Working Capital - Financing Current Assets

CHAPTER ! "#$A$C#$% C&RRE$T A''ET' (Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual Easy: Current asset financing policy

1.

Answer: a

Diff: E

Firms generally choose to finance temporary assets with short-term debt because a. Matching the maturities of assets and liabilities reduces risk. b. Short-term interest rates rat es have traditionally tr aditionally been more stable than th an long-term interest rates. c. A firm that borrows heavily long-term is more apt to be unable to repay the debt than a firm that borrows heavily short-term. d. The yield curve has traditionally been downward sloping. e. Sales remain constant over the year, and financing reuirements also remain constant.

Current asset financing

!.

Answer: e

Diff: E

N

"hich of the following statements is most correct# a. $ermanent current assets are those current assets asse ts that must be increased when sales increase during an upswing. b. Temporary current assets are those current assets on hand at the low point of the business cycle. c. Maturity matching is considered an aggressive financing policy. d. An aggressive current asset financing policy uses a minimum amount of short-term debt. e. %one of the statements above is correct.

Commercial paper

&.

Answer: d

Diff: E

"hich of the following statements concerning commercial paper is incorrect# a. 'ommercial paper is generally written for terms less than !() days. b. 'ommercial paper pape r generally carries carrie s an interest rate below bel ow the prime rate. c. 'ommercial paper is sold to money market mutual funds, as well as to other financial institutions and nonfinancial corporations. d. 'ommercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. e. 'ommercial paper is a type of o f unsecured promissory promi ssory note issued issue d by large, strong firms.

Chapter 16 - Page 1

W orking orking

*.

capital financing

Answer: e

Diff: E

"hich of the following statements is most correct# a. Trade credit is provided to a business only when purchases are made. b. 'ommercial paper is a form of short-term financing that is primarily used by large, financially stable companies. c. Short-term debt, debt , while often cheaper than t han long-term debt, deb t, e+poses a firm to the potential problems associated with rolling over loans. d. Statements b and c are correct. e. All of the statements above are correct.

W orking orking

.

capital financing

Answer: a

Diff: E

"hich of the following statements is incorrect# a. 'ommercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. b. Accrued liabilities represent a source of free financing in the sense that no e+plicit interest is paid on these funds. c. A conservative approach to working capital will result in all permanent assets being financed using long-term securities. d. The risk to the firm of borrowing with short-term credit is usually greater than with long-term debt. Added risk can stem from greater variability of interest costs on short-term debt. e. Trade credit is often the largest source of short-term credit.

Chapter 16 - Page 2

Medium: W orking

/.

capital financing policy

Answer: c

Diff: M

Ski 0ifts nc. is a highly seasonal business. The following summary balance sheet provides data for peak and off-peak seasons 2in thousands of dollars34 'ash Marketable securities Accounts receivable nventories %et fi+ed assets Total assets

$eak 6 ) ) *) 1)) )) 6/7)

5ff-peak 6 &) !) !) ) )) 6/!)

Spontaneous liabilities Short-term debt 0ong-term debt 'ommon euity Total claims

6 &) ) &)) &1) 6/7)

6 1) ) &)) &1) 6/!)

From this data we may conclude that a. Ski 0ifts has a working capital financing policy of e+actly matching asset and liability maturities. b. Ski 0ifts8 working capital financing policy is relatively aggressive9 that is, the company finances some of its permanent assets with shortterm discretionary debt. c. Ski 0ifts follows a relatively conservative approach to working capital financing9 that is, some of its short-term needs are met by permanent capital. d. "ithout income statement data, we cannot determine the aggressiveness or conservatism of the company8s working capital financing policy. e. Statements a and c are correct. W orking

(.


Answer: b

Diff: M

"hich of the following statements is most correct# a. %et working capital may be defined as current assets minus current liabilities. Any increase in the current ratio will automatically lead to an increase in net working capital. b. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks of using shortterm financing. c. f a company follows a policy of matching maturities, this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt. d. All of the statements above are correct. e. %one of the statements above is correct.

Chapter 16 - Page 3

W orking

:.


Answer: c

Diff: M

"hich of the following statements is most correct# a. Accrued liabilities are an e+pensive way to finance working capital. b. A conservative financing policy is one in which the firm finances all of its fi+ed assets with long-term capital and part of its permanent current assets with short-term, nonspontaneous credit. c. f a company receives trade credit under the terms !;1) net &), this implies the company has 1) days of free trade credit. d. Statements a and b are correct. e. %one of the answers above is correct.

Short-term financing

7.

Answer: a

Diff: M

"hich of the following statements is most correct# a. would probably be higher if it financed with short-term rather than with long-term debt, but the use of short-term debt would probably increase the firm8s risk. b. 'onservative firms generally use no short-term debt and thus have ?ero current liabilities. c. A short-term loan can usually be obtained more uickly than a long-term loan, but the cost of short-term debt is likely to be higher than that of long-term debt. d. f a firm that can borrow from its bank buys on terms of !;1), net &), and if it must pay by @ay &) or else be cut off, then we would e+pect to see ?ero accounts payable on its balance sheet. e. f one of your firm8s customers is stretching its accounts payable, this may be a nuisance but does not represent a real financial cost to your firm as long as the firm periodically pays off its entire balance.

