Ch27 Test Bank 4-5-10

CHAPTER 27
Providing and Obtaining Credit
Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.
(Difficulty: E = Easy, M = Medium, and T = Tough)
True-False
Medium:
Credit period FI Answer: b Diff: M
1. The credit period is the amount of time it takes to do a credit search

on a potential customer.
a. True
b. False
Credit standards FI Answer: b Diff: M
2. Credit standards refer to the financial strength and importance of a

potential customer to the firm required in order to qualify for credit.
a. True
b. False
Collection policy FI Answer: b Diff: M
3. The collection process, although sometimes difficult, is a fairly

inexpensive component of doing business.
a. True
b. False
Collection policy FI Answer: a Diff: M
4. The collection process, although sometimes difficult, is also expensive

in terms of out-of-pocket expenses.
a. True
b. False
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Chapter 27 - Page 1
Cash discounts FI Answer: b Diff: M
5. Cash discounts are mostly used to get new customers in the door since
existing customers almost always use the delayed payment terms.
a. True
b. False
Cash discounts FI Answer: a Diff: M
6. When deciding whether to offer a discount for cash payment, a firm must
balance the profits from additional sales with the lost revenues from
the discount.
a. True
b. False
Payments pattern approach FI Answer: a Diff: M
7. The primary reason to monitor aggregate accounts receivable is to see

if customers, on average, are paying more slowly.
a. True
b. False
Payments pattern approach FI Answer: b Diff: M
8. DSO analysis of accounts receivable is the most robust way to see if

customers are, on average, paying more slowly, because it is unaffected
by seasonal changes in sales.
a. True
b. False
Payments pattern approach FI Answer: a Diff: M
9. If sales are seasonal, the days sales outstanding will fluctuate from
month to month, even if the amount of time customers take to pay
remains unchanged.
a. True
b. False
Payments pattern approach FI Answer: b Diff: M
10. The percentage aging schedule of accounts receivable is the most robust
way to see if customers are, on average, paying more slowly, because it
is unaffected by seasonal changes in sales.
a. True
b. False
Chapter 27 - Page 2
Uncollected balances schedule FI Answer: a Diff: M
11. The uncollected balances schedule is constructed at the end of a

quarter by dividing the dollar amount of remaining receivables from
each month in that quarter by that month’s sales.
a. True
b. False
Multiple Choice: Conceptual
Medium:
Credit policy CI Answer: b Diff: M
12. A firm’s credit policy consists of which of the following items?
a. Credit period, cash discounts, credit standards, receivables

monitoring.
b. Credit period, cash discounts, credit standards, collection policy.
c. Credit period, cash discounts, receivables monitoring, collection
policy.
d. Cash discounts, credit standards, receivables monitoring, collection
policy.
e. Credit period, receivables monitoring, credit standards, collection
policy.
Collection policy CI Answer: b Diff: M

13. Which of the following is not correct?
a. Collection policy is how a firm goes about collecting past-due

accounts.
b. A more aggressive collection policy will reduce bad debt expenses,
but may also decrease sales.
c. Collection policy usually has little impact on sales since
collecting past-due accounts occurs only after the customer has
already purchased.
d. Typically a firm will turn over an account to a collection agency
only after it has tried several times on its own to collect the
account.
e. A lax collection policy will frequently lead to an increase in
accounts receivable.
Chapter 27 - Page 3
Payments pattern approach CI Answer: c Diff: M
14. Which of the following is not correct for a firm with seasonal sales
and customers who all pay promptly at the end of 30 days?
a. DSO will vary from month to month.

b. The quarterly uncollected balances schedule will be the same in each
quarter.
c. The level of accounts receivable will be constant from month to
month.
d. The ratio of accounts receivable to sales will vary from month to
month.
e. The level of accounts receivable at the end of each quarter will be
the same.
Credit policy and seasonal dating CI Answer: b Diff: M

