3. Chapter 15 Current Liabilities Management Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui395 ANSWERS TO REVIEW QUESTIONS 15-1 The two key sources of spontaneous short-term financing (financing that arises from the normal operating cycle) are accounts payable and accruals. Both of these sources are spontaneous, since their levels increase and decrease directly with increases or decreases in sales. If sales increase, the firm will purchase more new materials, resulting in higher accruals of these items. 15-2 There is no cost⎯stated or unstated⎯associated with taking a cash discount; there is a cost of giving up a cash discount. By giving up a cash discount, the purchaser pays the full price for merchandise but can make the payment later. The unstated cost of giving up a cash discount is the implied rate of interest paid to delay payments. This rate can be used to make decisions with respect to whether or not the discount should be taken. If the cost of giving up the cash discount is greater than the cost of borrowing short-term funds, the firm should take the discount. Cash discounts can be a source of additional profitability for a firm. However, some firms, either due to lack of alternative funding sources or ignorance of the true cost, do not take advantage of these discounts. 15-3 Stretching accounts payable is the process of delaying the payment of accounts payable for as long as possible without damaging the firm’s credit rating. Stretching payments reduces the implicit cost of giving up a cash discount. 15-4 The prime rate of interest, which is the lowest rate charged on business loans to the best business borrowers, is usually used by the lender as a base rate to which a premium is added by the lender, depending upon the risk of the borrower, in order to determine the rate charged. A floating-rate loan has its interest tied to the prime rate. The rate of interest is established at an increment above the prime rate and floats at that increment above prime over the term of the note. 15-5 The effective interest rate is the actual rate of interest paid for the period. The calculation of this rate depends on whether interest is paid at maturity or in advance (deducted from the loan so that the borrower receives less than the requested amount). When interest is paid at maturity, the effective interest rate is equal to: borrowedAmount Interest The effective interest rate when interest is paid in advance–a discount loan–is calculated as follows: Interest-borrowedAmount Interest Paying interest in advance raises the effective rate above the stated rate. 15-6 A single-payment note is an unsecured loan from a commercial bank. It usually has a short maturity⎯30 to 90 days⎯and the interest rate is normally tied in some way to the prime rate of interest. The interest rate on these notes may be fixed or floating. The effective annual interest rate when the note is rolled over throughout the year on the same terms is calculated on a compound basis as follows, using Equation 5.10: 1 m k 1k m eff −⎟ ⎠ ⎞ ⎜ ⎝ ⎛ += 15-7 A line of credit is an agreement between a commercial bank and a business that states the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.
  • 4. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui396 a. In a line of credit agreement, a bank may retain the right to revoke the line if any major changes occur in the firm's financial condition or operations. b. To ensure that the borrower will be a good customer, frequently a line of credit will require the borrower to maintain compensating balances in a demand deposit. In some cases, fees in lieu of balances may be negotiated. c. To ensure that money lent under the credit agreement is actually being used to finance seasonal needs, banks require that the borrower have a zero loan balance for a certain number of days per year. This is called the annual cleanup period. 15-8 A revolving credit agreement is a guaranteed line of credit. Under a line of credit agreement, a firm is not guaranteed that the bank will have funds available to lend upon demand, while under the more formal revolving credit agreement the availability of funds is guaranteed. Since the lender under the revolving credit agreement guarantees the availability of funds, the borrower must pay a commitment fee, a fee levied against the average unused portion of the line. 15-9 Commercial paper (CP), which is a short-term, unsecured promissory note, can be sold by large, creditworthy firms in order to raise funds. Commercial paper is merely the IOU of a financially sound firm. The maturity of commercial paper is generally between 3 to 270 days and is normally issued in multiples of $100,000 or more. The interest rate on CP is usually 1 to 2 percent below the prime rate and is a less costly source of short-term funds than bank loans. Commercial paper is purchased by corporations, life insurance companies, pension funds, banks, and other financial institutions and investors. Commercial paper may be sold directly by the issuing firm to a purchaser or may be sold through a middleman known as a commercial paper house, which charges a fee to the issuer for its marketing efforts. 