Short-term versus long-term financing

1).

Answer: d

Diff: M

"hich of the following statements is most correct# a.
Chapter 16 - Page 4

Choosing a bank

11.

Answer: e

Diff: M

"hich one of the following aspects of banks is considered most relevant to businesses when choosing a bank# a. b. c. d. e.

'onvenience of location. 'ompetitive cost of services provided. Si?e of the bank8s deposits. >+perience of personnel. 0oyalty and willingness to assume lending risks.

Multiple Choice: Polems Easy: Maturity matching

1!.

6 7),))) 6!/),))) 6&),))) 6*1),))) 6&!),)))

Cost of trade credit

Answer: a

Diff: E



A firm is offered trade credit terms of &;1, net * days. The firm does not take the discount, and it pays after /( days. "hat is the nominal annual cost of not taking the discount# 2Assume a &/-day year.3 a. b. c. d. e.

!1.(1B !!.)(B !!.7B !&.*:B !*.!B


1*.

Diff: E

"ildthing Amusement 'ompany8s total assets fluctuate between 6&!),))) and 6*1),))), while its fi+ed assets remain constant at 6!/),))). f the firm follows a maturity matching or moderate working capital financing policy, what is the likely level of its long-term financing# a. b. c. d. e.

1&.

Answer: e

Answer: d

Diff: E



@i+ie Tours nc. buys on terms of !;1, net &) days. t does not take discounts, and it typically pays & days after the invoice date. %et purchases amount to 6(!),))) per year. "hat is the nominal annual cost of its non-free trade credit# 2Assume a &/-day year.3 a. b. c. d. e.

1(.!B !&./B !/.1B &(.!B )./B

Chapter 16 - Page 5


1.

Answer: b

Diff: E



Cour company has been offered credit terms on its purchases of *;&), net 7) days. "hat will be the nominal annual cost of trade credit if your company pays on the &th day after receiving the invoice# 2Assume a &/-day year.3 a. &)B b. &)*B c. &B d. :(B e. 1/B

!ree trade credit

1/.



6&),))) 6*),))) 6),))) 6/),))) 6(),)))

!ree trade credit

Answer: b

Diff: E

N

E' nc. buys on terms of !;1), net &) days. t does not take discounts, and it typically pays &) days after the invoice date. %et purchases amount to 61,(),))) per year. 5n average, how much free trade credit does E' receive during the year# 2Assume a &/-day year.3 a. b. c. d. e.

6!,!7&.* 6*(,7*.!1 6/:,/1.&& 6(,))).)) 67,:7).*!

Nominal interest rate

1:.

Diff: E

$hillips Dlass 'ompany buys on terms of !;1, net &) days. t does not take discounts, and it typically pays &) days after the invoice date. %et purchases amount to 6(&),))) per year. 5n average, how much free trade credit does $hillips receive during the year# 2Assume a &/-day year.3 a. b. c. d. e.

1(.

Answer: a

Answer: d

Diff: E

'overall 'arpets nc. is planning to borrow 61!,))) from the bank. The bank offers the choice of a 1! percent discount interest loan or a 1).17 percent add-on, 1-year installment loan, payable in * eual uarterly payments. "hat is the appro+imate 2nominal3 rate of interest on the 1).17 percent add-on loan# a. b. c. d. e.

.1)B 1).17B 1!.))B !).&:B &).(B

Chapter 16 - Page 6

Discount interest face value

17.

6111,))) 61)),))) 611!,&/) 6 :7,))) 61):,:*)


Answer: a

Diff: E

Giking Farms harvests crops in roughly 7)-day cycles based on a &/)-day year. The firm receives payment from its harvests sometime after shipment. @ue in part to the firm8s rapid growth, it has been borrowing to finance its harvests using 7)-day bank notes on which the firm pays 1! percent discount interest. f the firm reuires 6/),))) in proceeds from each note, what must be the face value of each note# a. b. c. d. e.

6/1,:/ 6/(,&1 6/),))) 6/:,1:! 6/(,*!&

evolving credit agreement cost

!1.

Diff: E

$icard 5rchards reuires a 61)),))) annual loan in order to pay laborers to tend and harvest its fruit crop. $icard borrows on a discount interest basis at a nominal annual rate of 11 percent. f $icard must actually receive 61)),))) net proceeds to finance its crop, then what must be the face value of the note# a. b. c. d. e.

!).

