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Short-Term Sources For Financing Current Assets: S A R Q P I. Questions
Short-Term Sources For Financing Current Assets: S A R Q P I. Questions
CHAPTER 20
SHORT-TERM SOURCES
FOR FINANCING CURRENT ASSETS
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. It is advisable to borrow in order to take a cash discount when the cost of
borrowing is less than the cost of foregoing the discount. If it cost us 36
percent to miss a discount, we would be much better off finding an
alternate source of funds for 8 to 10 percent.
2. The prime rate is the rate that a bank charges its most creditworthy
customers. The average customer can expect to pay one or two percent
(or more) above prime.
3. The stated interest rate is the percentage rate unadjusted for time or
method of repayment. The effective interest rate is the true rate and
considers all these variables. A 5 percent stated rate for 90 days provides
a 20 percent effective rate. The financial manager should recognize the
effective rate as the true cost of borrowing. The effective rate is also
referred to as the APR (Annual Percentage Rate).
4. Commercial paper can be either purchased or issued by a corporation.
To the extent one corporation purchases another corporation’s
commercial paper as a short-term investment, it is a current asset.
Conversely, if a corporation issues its own commercial paper, it is a
current liability.
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Chapter 20 Short-term Sources for Financing Current Assets
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Short-term Sources for Financing Current Assets Chapter 20
III. Problems
Problem 1
RATE = x
RATE = 46%
Problem 2
RATE = x
Note that Jan would actually have to borrow more than the needed P500,000 in
order to cover the compensating balance requirement. However, as we
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Chapter 20 Short-term Sources for Financing Current Assets
However, for the August trade credit the firm actually pays at the end of
the credit period (the 30th day), so that the cost of trade credit becomes
c.
= .12 x x P500,000
= P10,000
RATE = x
Problem 3
a. RATE = x
= .18, or 18%
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Short-term Sources for Financing Current Assets Chapter 20
b. RATE = x
= .20, or 20%
c. RATE = x
= .21212, or 21.212%
Alternative (a) offers the lower-cost service of financing, although it carries the
highest stated rate of interest. The reason for this, of course, its that there
is no compensating balance requirement nor is interest discounted for
this alternative.
Problem 4
= x
= x = 2.04% x 8 = 16.32%
= Interest rate / (1 − C)
= 14% / (1 − .2)
= 14% / (.8) = 17.5%
The effective cost of the loan, 17.5%, is more than the cost of passing up the
discount, 16.32%. Kiwi Corporation should continue to pay in 55 days and
pass up the discount.
Problem 5
= 1.83% x 6 = 10.98%
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Chapter 20 Short-term Sources for Financing Current Assets
= 2.04% x 6 = 12.24%
c. Yes, because the cost of borrowing is less than the cost of losing the
discount.
d.
= =
= x 6 = 2.28% x 6
= 13.68%
No, do not borrow with a compensating balance of 20 percent since the effective
rate is greater than the savings from taking the cash discount.
Problem 6
a. Trust Bank
Northeast Bank
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Short-term Sources for Financing Current Assets Chapter 20
Choose Northeast Bank since it has the lowest effective interest rate.
b. The numerators stay the same as in part (a) but the denominator increases
to reflect the use of more money because compensating balances are
already maintained at both banks.
Trust Bank
Northeast Bank
Problem 7
a. 11.73%
b. 12.09%
c. 18%
Problem 8
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Chapter 20 Short-term Sources for Financing Current Assets
= 2.345%
= 2.20%
Effective cost = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.)
= .02345 + 3(.02200)
= .02345 + .06600
= .08945
= 8.95%
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Short-term Sources for Financing Current Assets Chapter 20
Familia Inc. should choose commercial paper because the cost of bank
financing (10.4 percent) exceeds the cost of commercial paper (8.95
percent) by greater than 1 percent.
Problem 9
a. The expected monthly cost of bank financing is the sum of the interest
cost, processing cost, bad debt expense, and credit department cost. The
calculations are as follows:
b. The expected monthly cost of factoring is the sum of the interest cost and
the factor cost. The calculations are as follows:
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Chapter 20 Short-term Sources for Financing Current Assets
Problem 10
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Short-term Sources for Financing Current Assets Chapter 20
Cost = x
The cost of each supplier must be weighted by the proportion of the total
provided by the supplier.
Annual Weighted
Percentage Cost Weight Average Cost
Supplier (1) (2) (1) x (2)
Fort Co. .367 .30 .110
Jester Co. .242 .25 .061
Jam Co. - .35 -
Smitt & Co. .172 .10 .017
Total 1.00 .188
b. No, the average effective annual interest rate does not indicate whether
they should borrow funds to take advantage of the terms on a specific
account. The borrowing decision should be based on the effective annual
interest rate of each supplier’s credit terms. Money should be borrowed
to pay within the discount period only when the cost of borrowing is less
than the effective annual interest rate of the credit terms. For instance,
Fort Co. has an effective annual interest rate of 36.7% and should be paid
on day 10 only if the cost of borrowing is less than 36.7%.
c. 1. A line of credit is a loan agreement in which the borrower has, with
certain specified limitations, control over the amount borrowed (up
to some maximum) and when the funds are repaid.
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Chapter 20 Short-term Sources for Financing Current Assets
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