15-10 International transactions differ from domestic ones because they involve payments made or received in a foreign currency. This results in additional foreign costs and also exposes the company to foreign exchange risk. A letter of credit is a letter written by a company's bank to a foreign supplier that effectively guarantees payment of an invoiced amount, assuming that all the specified terms are met. "Netting" occurs when a company's subsidiaries or divisions located in different countries have transactions that result in intracompany receivables and payables. Rather than pay the gross amount of both the receivables and payables, paying the net amount due⎯which is lower⎯allows the parent to reduce foreign exchange fees and other transaction costs. 15-11 Lenders view secured and unsecured short-term loans as having the same degree of risk. The benefit of the collateral for a secured loan is only beneficial if the firm goes into bankruptcy. The risk associated with going bankrupt and defaulting on and loan does not change due to be secured or unsecured. 15-12 The interest rate charged on secured short-term loans is typically higher than the interest rate on unsecured short-term loans. Typically, companies that require secured loans may not qualify for unsecured debt, and they are perceived as higher-risk borrowers by lenders. The presence of collateral does not change the risk of default; it provides a means to reduce losses if the borrower defaults. In general, lenders require security for less creditworthy, higher-risk borrowers. Since the negotiation and administration of these loans is more troublesome for the lender, the lender normally requires certain fees to be paid by the secured borrower. The higher rates on these secured short-term loans are attributable to the greater risk of default and the increased loan administration costs of these loans over the unsecured short-term loan.
  • 5. Chapter 15 Current Liabilities Management Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui397 15-13 a. A pledge of accounts receivable is the use of a firm's receivables to secure a short-term loan. The lender evaluates the quality of the accounts receivable, selects acceptable accounts, and files a lien on the collateral. After the selection of accounts, the lender determines the percentage advanced against receivables. Typically ranging from 50 to 90 percent of the face value of the acceptable receivables, this amount becomes the principal on the loan. Pledging receivables usually costs 2 to 5 percent above the prime rate due to the nature of the borrower and additional administrative costs. Commercial banks offer this type of financing. b. Factoring accounts receivable is the outright sale to the factor or other financial institution. The factor sets the conditions of the sale in a factoring agreement. Normally factoring is done on a nonrecourse basis (the factor accepts all credit risks), and the customer is usually notified that the account receivable has been sold. Factoring can typically cost from 3 to 7 percent above the prime rate, including commissions and interest. This type of financing is handled by specialized financial institutions called factors; some commercial banks and commercial finance companies factor receivables. While the cost is high, the advantages include immediate conversion of receivables into cash and also the known pattern of cash flows. 15-14 a. Floating inventory liens are made by lenders and secured by a claim on general inventory consisting of a diversified and low cost group of merchandise. Generally less than 50 percent of the book value of the average inventory is advanced. The interest charge on a floating lien is typically 3 to 5 percent above the prime rate. b. Trust receipt inventory loans are often made by manufacturers' financing subsidiaries to their customers. Under this arrangement, merchandise is typically expensive (automotive, industrial and consumer-durable equipment, for example) and remains in the hands of the borrower. The lender advances 80 to 100% of the cost of the salable inventory. The borrower is free to sell the merchandise and is trusted to remit the loan amount plus accrued interest to the lender immediately. The interest charge is generally 2 percent or more above the prime rate. c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged collateral. The inventory may be retained by the borrower in the firm's warehouse with security administered by a field warehousing company. Or the inventory may be stored in a terminal warehouse located in the geographic vicinity of the borrower. Generally, less than 75 to 90 percent of the collateral's value is advanced to the borrower at an interest rate from 4 to 8 percent above the prime rate.
