Chapter Ten: Short-term finance — working capital

Questions

10.2 What is the trade-off that a financial manager must juggle in deciding on
the most appropriate level of working capital?

Having sufficient working capital but minimising the cost. Having more may be easily
arranged, but almost certainly will reduce the return on investors’ funds.

10.3 How can having excessive working capital reduce the profitability of the
firm?

Cash and inventory are essential to many firms and debtors allow increases in sales
that otherwise would not be made. However, excess cash has an opportunity cost,
excess stock increases costs and too high a debtor level can mean the firm is pushing
for sales to potentially risky clients. Hence all areas of working capital is allowed to
become excessive can increase costs and reduce profits.

10.4 Explain the apparent paradox that the excessive use of short-term funds
could increase the risk of illiquidity for a firm.

Short-term debt must be repaid more often, so funds must be available at those times
to repay the debt easily. If it is not available, the firm faces illiquidity and may have to
try to raise funds quickly and expensively.

10.11 Temporary assets should be funded with temporary sources of funding.

Why?

To match repayment needs with the liquidation of the assets

10.20 Explain the differences between factoring and discounting invoices.

Factoring means the debts are sold to another party which takes over the collection
role; discounting means the debts are used as security for a loan and the issuer of the
invoices continues to collect the proceeds.

Financial Problems
10.1 David Pride Fashions has an overdraft account at its bank with a limit of
$100 000. Interest is charged at the rate of 11.25% p.a. on daily balance,
debited monthly. The balance remains at $26  833.25 O/D for 7 days and

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Introducing Corporate Finance 2e Solutions Manual

then falls to $55 800.02 O/D for the remaining 23 days in the month. What
is the monthly interest expense?

$26 833.25 × .000308219 × 7 = $57.89

$55 800.02 × .000308219 × 23 = $395.57
Total = $453.46

10.2 Georg Zeller is a conservative chief financial officer. He often over-

estimates the need for cash in his firm. The internal auditor has just
reported to the board that Georg kept $250 000 more in the current
account than was necessary for a particular 6 months period. Funds in
the current account earned 0.25% while funds in the almost risk-free
short-term money market earned 5.25%. The internal audit reported a
cost to the firm post-tax through this action. What amount would you
report to the board as the cost? Would it be pre- or post-tax?

Opportunity interest cost = 5%. Interest lost = $6250 pre-tax or $4375 after-tax.

10.9 Bill Smith Sportstore has funds to invest for a short period. Bill, the
owner, approaches his bank and finds he can lend funds to other
businesses for short periods via the bank-accepted bill medium. Bill is
happy that there is little risk with the bank acceptance of the security. Bill
pays over the funds to finance a $100  000 commercial bills for 180 days at
6.3% yield. How much does Bill pay to the bank? How much will Bill be
repaid at the end of the period?

100 000
P=
(1+0. 063×180 ) 100 000
365 = 1 .0311 = $96 983.80  

Repayment = $100 000

10.15 Ace Discounters buy $600 000 of invoices for a 4.3% fee. Ace collects 90%
of the debts in 30 days and 10% in 61 days. If funds cost Ace 6.0% p.a.
and assuming the costs of collecting the debts amount to 2% of face value
per month for debts collected within 30 days and 3% of face value per
month for debts collected within 2 months. Was this deal worth doing for
Ace? Why? How could Ace manage a better outcome?

Revenue: .043 × 600 000 = $25 800

Costs: interest: $2700 + $600 = $3300. Collection: $10  800 + $3600 = $14 400. Total
cost = $17 700. Yes, an $8100 surplus. Faster collection would reduce interest costs
and probably collection costs.

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 Chapter Ten: Short-term finance — working capital

10.18 A floor-plan financier agrees to lend a car dealer funds to buy stock up to
a limit of $1 million. The first order under this scheme is for 25 sedans
and wagons which average $23 000 each with all ordered optional extras
included. The cars are delivered and the invoice paid by the financier on
Monday, 1 October. The interest charge is 6.5% p.a., charged monthly on
balance at 5.00 pm each day. Five vehicles are sold in the first week, and
6 in the second week, at an average price of $30  000 each. The dealer pays
the financier electronically, at cost price, late on Friday at the end of each
week for the vehicles sold during that week. The dealer re-orders vehicles
at the end of the second week, and 10 new vehicles are delivered and paid
for by the financier on the Monday of the fourth week at the same
average price as the original lot. Sales comprise 5 vehicles in each of
weeks 3 and 4, and 2 in the last few days of the month. How much does
the dealer owe the financier on the first day of the new month?

This problem is best tackled by means of a time line on which are marked the days
each amount is outstanding. For example, in the first period of 4 days, the outstanding
amount is $575 000, then it drops to $460 000 for 7 days, then $322 000 for 7 days,
$207 000 for 3 days, $437 000 for 4 days and $322 000 for 6 days. Ignore the last two
cars sold as they are not brought to account until the first Friday of the new month.
Check that you have 31 days for the month. You can also check that each addition and
subtraction of total outstanding funds does indeed equal a multiple of $23 000. The
interest rate is 0.178 per $1000 per day. On 1 November, the dealer owes $2149.35
interest and $322 000 principal. A table also helps as an analytical tool.

Date 1 5 12 19 22 26 31
Day Mon Fri Fri Fri Mon Fri Wed
Days to date 0 4 7 7 3 4 6
Balance owing
before payment 207
($000) 575 575 460 322 437 437 322
Balance owing after
payment ($000) n.a. 460 322 207 n.a. 322 n.a.
No. cars in stock 25 20 14 9 19 14 n.a.
Interest for period n.a. 409.4 573.16 401.21 110.54 311.14 343.90

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