15. Which of the following statements is most correct?
a. If credit sales as a percentage of a firm's total sales increases,

and the volume of credit sales also increases, then the firm's
accounts receivable will automatically increase.
b. It is possible for a firm to overstate profits by offering very
lenient credit terms which encourage additional sales to financially
"weak" firms. A major disadvantage of such a policy is that it is
likely to increase uncollectible accounts.
c. A firm with excess production capacity and relatively low variable
costs would not be inclined to extend more liberal credit terms to
its customers than a firm with similar costs that is operating close
to capacity.
d. Firms use seasonal dating primarily to decrease their DSO.
e. Seasonal dating with terms 2/15, net 30 days, with April 1 dating,
means that if the original sale took place on February 1st, the
customer can take the discount up until March 15th, but must pay the
net invoice amount by April 1st.
Choosing a bank CI Answer: e Diff: M

16. Which one of the following aspects of banks is considered most relevant
to businesses when choosing a bank?
a. Convenience of location.
b. Competitive cost of services provided.
c. Size of the bank's deposits.
d. Experience of personnel.
e. Loyalty and willingness to assume lending risks.
Chapter 27 - Page 4
Multiple Choice: Problems
Easy:
Multiple part:
(The following information applies to the next two problems.)
You have just taken out a loan for $75,000. The stated (simple) interest
rate on this loan is 10 percent, and the bank requires you to maintain a
compensating balance equal to 15 percent of the initial face amount of the
loan. You currently have $20,000 in your checking account, and you plan to
maintain this balance. The loan is an add-on installment loan which you will
repay in 12 equal monthly installments, beginning at the end of the first
month.
Loan payments CI Answer: e Diff: E

17. How large are your monthly payments?
a. $6,250
b. $7,000
c. $7,500
d. $5,250
e. $6,875
Add-on installment loan CI Answer: d Diff: E

18. What is the nominal annual add-on interest rate on this loan?
a. 10.00%
b. 16.47%
c. 18.83%
d. 20.00%
e. 24.00%
EAR discount/compensating balance loan CI Answer: d Diff: E

19. Suppose you borrow $2,000 from a bank for one year at a stated annual
interest rate of 14 percent, with interest prepaid (a discounted loan).
Also, assume that the bank requires you to maintain a compensating
balance equal to 20 percent of the initial loan value. What effective
annual interest rate are you being charged?
a. 14.00%
b. 8.57%
c. 16.28%
d. 21.21%
e. 28.00%
Chapter 27 - Page 5
EAR discount/compensating balance loan CI Answer: b Diff: E
20. Wentworth Greenery harvests its crops four times annually and receives
payment for its crop 90 days after it is picked and shipped. However,
the firm must plant, irrigate, and harvest on a near continual
schedule. The firm uses 90-day bank notes to finance its operations.
The firm arranges an 11 percent discount interest loan with a 20
percent compensating balance four times annually. What is the
effective annual interest rate of these discount loans?
a. 11.00%
b. 15.94%
c. 11.46%
d. 13.75%
e. 12.72%
Effective annual rate CI Answer: d Diff: E

21. Assume you borrow $12,000 from the bank using a 10.19 percent “add-on”,
one-year installment loan, payable in four equal quarterly payments.
What is the effective annual rate of interest?
a. 9.50%
b. 10.19%
c. 15.99%
d. 16.98%
e. 20.38%
Effective annual rate CI Answer: c Diff: E

22. XYZ Company needs to borrow $200,000 from its bank. The bank has
offered the company a 12-month installment loan (monthly payments) with
9 percent add-on interest. What is the effective annual rate (EAR) of
this loan?
a. 16.22%
b. 17.97%
c. 17.48%
d. 18.67%
e. 18.00%
Chapter 27 - Page 6
Effective annual rate CI Answer: e Diff: E
23. First National Bank of Micanopy has offered you the following loan
alternatives in response to your request for a $75,000, 1-year loan.
Alternative 1: 7 percent discount interest, with a 10 percent

compensating balance.
Alternative 2: 8 percent simple interest, with interest paid monthly.
What is the effective annual rate on the cheaper loan?
a. 8.00%
b. 7.23%
c. 7.67%
d. 8.43%
e. 8.30%
EAR discounted loan CI Answer: d Diff: E

24. Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The
bank offers the choice of a 12 percent discount interest loan or a
10.19 percent add-on, one-year installment loan, payable in 4 equal
quarterly payments. What is the effective rate of interest on the 12
percent discounted loan?
a. 10.7%
b. 12.0%
c. 12.5%
d. 13.6%
e. 14.1%
Discount interest face value CI Answer: c Diff: E