Answer: c

Answer: b

Diff: E

nland 5il arranged a 61),))),))) revolving credit agreement with a group of small banks. The firm paid an annual commitment fee of one-half of one percent of the unused balance of the loan commitment. 5n the used portion of the loan, nland paid 1. percent above prime for the funds actually borrowed on an annual, simple interest basis. The prime rate was at 7 percent for the year. f nland borrowed 6/,))),))) immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar cost of the loan agreement for one year# a. b. c. d. e.

6/),))) 6/),))) 6*),))) 67)),))) 6/(,)))

Chapter 16 - Page 7

Medium: Accounts payable balance

!!.

Diff: M



Cour firm buys on credit terms of !;1), net * days, and it always pays on @ay *. f you calculate that this policy effectively costs your firm 617,/!1 each year, what is the firm8s average accounts payable balance# 2Eint4
61,!&*,))) 6 (,))) 6 1(,)) 6 /!,))) 6 (),)))

EA cost of trade credit

!&.

Answer: e

Answer: e

Diff: M



Suppose the credit terms offered to your firm by your suppliers are !;1), net &) days. 5ut of convenience, your firm is not taking discounts, but is paying after !) days, instead of waiting until @ay &). Cou point out that the nominal cost of not taking the discount and paying on @ay &) is appro+imately &( percent. ut since your firm is not taking discounts and is paying on @ay !), what is the effective annual cost of your firm8s current practice, using a &/-day year# a. &/.(B b. 1).*B c. (&.*B d. *&./B e. 1)7.)B


!*.

Answer: e

Diff: M



Eayes Eypermarket purchases 6*,/!,)) in goods over a 1-year period from its sole supplier. The supplier offers trade credit under the following terms4 !;1, net ) days. f Eayes chooses to pay on time but not to take the discount, what is the average level of the company8s accounts payable, and what is the effective annual cost of its trade credit# 2Assume a &/day year.3 a. b. c. d. e.

6!):,&&&9 6*1/,//(9 6*1/,//(9 6/!,)))9 6/!,)))9

Chapter 16 - Page 8

1(.:1B 1(.*B !(.*&B 1(.*B !&.*B


!.

Answer: d

Diff: M



A firm is offered trade credit terms of !;:, net * days. The firm does not take the discount, and it pays after : days. "hat is the effective annual cost of not taking this discount# 2Assume a &/-day year.3 a. b. c. d. e.

!1./&B 1&.&B 1*.7)B 1.:7B 1:.()B

EA discount loan

Answer: d

Diff: M

'overall 'arpets nc. is planning to borrow 61!,))) from the bank. The bank offers the choice of a 1! percent discount interest loan or a 1).17 percent add-on, 1-year installment loan, payable in * eual uarterly payments. "hat is the effective rate of interest on the 1! percent discount loan# a. b. c. d. e.

1).(B 1!.)B 1!.B 1&./B 1*.1B

EA discount"compensating balance loan

!:.

N

**.&)B &!.!B &).))B &(.&7B *.)B


!(.

Diff: M

A firm is offered trade credit terms of &;1, net &) days. The firm does not take the discount, and it pays after ) days. "hat is the effective annual cost of not taking this discount# 2Assume a &/-day year.3 a. b. c. d. e.

!/.

Answer: d

Answer: d

Diff: M

Suppose you borrow 6!,))) from a bank for one year at a stated annual interest rate of 1* percent, with interest prepaid 2a discounted loan3. Also, assume that the bank reuires you to maintain a compensating balance eual to !) percent of the initial loan value. "hat effective annual interest rate are you being charged# a. b. c. d. e.

1*.))B :.(B 1/.!:B !1.!1B !:.))B

Chapter 16 - Page 9


!7.

11.))B 1.7*B 11.*/B 1&.(B 1!.(!B

EA add-on installment loan

Answer: d

Diff: M

Matheson Manufacturing nc. is planning to borrow 61!,))) from the bank. The bank offers the choice of a 1! percent discount interest loan or a 1).17 percent add-on, 1-year installment loan, payable in * eual uarterly payments. "hat is the effective rate of interest on the 1).17 percent addon loan# a. b. c. d. e.

7.)B 1).17B 1.!!B 1/.77B !!.)B


&1.

Diff: M

"entworth Dreenery harvests its crop four times annually and receives payment 7) days after it is picked and shipped. Eowever, the firm must plant, irrigate, and harvest on a near continual schedule. The firm uses 7)-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a !) percent compensating balance four times annually. "hat is the effective annual interest rate of these discount loans# a. b. c. d. e.

&).

Answer: b

Answer: c

Diff: M

HCI 'ompany needs to borrow 6!)),))) from its bank. The bank has offered the company a 1!-month installment loan 2monthly payments3 with 7 percent add-on interest. "hat is the effective annual rate 2>A=3 of this loan# a. b. c. d. e.

1/.!!B 1(.7(B 1(.*:B 1:./(B 1:.))B

Chapter 16 - Page 10

EA monthly loan

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Answer: e

Diff: M

First %ational ank of Micanopy has offered you the following alternatives in response to your reuest for a 6(,))), 1-year loan.

loan

Alternative 14 ( percent discount pensating balance.

com-

interest,

with

a

1)

percent

Alternative !4 : percent simple interest, with interest paid monthly. "hat is the effective annual rate on the cheaper loan# a. b. c. d. e.