  • 6. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui398 SOLUTIONS TO PROBLEMS 15-1 LG 1: Payment Dates a. December 25 b. December 30 c. January 9 d. January 30 15-2 LG 1: Cost of Giving Up Cash Discount a. (.02 ÷ .98) x (360 ÷ 20) = 36.73% b. (.01 ÷ .99) x (360 ÷ 20) = 18.18% c. (.02 ÷ .98) x (360 ÷ 35) = 20.99% d. (.03 ÷ .97) x (360 ÷ 35) = 31.81% e. (.01 ÷ .99) x (360 ÷ 50) = 7.27% f. (.03 ÷ .97) x (360 ÷ 20) = 55.67% g. (.04 ÷ .96) x (360 ÷ 170) = 8.82% 15-3 LG 1: Credit Terms a. 1/15 net 45 date of invoice 2/10 net 30 EOM 2/7 net 28 date of invoice 1/10 net 60 EOM b. 45 days 50 days 28 days 80 days c. N 360 CD-100% CD discountcashupgivingofCost ×= %12.121212.120101.discountcashupgivingofCost 30 360 1%-100% 1% discountcashupgivingofCost ==×= ×= %72.361836.180204.discountcashupgivingofCost 20 360 2%-100% 2% discountcashupgivingofCost ==×= ×= %97.343497.14.170204.discountcashupgivingofCost 21 360 2%-100% 2% discountcashupgivingofCost ==×= ×= %69.141049.2.70204.discountcashupgivingofCost 50 360 1%-100% 1% discountcashupgivingofCost ==×= ×= d. In all four cases the firm would be better off to borrow the funds and take the discount. The annual cost of not taking the discount is greater than the firm's 8% cost of capital. 15-4 LG 1: Cash Discount versus Loan
  • 7. Chapter 15 Current Liabilities Management Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui399 Cost of giving up cash discount = (.03 ÷ .97) x (360 ÷ 35) = 31.81% Since the cost of giving up the discount is higher than the cost of borrowing for a short-term loan, Erica is correct; her boss is incorrect. 15-5 LG 1, 2: Cash Discount Decisions a. Supplier Cost of Forgoing Discount b. Decision J (.01 ÷ .99) x (360 ÷ 20) = 18.18% Borrow K (.02 ÷ .98) x (360 ÷ 60) = 12.24% Give up L (.01 ÷ .99) x (360 ÷ 40) = 9.09% Give up M (.03 ÷ .97) x (360 ÷ 45) = 24.74% Borrow Prairie would have lower financing costs by giving up Ks and Ls discount since the cost of forgoing the discount is lower than the 16% cost of borrowing. c. Cost of giving up discount from Supplier M = (.03 ÷ .97) x (360 ÷ 75) = 14.85% In this case the firm should give up the discount and pay at the end of the extended period. 15-6 LG 2: Changing Payment Cycle Annual Savings = ($10,000,000) x (.13) = $1,300,000 15-7 LG 2: Spontaneous Sources of Funds, Accruals Annual savings = $750,000 x .11 = $82,500 15-8 LG 3: Cost of Bank Loan a. Interest = ($10,000 x .15) x (90 ÷ 360) = $375 b. %75.3 $10,000 $375 =rateday90Effective = c. Effective annual rate = (1 + 0.0375)4 - 1 = 15.87% 15-9 LG 3: Effective Annual Rate of Interest ( )[ ] %29.14 .20-.10-1$10,000 .10$10,000 =interestEffective = × × 15-10 LG 3: Compensating Balances and Effective Annual Rates a. Compensating balance requirement = $800,000 borrowed x 15% = $120,000
  • 8. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui400 Amount of loan available for use = $800,000 - $120,000 = $680,000 Interest paid = $800,000 x 11 % = $ 88,000 Effective interest rate = = $88, $680, . 000 000 12 94% b. Additional balances required = $120,000 - $70,000 = $ 50,000 Effective interest rate = − = $88, $800, $50, . 000 000 000 1173% c. Effective interest rate = 11% (None of the $800,000 borrowed is required to satisfy the compensating balance requirement.) d. The lowest effective interest rate occurs in situation c, when Lincoln has $150,000 on deposit. In situations a and b, the need to use a portion of the loan proceeds for compensating balances raises the borrowing cost. 15-11 LG 4: Compensating Balance vs. Discount Loan a. %0.10 000,135$ 500,13$ .10)($150,000-$150,000 .09$150,000 interestBankState == × × = This calculation assumes that Weathers does not maintain any normal account balances at State Bank. %89.9 500,136$ 500,13$ .09)($150,000-$150,000 .09$150,000 interestFinanceFrost == × × = b. If Weathers became a regular customer of State Bank and kept its normal deposits at the bank, then the additional deposit required for the compensating balance would be reduced and the cost would be lowered. 15-12 LG 5: Integrative–Comparison of Loan Terms a. (.08 + .033) ÷ .80 = 14.125% b. Effective annual interest rate = [ ] %125.14 .80)0($2,000,00 )$2,000,000(.005+.028)+(.08$2,000,000 = × ×× c. The revolving credit account seems better, since the cost of the two arrangements is the same; with a revolving loan arrangement, the loan is committed.