25. Picard Orchards requires a $100,000 annual loan in order to pay
laborers to tend and harvest its fruit crop. Picard borrows on a
discount interest basis at a nominal annual rate of 11 percent. If
Picard must actually receive $100,000 net proceeds to finance its crop,
then what must be the face value of the note?
a. $111,000
b. $100,000
c. $112,360
d. $ 89,000
e. $108,840
Chapter 27 - Page 7
Discount interest face value CI Answer: a Diff: E
26. Viking Farms harvests crops in roughly 90-day cycles based on a 360-day
year. The firm receives payment from its harvests sometime after
shipment. Due in part to the firm's rapid growth, it has been
borrowing to finance its harvests using 90-day bank notes on which the
firm pays 12 percent discount interest. If the firm requires $60,000
in proceeds from each note, what must be the face value of each note?
a. $61,856
b. $67,531
c. $60,000
d. $68,182
e. $67,423
Medium:
Add-on interest loan CI Answer: d Diff: M
quarterly payments. What is the approximate (nominal) rate of interest
on the 10.19 percent add-on loan?
a. 5.10%
b. 10.19%
c. 12.00%
d. 20.38%
e. 30.57%
(The following information applies to the next three problems.)
East Lansing Appliances (ELA) expects to have sales this year of $15 million
under its current credit policy. The present terms are net 30; the days sales
outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent.
Since ELA wants to improve its profitability, the treasurer has proposed that
the credit period be shortened to 15 days. This change would reduce expected
sales by $500,000, but it would also shorten the DSO on the remaining sales to
30 days. Expected bad debt losses on the remaining sales would fall to 3
percent. The variable cost percentage is 60 percent, and the cost of capital
is 15 percent.
Bad debt losses CI Answer: d Diff: E

28. What would be the incremental bad losses if the change were made?
a. $315,000
b. $260,500
c. -$260,500 (bad debt losses would decline)
d. -$315,000 (Bad debt losses would decline)
e. $ 0 (no change would occur)
Chapter 27 - Page 8
Cost of carrying receivables CI Answer: b Diff: M
29. What would be the incremental cost of carrying receivables if this change
were made?
a. $108,750
b. -$116,250 (carrying costs would decline)
c. $157,900
d. -$225,000 (carrying costs would decline)
e. $260,500
Incremental profits CI Answer: e Diff: M

30. What are the incremental pre-tax profits from this proposal?
a. $181,250
b. $271,750
c. $256,250
d. $206,500
e. $231,250
(The following information applies to the next four problems.)
Berkeley Prints expects to have sales this year of $15 million under its
current credit policy. The present terms are net 30; the days dales
outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent.
Also, Berkeley’s cost of capital is 15 percent, and its variable costs total 60
percent of sales. Since Berkeley wants to improve its profitability, a
proposal has been made to offer a 2 percent discount for payment within 10
days; that is, change the credit terms to 2/10, net 30. The consultants
predict that sales would increase by $500,000, and that 50 percent of all
customers would take the discount. The new DSO would be 30 days, and the bad
debt loss percentage on all sales would fall to 4 percent.
Cash discounts CI Answer: c Diff: E

31. What would be the cost to Berkeley of the discounts taken?
a. $116,750
b. -$108,750
c. $155,000
d. $225,000
e. $260,500
Bad debt losses CI Answer: d Diff: E

32. What would be the incremental bad debt losses if the change were made?
a. $130,000
b. $250,000
c. -$250,000 (bad debt losses would decline)
d. -$130,000 (bad debt losses would decline)
e. $620,000
Chapter 27 - Page 9
Cost of carrying receivables CI Answer: a Diff: M
33. What would be the incremental cost of carrying receivables if the change
were made?
a. -$108,750 (carrying costs would decline)

b. $116,250
c. $157,900
d. -$225,000 (carrying costs would decline)
e. $260,000
Incremental profits CI Answer: a Diff: M

34. What are the incremental pre-tax profits from this proposal?
a. $283,750
b. $250,500
c. $303,250
d. $493,750
e. $288,250
Cost of short-term financing CI Answer: d Diff: M