:.))B (.!&B (./(B :.*&B :.&)B

EA short-term financing

&&.

Diff: M

The 0asser 'ompany needs to finance an increase in its working capital for the coming year. 0asser is reviewing the following three options4 213 The firm can borrow from its bank on a simple interest basis for one year at 1& percent. 2!3 t can borrow on a &-month, but renewable, loan at a 1! percent nominal rate. The loan is a simple interest loan, completely paid off at the end of each uarter, then renewed for another uarter. 2&3 The firm can increase its accounts payable by not taking discounts. 0asser buys on credit terms of 1;&), net /) days. "hat is the effective annual cost 2not the nominal cost3 of the least e+pensive type of credit, assuming &/) days per year# a. b. c. d. e.

1&.))B 1!.:!B 11.*/B 1!.1!B 1!.B


&*.

Answer: e

Answer: c

Diff: M

Cou need to borrow 6!,))) for one year. Cour bank offers to make the loan, and it offers you three choices4 213 1 percent simple interest, annual compounding9 2!3 1& percent nominal interest, daily compounding 2&/)-day year39 2&3 7 percent add-on interest, 1! end-of-month payments. The first two loans would reuire a single payment at the end of the year, the third would reuire 1! eual monthly payments beginning at the end of the first month. "hat is the difference between the highest and lowest effective annual rates# a. b. c. d. e.

1.1!B !.*:B &./)B *.!B .))B


Costly trade credit

&.

$hranklin terms of 6:17,&:: $hranklin 2Assume a a. b. c. d. e.



6::,))) 6&&,))) 6,))) 6),))) 6**,))) Answer: e

Diff: M



'J %otes8 business is booming, and it needs to raise more capital. The company purchases supplies from a single supplier on terms of 1;1), net !) days, and it currently takes the discount. 5ne way of getting the needed funds would be to forgo the discount, and 'J8s owner believes she could delay payment to *) days without adverse effects. "hat is the effective annual rate of stretching the accounts payable# a. b. c. d. e.

1).))B 11.11B 11.(B 1!.!7B 1&.)1B

#ermanent assets financing

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Diff: M

$harms nc. purchases merchandise from a company that gives sales !;1, net *) days. $hranklin $harms has gross purchases of per year. "hat is the ma+imum amount of costly trade credit could get, assuming it abides by the supplier8s credit terms# &/-day year.3

Stretching accounts payable

&/.

Answer: a

Answer: c

Diff: M



"icker 'orporation is determining whether to support 61)),))) of its permanent current assets with a bank note or a short-term bond. The firm8s bank offers a two-year note for which the firm will receive 61)),))) and repay 611:,:1) at the end of two years. The firm has the option to renew the loan at market rates. Alternatively, "icker can sell :. percent annual coupon bonds with a !-year maturity and 61,))) par value at a price of 67(&.7(. Eow many percentage points lower is the interest rate on the less e+pensive debt instrument# a. b. c. d. e.

).)B 1.!B 1.)B 1.:B )./B


Tough:

Accounts payable balance

&:.

N

61:(,*( 6&(*,71 6!!&,&&& 6/!,*!/ 6*(,**&

!inancial statements and trade credit

Answer: d

Diff: $



Kuickbow 'ompany currently uses ma+imum trade credit by not taking discounts on its purchases. Kuickbow is considering borrowing from its bank, using notes payable, in order to take trade discounts. The firm wants to determine the effect of this policy change on its net income. The standard industry credit terms offered by all its suppliers are !;1), net &) days, and Kuickbow pays in &) days. ts net purchases are 611,(/) per day, using a &/-day year. The interest rate on the notes payable is 1) percent and the firm8s ta+ rate is *) percent. f the firm implements the plan, what is the e+pected change in Kuickbow8s net income# a. b. c. d. e.

-6!&,!) -6&1,**) J6!&,!) J6&:,**: J6/7,:::

DS% and the cost of trade credit

*).

Diff: $

@alrymple Drocers buys on credit terms of !;1), net &) days, and it always pays on the &)th day. @alrymple calculates that its annual costly trade credit is 6&(,))). "hat is the firm8s average accounts payable balance# Assume a &/-day year. a. b. c. d. e.

&7.

Answer: d

Answer: e

Diff: $

0einer 'orp. is a retailer that finances its purchases with trade credit under the following terms4 1;1), net &) days. The company plans to take advantage of the free trade credit that is offered. After all the free trade credit is used, the company can either finance the clothing purchases with a bank loan that has an effective rate of 1).1&*7 percent 2on a &/day year3, or the firm can continue to use trade credit. The company has an understanding with its suppliers that within moderation, it is all right to stretch out its payments beyond &) days without facing any additional financing costs. Therefore, the longer it takes the company to pay its suppliers, the lower the cost of trade credit. Eow many days would the firm wait to pay its suppliers in order for the cost of the trade credit to eual the cost of the bank loan# a. b. c. d. e.