  • 9. Chapter 15 Current Liabilities Management Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui401 15-13 LG 4: Cost of Commercial Paper a. 2.25%= $978,000 $978,000-$1,000,000 =rateday-90Effective Effective annual rate = ( 1 + .0225)4 – 1 = 9.31% b. [ ] %26.3 $9,612)-($978,000 $9,612+$978,000-$1,000,000 =rateday-90Effective = Effective annual rate = ( 1 + .0326)4 – 1 = 13.69% 15-14 LG 5: Accounts Receivable as Collateral a. Acceptable Accounts Receivable Customer Amount D $ 8,000 E 50,000 F 12,000 H 46,000 J 22,000 K 62,000 Total Collateral $200,000 b. Adjustments: 5% returns/allowances, 80% advance percentage. Level of available funds = [$200,000 x (1 - .05)] x .80 = $152,000 15-15 LG 5: Accounts Receivable as Collateral a. Customer Amount A $20,000 E 2,000 F 12,000 G 27,000 H 19,000 Total Collateral $80,000 b. $80,000 x (1 - .1) = $72,000 c. $72,000 x (.75) = $54,000 15-16 LG 3, 5: Accounts Receivable as Collateral, Cost of Borrowing a. [$134,000 – ($134,000 x .10)] x .85 = $102,510 b. ($100,000 x .02) + ($100,000 x .115) = $2,000 + $11,500 = $13,500
  • 10. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui402 %5.13 $100,000 $13,500 costInterest == ($100,000 x .02) + ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ × 2 115. 000,100$ = $2,000 + $5,750 = $7,750 months6for%75.7 $100,000 $7,750 costInterest == Effective annual rate = (1 + .0775)2 - 1 = 16.1% ($100,000 x .02) + ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ × 4 115. 000,100$ = $2,000 + $2,875 = $4,875 %88.4 $100,000 $4,875 costInterest == Effective annual rate = (1 + .0488)4 - 1 = 21.0% 15-17 LG 5: Factoring Holder Company Factored Accounts May 30 Accounts Amount Date Due Status on May 30 Amount Remitted Date of Remittance A $200,000 5/30 C 5/15 $196,000 5/15 B 90,000 5/30 U 88,200 5/30 C 110,000 5/30 U 107,800 5/30 D 85,000 6/15 C 5/30 83,300 5/30 E 120,000 5/30 C 5/27 117,600 5/27 F 180,000 6/15 C 5/30 176,400 5/30 G 90,000 5/15 U 88,200 5/15 H 30,000 6/30 C 5/30 29,400 5/30 The factor purchases all acceptable accounts receivable on a nonrecourse basis, so remittance is made on uncollected as well as collected accounts. 15-18 LG 6, 7: Inventory Financing a. City-Wide Bank: [$75,000 x (.12 ÷ 12)] +(.0025 x $100,000) = $1,000 Sun State Bank: $100,000 x (.13 ÷ 12) = $1,083 Citizens’ Bank and Trust: [$60,000 x (.15 ÷ 12)] + (.005 x $60,000) = $1,050 b. City-Wide Bank is the best alternative, since it has the lowest cost. c. Cost of giving up cash discount = (.02 ÷ .98)(360 / 20) = 36.73%
  • 11. Chapter 15 Current Liabilities Management Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui403 The effective cost of taking a loan = ($1,000 / $75,000) x 12 = 16.00% Since the cost of giving up the discount (36.73%) is higher than borrowing at Citywide Bank (16%), the firm should borrow to take the discount.
  • 12. Part 5 Short-Term Financial Decisions Find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui404 CHAPTER 15 CASES Selecting Kanton Company's Financing Strategy and Unsecured Short-Term Borrowing Arrangement This case asks the student to evaluate the permanent and short-term funding requirements of Kanton Company, and to choose a financing strategy from among three alternatives: aggressive, conservative, and trade-off. The company's funding requirements vary considerably during the year, showing a seasonal pattern and peaking mid- year. Then the student must calculate the effective annual interest rates for two short-term borro
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