35. Judy's Fashions, Inc. purchases supplies from a single supplier on terms
of 1/10, net 20. Currently, Judy takes the discount, but she believes
she could extend the payment to 40 days without any adverse effects if
she decided not to take the discount. Judy needs an additional $50,000
to support an expansion of fixed 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 12 percent discount interest.
Additionally, the bank requires an average compensating balance of 20
percent of the loan amount. Judy already has a commercial checking
account at this bank which could be counted toward the compensating
balance, but the required compensating balance amount is twice the amount
that Judy would otherwise keep in the account. Which of the following
statements is most correct?
a. The cost of using additional trade credit is approximately 36 percent.

b. Considering only the explicit costs, Judy should finance the expansion
with the bank loan.
c. The cost of expanding trade credit using the approximation formula is
less than the cost of the bank loan. However, 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 17.65 percent to
15.38 percent because Judy would hold a cash balance of one-half the
compensating balance amount even if the loan were not taken.
e. If Judy had transaction balances that exceeded the compensating
balance requirement, the effective cost of the bank loan would be
12.00 percent.
Chapter 27 - Page 10
Cost of short-term financing CI Answer: c Diff: M
36. You need to borrow $25,000 for one year. Your bank offers to make the
loan, and it offers you three choices: (1) 15 percent simple interest,
annual compounding; (2) 13 percent nominal interest, daily compounding
(360-day year); (3) 9 percent add-on interest, 12 end-of-month
payments. The first two loans would require a single payment at the end
of the year, the third would require 12 equal monthly payments
beginning at the end of the first month. What is the difference
between the highest and lowest effective annual rates?
a. 1.12%
b. 2.48%
c. 3.60%
d. 4.25%
e. 5.00%
Tough:
Change in credit policy CI Answer: e Diff: T
37. Bass Boats Inc. currently has sales of $1,000,000, and its days sales
outstanding is 30 days. The financial manager estimates that offering
longer credit terms would (1) increase the days sales outstanding to 50
days and (2) increase sales to $1,200,000. However, bad debt losses,
which were 2 percent on the old sales, would amount to 5 percent on the
incremental sales only (bad debts on the old sales would stay at 2
percent). Variable costs are 80 percent of sales, and Bass has a 15
percent receivables financing cost. What would the annual incremental
pre-tax profit be if Bass extended its credit period?
a. -$20,000
b. -$10,000
c. $ 0
d. $10,000
e. $20,000
Effective interest rate CI Answer: d Diff: T

quarterly payments. What is the effective rate of interest on the
10.19 percent add-on loan?
a. 9.50%
b. 10.19%
c. 15.22%
d. 16.99%
e. 22.05%
CHAPTER 27
ANSWERS AND SOLUTIONS
1. Credit period FI Answer: b Diff: M
2. Credit standards FI Answer: b Diff: M
3. Collection policy FI Answer: b Diff: M
4. Collection policy FI Answer: a Diff: M
5. Cash discounts FI Answer: b Diff: M
6. Cash discounts FI Answer: a Diff: M
7. Payments pattern approach FI Answer: a Diff: M
8. Payments pattern approach FI Answer: b Diff: M
9. Payments pattern approach FI Answer: a Diff: M
10. Payments pattern approach FI Answer: b Diff: M
11. Uncollected balances schedule FI Answer: a Diff: M
12. Credit policy CI Answer: b Diff: M
13. Collection policy CI Answer: b Diff: M
14. Payments pattern approach CI Answer: c Diff: M
15. Credit policy and seasonal dating CI Answer: b Diff: M
16. Choosing a bank CI Answer: e Diff: M
17. Loan payments CI Answer: e Diff: E

The monthly payments would be:
$75,000 + $7,500
Monthly payment = = $6,875.
12
18. Add-on installment loan CI Answer: d Diff: E

$7,500
Approximate rate = = 20%.
$75,000 / 2
19. EAR discount/compensating balance loan CI Answer: d Diff: E
Will receive $2,000.
Face amount of loan = $2,000/(1 - 0.14 - 0.20) = $3,030.30.
Discount interest = 0.14($3,030.30) = $424.24.
Compensating balance = 0.20($3,030.30) = $606.06.
0 1
I = ?
3,030.30 -3,030.30
- 424.24 discount interest + 606.06
- 606.06 comp. balance -2,424.24
2,000.00
With a financial calculator, enter N = 1, PV = 2,000, PMT = 0, FV =