&) &/ *) */ *:

days days days days days



*1.

Answer: d

Diff: $

Ludy8s Fashions nc. purchases supplies from a single supplier on terms of 1;1), net !). 'urrently, Ludy takes the discount, but she believes she could e+tend the payment to *) days without any adverse effects if she decided not to take the discount. Ludy needs an additional 6),))) to support an e+pansion of fi+ed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 1! percent discount interest. Additionally, the bank reuires an average compensating balance of !) percent of the loan amount. Ludy already has a commercial checking account at this bank that could be counted toward the compensating balance, but the reuired compensating balance amount is twice the amount that Ludy would otherwise keep in the account. "hich of the following statements is most correct# a. The nominal cost of using additional trade credit is &/ percent. b. 'onsidering only the e+plicit costs, Ludy should finance the e+pansion with the bank loan. c. The cost of e+panding trade credit using the nominal formula is less than the cost of the bank loan. Eowever, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan. d. The effective cost of the bank loan is decreased from 1(./ percent to 1.&: percent because Ludy would hold a cash balance of one-half the compensating balance amount even if the loan were not taken. e. f Ludy had transaction balances that e+ceeded the compensating balance reuirement, the effective cost of the bank loan would be 1!.)) percent.

Multiple Par t: (The following data apply to the next two problems.)

Cou have ust taken out a loan for 6(,))). The stated 2simple3 interest rate on this loan is 1) percent, and the bank reuires you to maintain a compensating balance eual to 1 percent of the initial face amount of the loan. Cou currently have 6!),))) in your checking account, and you plan to maintain this balance. The loan is an add-on installment loan that you will repay in 1! eual monthly installments, beginning at the end of the first month. Add-on loan payments

*!.

Eow large are your monthly payments# a. b. c. d. e.

6/,!) 6(,))) 6(,)) 6,!) 6/,:(


Answer: e

Diff: E

Nominal add-on interest rate

*&.

Answer: d

Diff: E

"hat is the nominal annual add-on interest rate on this loan# a. b. c. d. e.

1).))B 1/.*(B 1:.:&B !).))B !*.))B


CHAPTER ! A$'*ER' A$D '+&T#+$' 1.

Current asset financing policy

&.

Current asset financing

Answer: a Answer: e

Diff: E

Diff: E

N

The correct answer is statement e. The definitions for permanent and temporary current assets have been reversed. Statement a is the definition of temporary current assets, while statement b is the definition of permanent current assets. Statement c is incorrect because maturity matching is considered a conservative financing policy. Statement d is also incorrect because an aggressive current asset financing policy uses the greatest amount of short-term debt. '.

Commercial paper

Answer: d

Diff: E

(.

W orking

capital financing

Answer: e

Diff: E

).

W orking

capital financing

Answer: a

Diff: E

Statement a is incorrect, and therefore the right answer. 'ommercial paper is a type of unsecured promissory note issued by large, strong firms. Statements b, c, d, and e are all accurate statements. *.

W orking


Answer: c

Diff: M

+.

W orking


Answer: b

Diff: M

,.

W orking


Answer: c

Diff: M

Statement b illustrates conservative one. .

an

aggressive

Short-term financing

financing

policy, Answer: a

not

a

Diff: M

. Eowever, a firm increases its risk by financing with short-term debt because such debt must be rolled over freuently, and the firm is e+posed to the volatility of short-term rates. The other statements are false. 10.

Short-term versus long-term financing

Answer: d

Diff: M

11.

Choosing a bank

Answer: e

Diff: M


1&.

Maturity matching

Answer: e

Diff: E

A maturity matching policy implies that fi+ed assets and permanent current assets are financed with long-term sources. Thus, since the minimum balance that total assets approach is 6&!),))), and 6!/),))) of that balance is fi+ed assets, permanent current assets eual 6/),))). The likely level of long-term financing is 6&!),))). 0ong-term debt financing  $ermanent cash assets J Fi+ed assets. $ermanent cash assets  0ow end of total assets - Fi+ed assets  6&!),))) - 6!/),)))  6/),))). 0ong-term debt financing  6/),))) J 6!/),)))  6&!),))). 1'.


%ominal percentage cost  1(.

1).

Diff: E



Answer: d

Diff: E



Answer: b

Diff: E



Diff: E



Diff: E

N

& &/   !1.(1B. 7( !


%ominal percentage cost 

Answer: a

! &/  &(.!*B.  7: & - 1


 *   &/  %ominal percentage cost       &.)*!  &)*.!B.  7/     1*.

!ree trade credit

Answer: a

6(&),)))  6!,))). &/ Free trade credit  6!,)))  1  6&),))). @aily purchases 

1+.