-2,424.24, and solve for I/YR = 21.21%.
20. EAR discount/compensating balance loan CI Answer: b Diff: E

Assume firm needs $10,000.
Face amount of loan = $10,000/(1 - 0.11 - 0.20) = $14,492.75.
Discount interest = 0.11($14,492.75) = $1,594.20.
Compensating balance = 0.20($14,492.75) = $2,898.55.
0 1
I = ?
14,492.75 -14,492.75
- 1,594.20 discount interest + 2,898.55
- 2,898.55 comp. balance -11,594.20
10,000.00

-11,594.20, and solve for I/YR = 15.94%.
21. Effective annual rate CI Answer: d Diff: E

First, calculate the amount of "add-on" interest. Interest =
0.1019($12,000)= $1,222.80. The total amount to be repaid is $1,222.80
+ $12,000 = $13,222.80. The quarterly payments are $13,222.80/4 =
$3,305.70. Find the periodic rate, where N = 4, PV = 12,000, PMT =
-3,305.70, FV = 0, so the quarterly rate = 3.9977%. Finally, enter the
nominal rate into your calculator, 4  3.9977% = 15.99% = NOM%. Enter
P/YR = 4. Now, solve for EFF% = 16.98%.
22. Effective annual rate CI Answer: c Diff: E
Interest is 9%($200,000) = $18,000. Thus, the face value of the loan
is $200,000 + $18,000 = $218,000. Monthly payments are $218,000/12 =
$18,166.67.
Calculate the periodic rate as follows:

N = 12, PV = 200,000, FV = 0, PMT = -18,166.67, I/YR = ? = 1.3514%.
Convert this to an annual rate: 1.3514%  12 = 16.2168%. Applying the
EAR formula, solve for EAR = (1 + 0.162168/12)12 - 1 = 17.48%.
23. Effective annual rate CI Answer: e Diff: E

Alternative 1:
Face amount of loan = $75,000/(1 - 0.07 - 0.10) = $90,361.45  $90,361.
0 1
I = ?
90,361 -90,361
- 6,325 discount interest + 9,036
- 9,036 comp. balance -81,325
75,000
To solve for the loan’s effective rate enter N = 1, PV = 75,000, PMT =

0, FV = -81,325, and solve for I/YR = 8.43%.
Alternative 2:
EAR = (1 + 0.08/12)12 - 1 = 8.30%.
24. EAR discounted loan CI Answer: d Diff: E

Will receive $12,000.
Face amount of loan = $12,000/(1 - 0.12) = $13,636.36.
Discount interest = 0.12($13,636.36) = $1,636.36.
0 1
I = ?
13,636.36 -13,636.36
- 1,636.36 discount interest
12,000.00

-13,636.36 , and solve for I/YR = 13.64%  13.6%.
25. Discount interest face value CI Answer: c Diff: E

Funds required
Face value =
1.0 - Nominal rate (decimal)
$100,000 $100,000
= = = $112,359.55  $112,360.
1.0 - 0.11 0.89
26. Discount interest face value CI Answer: a Diff: E
Convert the annual rate to a periodic rate (quarterly) in the
denominator of the face value formula:
Funds required
Face value =
1.0 - Nominal rate  90 / 360
$60,000 $60,000
= = = $61,855.67  $61,856.
1.0 - 0.12(0.25) 0.97
27. Add-on interest loan CI Answer: d Diff: M

Total to be repaid = $12,000(1.1019) = $13,222.80.
Interest = $13,222.80 - $12,000 = $1,222.80.
$1,222.80
Approximate rateAdd-on = = 0.2038 = 20.38%.
$12,000 / 2
28. Bad debt losses CI Answer: d Diff: E
Bad debt losses old: (.05)($15,000,000) = $750,000.
Bad debt losses new: (.03)($14,500,000) = $435,000.
Change in bad debt losses = $435,000 - $750,000 = -$315,000.
29. Cost of carrying receivables CI Answer: b Diff: M

DSO0 = 60 days; DSON = 30 days. No discounts.
Calculate cost of carrying receivables at current and new sales levels:
Cost of carrying
receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds)
Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.