!ree trade credit

Answer: b

61,(),)))  6*,(7*.!. &/ Free trade credit  6*,(7*.!  1)  6*(,7*.!1. @aily purchases 

1,.

Nominal interest rate

Answer: d

Diff: E

Total to be repaid  61!,)))21.1)173  61&,!!!.:). nterest  61&,!!!.:) - 61!,)))  61,!!!.:). 61,!!!.:) Appro+imate rateAdd-on   ).!)&:  !).&:B. 61!,))) ; !


1.


Answer: c

Funds reuired 1.) - %ominal rate 2decimal3 61)),))) 61)),)))    611!,&7. 1.) - ).11 ).:7

Diff: E

Face value 

&0.

611!,&/).


Answer: a

'onvert the annual rate to a periodic denominator of the face value formula4 Funds reuired Face value  1.) - %ominal rate N 7) ; &/)  &1.



rate

2uarterly3

6/),))) 6/),)))   6/1,:./( 1.) - ).1!2).!3 ).7(

evolving credit agreement cost

Diff: E

in

the

6/1,:/.



Answer: b

Diff: E

nterest rate on borrowed funds  ).)7 J ).)1  1).B. 'ost of unused portion4 6*,))),)))  ).))  6 !),))) 'ost of used portion4 6/,))),)))  ).1)  /&),))) Total cost of loan agreement 6/),))) &&.


Appro+imate percentage cost  Accounts payable  &'.

Answer: e

! 7:



&/ &

Diff: M



Diff: M



 ).!1!:!:.

617,/!1  6(),))). ).!1!:!:


Answer: e

'alculate the nominal percentage, which is the nominal annual cost4 ! &/ days  %ominal cost   ).)!)*  &/.  ).(**7 (*.B. 1))  ! !)  1) 

'alculate the effective annual rate 2>A=34 %umerical solution4 >A=  21.)!)*3&/. - 1.)  !.)7) - 1.)  1)7.)B Financial calculator solution4 2>A=3 nputs4 $;C=  &/.9 %5MB  (*.*7. 5utput4 &(.




1)7B.

>FFB  1)7B. Answer: e

Diff: M

The company pays every ) days or &/;)  (.& times per year. the average accounts payable are 6*,/!,));(.&  6/!,))). effective cost of trade credit can be found as follows4 >A=  21 J !;7:3&/;& - 1  1.!&* - 1  ).!&*  !&.*B. Chapter 16 - Page 18



Thus, The

&).


Answer: d

Diff: M

N

'alculate the interest rate per period4 $eriodic rate  &;7(  &.)7&B. 'alculate the number of compounding periods4 %umber of compounding periods  &/;&  1).*!:/. A=4 >A=  21 J &;7(3&/;& - 1  21.)&)7&31).*!:/ - 1  1.&(&:7 - 1  &(.&7B. &*.


Answer: d

Diff: M



'alculate the interest rate per period4 $eriodic rate  !;7:  !.)*B. 'alculate the number of compounding periods4 %umber of compounding periods  &/;)  (.&).
!.)*B  (.&  1*.7)B. 'alculate >A= >A=  21 J !;7:3&/;) O 1  21.)!)*3(.& O 1  1.1:7 O 1  ).1:7  1.:7B. &+.

EA discount loan

Answer: d

Diff: M

"ill receive 61!,))). Face amount of loan  61!,)));21 - ).1!3  61&,/&/.&/. @iscount interest  ).1!261&,/&/.&/3  61,/&/.&/.

)

1

i  #

1&,/&/.&/ - 1,/&/.&/ discount interest 1!,))).))

-1&,/&/.&/

"ith a financial calculator, enter %  19 $G  1!)))9 $MT  )9 FG  -1&/&/.&/9 and then solve for ;C=  1&./*B 1&./B. 


&,.


Answer: d

Diff: M

"ill receive 6!,))). Face amount of loan  6!,)));21 - ).1* - ).!)3  6&,)&).&). @iscount interest  ).1*26&,)&).&)3  6*!*.!*. 'ompensating balance  ).!)26&,)&).&)3  6/)/.)/.

)

i  #

&,)&).&) - *!*.!* discount interest - /)/.)/ comp. balance !,))).))

1 -&,)&).&) J /)/.)/ -!,*!*.!*

"ith a financial calculator, enter %  19 $G  !)))9 $MT  )9 FG  -!*!*.!*9 and then solve for ;C=  !1.!1B. &.


Answer: b

Diff: M

Assume firm needs 61),))). Face amount of loan  61),)));21 - ).11 - ).!)3  61*,*7!.(. @iscount interest  ).11261*,*7!.(3  61,7*.!). 'ompensating balance  ).!)261*,*7!.(3  6!,:7:..

)

  #

1*,*7!.( - 1,7*.!) discount interest - !,:7:. comp. balance 1),))).))

1 -1*,*7!.( J !,:7:. -11,7*.!)

"ith a financial calculator, enter %  19 $G  1))))9 $MT  )9 FG  -117*.!)9 and then solve for ;C=  1.7*B. '0.


Answer: d

Diff: M

'alculate total to be repaid and uarterly payments4 Total to be repaid  61!,)))21.1)173  61&,!!!.:). Kuarterly payment  61&,!!!.:);*  6&,&).(). 'alculate the nominal interest rate per period4 nputs4 %  *9 $G  -1!)))9 $MT  &&).(19 FG  ). 5utput4   *.)B. 'alculate >A= using periodic rate and interest rate conversion feature4 %ominal annual rate  %5MB  *  *.)B  1/.)B. nputs4 %5MB  1/9 $;C=  *. 5utput4 >FFB  1/.77B.


'1.


Answer: c

Diff: M

nterest is 7B26!)),)))3  61:,))). Thus, the face value of the loan is 6!)),))) J 61:,)))  6!1:,))). Monthly payments are 6!1:,)));1!  61:,1//./(. 'alculate the periodic rate as follows4 %  1!9 $G  !)))))9 FG  )9 $MT  -1:1//./(9 and then solve for ;C=  1.&1*B. 'onvert this to an annual rate4 1.&1*B  1!  1/.!1/:B. Applying the >A= formula, solve for >A=  21 J ).1/!1/:;1!3 1! - 1  1(.*:B. '&.

EA monthly loan

Answer: e

Alternative 14 Face amount of loan  6(,)));21 - ).)( - ).1)3  67),&/1.*

)

i  #

7),&/1 - /,&! discount interest - 7,)&/ comp. balance (,)))

Diff: M

67),&/1.



1 -7),&/1 J 7,)&/ -:1,&!

To solve for the loan8s effective rate enter %  19 $G  ()))9 $MT  )9 FG  -:1&!9 and then solve for ;C=  :.*&B. Alternative !4 >A=  21 J ).):;1!31! - 1  :.&)B. ''.


Answer: e

Diff: M

213 Simple interest4 1&.)B. >A=  1&.)B. 2!3 =enewable loan4 The rate on this loan is essentially a 1!B nominal annual rate with uarterly compounding. nputs4 %5MB  1!9 $;C=  *. 5utput4 >FFB  1!.B. 2&3 Trade credit4 Terms 1;&), net /). %ote that the nominal rate is really the rate per period multiplied by the number of periods, or a nominal annual rate. 21;7732&/);2/) - &)33  2).)1)1321!3  1!.1!B nominal rate. nputs4 %5MB  1!.1!9 $;C=  1!. 5utput4 >FFB  1!.:!B. The least e+pensive type of credit is the uarterly renewable loan at 1!.B effective annual rate.


'(.


Answer: c

Diff: M

Simple interest4 >A=  1B. %ominal interest, daily compounding4 &/)

).1&   >A=  1 J - 1 .   &/)  7B add-on, 1! mos. payments4 a. Total amount to be repaid is 6!,))) principal, plus ).)726!,)))3  6!,!) of interest, or 6!(,!). b. The monthly payment  6!(,!);1!  6!,!().:&. c. ) i  # 1 1!    P P P !,))) -!,!().:& -!,!().:&

"ith a financial calculator, enter %  1!9 $G  !)))9 $MT  -!!().:&9 and FG  ) to solve for   1.&1*B. Eowever, this is a monthly rate. d. >A=Add-on  21.)1&1*31! - 1  1(.*:B. The difference between the highest and lowest >A= is 1(.*:B - 1&.::B  &./)B. ').

Costly trade credit

Answer: a

Diff: M



$hranklin8s net purchases are 6:17,&::  21 - ).)!3  6:)&,))). $urchases per day are 6:)&,)));&/  6!,!)).)). Total trade credit is *)  6!,!))  6::,))). Free trade credit is 1  6!,!))  6&&,))). Thus, costly trade credit, assuming discounts are taken, is 6::,))) 6&&,)))  6,))). f discounts are not taken, then the ma+imum amount of costly trade credit is 6::,))). '*.

Stretching accounts payable

Answer: e

Accounts payable4 21;7732&/;2*) - 1)33  1!.!7B. nominal rate. >A= is calculated as follows4 >A=  21 J 1;7731!.1//( - 1  1&.)1B.


Diff: M



Eowever, this is a

'+.

#ermanent assets financing

Answer: c

Diff: M



Time lines4 %ote that the cash flows viewed from the firm8s perspective involve inflows at time ), and repayment of coupon and;or maturity value in the future. !-year note4 ) i  # P J1)),))) !-year bond4 ) i  # P J7(&.7(

1 P

! Cears P FG  -11:,:1)

1 P -:

! Cears P -: FG  -1,)))

%ote4

nputs4 5utput4

%  !9 $G  1)))))9 $MT  )9 FG  -11::1).   7.)B.

ond4

nputs4 5utput4

%  !9 $G  7(&.7(9 $MT  -:9 FG  -1))).   1).)B.