Sales at $14,500,000: 30($14,500,000/360)(0.6)(0.15) = $108,750.
Change = $108,750 - $225,000 = -$116,250.
30. Incremental profits CI Answer: e Diff: M

Analysis of policy change:
Current Effect of Credit New

Projections Policy Change Projections
Net sales $15,000,000 -$500,000 $14,500,000
Production costs 9,000,000 + 300,000 8,700,000
Profit before
credit costs $ 6,000,000 -$200,000 $ 5,800,000
Cost of carrying
receivables 225,000 + 116,250 108,750
Bad debt losses 750,000 + 315,000 435,000
Pre-tax profits $ 5,025,000 +$231,250 $ 5,256,250
Change in incremental pre-tax profits = $231,250.
31. Cash discounts CI Answer: c Diff: E

No discounts with old policy; 2% discount with new policy (2/10, net 30).
Discount = $15,500,000(0.5)(0.02) = $155,000.
32. Bad debt losses Answer: d Diff: E
Bad debt losses old: (0.05)($15,000,000) = $750,000.
Bad debt losses new: (0.04)($15,500,000) = $620,000.
Changes in bad debt losses = $620,000 - $750,000 = -$130,000.
33. Cost of carrying receivables CI Answer: a Diff: M

DSO0 = 60 days; DSON = 30 days.
Cost of carrying
Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000.
Sales at $15,500,000: 30($15,500,000/360)(0.6)(0.15) = $116,250.
Change = $116,250 - $225,000 = -$108,750.
34. Incremental profits CI Answer: a Diff: M

Analysis of policy change:

Sales $15,000,000 +$500,000 $15,500,000
Discounts 0 - 155,000 155,000
Net sales $15,000,000 +$345,000 $15,345,000
Production costs 9,000,000 - 300,000 9,300,000
Profit before
credit costs $ 6,000,000 +$ 45,000 $ 6,045,000
Cost of carrying
receivables 225,000 + 108,750 116,250
Bad debt losses 750,000 + 130,000 620,000
Pre-tax profits $ 5,025,000 +$283,750 $ 5,308,750
Change in incremental pre-tax profits = +$283,750.
35. Cost of short-term financing CI Answer: d Diff: M
Bank loan:
With account: 12%/(1 - 0.12 - 0.10) = 15.38%.

Without account: 12%/(1 - 0.12 - 0.20) = 17.65%.
Trade credit:
Approximately: (1%/99%)[360/(40 - 10)] = 12.12%.

Effective rate: (1.0101)12 - 1.0 = 12.82%.
36. Cost of short-term financing CI Answer: c Diff: M
Simple interest: EAR = 15%.
Nominal interest, daily compounding:
360
EAR = 1 +
0.13
 - 1 = 13.88%.
 360 
9% add-on, 12 mos. payments:
a. Total amount to be repaid is $25,000 principal, plus
0.09($25,000) = $2,250 of interest, or $27,250.
b. The monthly payment = $27,250/12 = $2,270.83.
c.
0 I = ? 1 12
| | ... |
25,000 -2,270.83 -2,270.83
With a financial calculator, enter N = 12; PV = 25,000; PMT =

-2,270.83; and FV = 0 to solve for I = 1.3514%. However, this is
a monthly rate.
d. EARAdd-on = (1.013514)12 - 1 = 17.48%.
The difference between the highest and lowest EAR is 17.48% - 13.88% =
3.60%.
37. Change in credit policy CI Answer: e Diff: T
DSO0 = 30 days; DSON = 50 days; no discounts.
Calculate cost of carrying receivables at current and new sales levels:
Cost of carrying
Sales at $1,000,000: 30($1,000,000/360)(0.8)(0.15) = $10,000.

Sales at $1,200,000: 50($1,200,000/360)(0.8)(0.15) = $20,000.
Analysis of policy changes:

Net sales $1,000,000 +$200,000 $1,200,000
Production costs 800,000 - 160,000 960,000
Profit before
credit costs $ 200,000 +$ 40,000 $ 240,000
Cost of carrying
receivables 10,000 - 10,000 20,000
Bad debt losses* 20,000 - 10,000 30,000
Pre-tax profits $ 710,000 +$ 20,000 $ 190,000
*Bad debt losses old: $1,000,000(0.02) = $20,000.