The difference is 1).)B - 7.)B  1.)B.


',.


Answer: d

Diff: $

N

Step 14

'alculate the nominal annual cost of trade credit. ! &/  %ominal annual cost  7: &)  1)  ).)!)*  1:.!  &(.!*B.

Step !4

Step &4

@etermine gross and net sales. 61&7,/)  @iscount, which represents !B of sales. .)!Sales  61&7,/) Sales  6/,7:!,)). %et sales  ).7:Sales  ).7:26/,7:!,))3  6/,:*!,:).

Step *4

Since accounts payable are shown net of discounts, determine daily sales based on net sales figure. Then multiply this amount by &) days. 6/,:*!,:) @aily net sales  &/  61:,(*(.&. Accounts payable balance  61:,(*(.&  &)  6/!,*!/.)&


6/!,*!/.



'.

!inancial statements and trade credit

Answer: d

Diff: $



'alculate A;$ with and without taking discounts4 A;$%o discount  611,(/)  &) days  6&!,:)). A;$@iscount  611,(/)  1) days  611(,/)). 'alculate financing amount in notes payable and interest cost. will need to borrow the difference in notes payable. 6&!,:)) - 611(,/))  6!&,!)). The additional interest cost is 6!&,!))  ).1)  6!&,!).

The firm

'alculate total purchases and discounts lost4 Total purchases  &/ days  1!,))) gross purchases  6*,&:),))). @iscounts lost  6*,&:),)))  ).)!  6:(,/)). 'onstruct comparative financial statements4 . $artial balance sheet4 Take @iscounts @on8t Take @iscounts 2orrow %;$3 2
@ifference -6!&,!)) J!&,!)) 6 )

. $artial income statement4 >TQ 61*),))) 0ess4 nterest !&,!) @iscounts lost ) >T 611/,*:) 0ess4 Ta+es 2at *)B3 */,7! %et income 6 /7,:::

6 ) J!&,!) -:(,/)) J6 /*,):) J!,/&! J6 &:,**:

QAny >T can be policies is ?ero. (0.

used,

since

DS% and the cost of trade credit

the

61*),))) ) :(,/)) 6 !,*)) !),7/) 6 &1,**) difference

in

>T

from

Answer: e

the

two

Diff: $

@etermine the number of days the firm would wait to pay its suppliers so that the cost of the trade credit euals the cost of the bank loan4 ;C=  1).1&*79 $G  -779 $MT  )9 FG  1))9 and then solve for %  ).1)*1. Multiply ).1)*1 by &/ to convert it to the number of days per year4 ).1)*12&/3  &: days. To get the final answer we must add back the initial 1) days of free financing. This gives &: J 1)  *: days.


(1.


Answer: d

Diff: $

ank loan with account4 =euires loan of 6),))). Face amount of loan  6),)));21 - ).1! - ).1)3  6/*,1)!./. @iscount interest  ).1!26/*,1)!./3  6(,/7!.&). 'ompensating balance  ).1)26/*,1)!./3  6/,*1).!/.

)

i  #

/*,1)!./ - (,/7!.&) discount interest - /,*1).!/ comp. balance ),))).))

1 -/*,1)!./ J /,*1).!/ -(,/7!.&)

"ith a financial calculator, enter %  19 $G  ))))9 $MT  )9 FG  -(/7!.&), and then solve for ;C=  1.&:B. ank loan without account4 =euires loan of 6),))). Face amount of loan  6),)));21 - ).1! - ).!)3  6(&,!7.*1. @iscount interest  ).1!26(&,!7.*13  6:,:!&.&. 'ompensating balance  ).!)26(&,!7.*13  61*,().::.

)

i  #

(&,!7.*1 - :,:!&.& discount interest -1*,().:: comp. balance ),))).))

1 -(&,!7.*1 J1*,().:: -:,:!&.&

"ith a financial calculator, enter %  19 $G  ))))9 $MT  )9 FG  -::!&.&9 and then solve for ;C=  1(./B. Trade credit4 %ominal4 21;773R&/);2*) - 1)3  1!.1!B. >ffective rate4 21.)1)131! - 1.)  1!.:!B. 'alculate the periodic rate and number of compounding periods and use to calculate annual nominal rate4 $eriodic rate  1;77  1.)1B. %umber of compounding periods  R&/);2*) - 1)3  1!. Annual nominal rate  21.)1B321!3  1!.1!B. 'alculate >A= using interest rate conversion feature4 nputs4 %5MB  1!.1!9 $;C=  1!. 5utput4 >FFB  >A=  1!.:!B. (&.

Add-on loan payments

Answer: e

Diff: E

Answer: d

Diff: E

The monthly payments would be4 6(,))) J 6(,)) Monthly payment   6/,:(. 1! ('.

Nominal add-on interest rate


Appro+imate rate 

6(,))  !)B. 6(,))) ; !


Working Capital - Financing Current Assets

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