Bad debt losses new: $1,000,000(0.02) + $200,000(0.05) = $30,000.
The annual incremental pre tax profit with the change in policy is
$20,000.
38. Effective interest rate CI Answer: d Diff: T

Calculate total to be repaid and quarterly payments
Total to be repaid = $12,000(1.1019) = $13,222.80.
Quarterly payment = $13,222.80/4 = $3,305.70.
Tabular solution:
PV = $12,000 = $3,305.70(PVIFAi,4)
(PVIFAi,4) = 3.6301
i  4.0%.
EAR = 1.0(FVIF4%,4) - 1.0 = 1.1699 - 1.0 = 0.1699 = 16.99%.
Financial calculator solution:

Calculate the nominal interest rate per period
Inputs: N = 4; PV = -12,000; PMT = 3,305.71; FV = 0. Output: I =
4.0%
Calculate EAR using periodic rate and interest rate conversion feature
Nominal annual rate = NOM% = 4  4.0% = 16.0%.
Inputs: NOM% = 16; P/YR = 4. Output: EFF% = 16.99%.

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CHAPTER 27

Providing and Obtaining Credit

(Difficulty: E = Easy, M = Medium, and T = Tough)

1. The credit period is the amount of time it takes to do a credit search

Credit standards FI Answer: b Diff: M

2. Credit standards refer to the financial strength and importance of a

Collection policy FI Answer: b Diff: M

3. The collection process, although sometimes difficult, is a fairly

Collection policy FI Answer: a Diff: M

4. The collection process, although sometimes difficult, is also expensive

Cash discounts FI Answer: a Diff: M

Payments pattern approach FI Answer: a Diff: M

7. The primary reason to monitor aggregate accounts receivable is to see

Payments pattern approach FI Answer: b Diff: M

8. DSO analysis of accounts receivable is the most robust way to see if

Payments pattern approach FI Answer: a Diff: M

Payments pattern approach FI Answer: b Diff: M

11. The uncollected balances schedule is constructed at the end of a

Multiple Choice: Conceptual

a. Credit period, cash discounts, credit standards, receivables

Collection policy CI Answer: b Diff: M

a. Collection policy is how a firm goes about collecting past-due

a. DSO will vary from month to month.

Credit policy and seasonal dating CI Answer: b Diff: M

a. If credit sales as a percentage of a firm's total sales increases,

Choosing a bank CI Answer: e Diff: M

(The following information applies to the next two problems.)

Loan payments CI Answer: e Diff: E

Add-on installment loan CI Answer: d Diff: E

EAR discount/compensating balance loan CI Answer: d Diff: E

Effective annual rate CI Answer: d Diff: E

Effective annual rate CI Answer: c Diff: E

Alternative 1: 7 percent discount interest, with a 10 percent

Alternative 2: 8 percent simple interest, with interest paid monthly.

What is the effective annual rate on the cheaper loan?

EAR discounted loan CI Answer: d Diff: E

Discount interest face value CI Answer: c Diff: E

(The following information applies to the next three problems.)

Bad debt losses CI Answer: d Diff: E

Incremental profits CI Answer: e Diff: M

(The following information applies to the next four problems.)

Cash discounts CI Answer: c Diff: E

Bad debt losses CI Answer: d Diff: E

a. -$108,750 (carrying costs would decline)

Incremental profits CI Answer: a Diff: M

Cost of short-term financing CI Answer: d Diff: M

a. The cost of using additional trade credit is approximately 36 percent.

Effective interest rate CI Answer: d Diff: T

2. Credit standards FI Answer: b Diff: M

3. Collection policy FI Answer: b Diff: M

4. Collection policy FI Answer: a Diff: M

5. Cash discounts FI Answer: b Diff: M

6. Cash discounts FI Answer: a Diff: M

7. Payments pattern approach FI Answer: a Diff: M

8. Payments pattern approach FI Answer: b Diff: M

9. Payments pattern approach FI Answer: a Diff: M

10. Payments pattern approach FI Answer: b Diff: M

11. Uncollected balances schedule FI Answer: a Diff: M