Course Code: Financial Management

Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

Lesson title: WORKING CAPITAL AND CASH MANAGEMENT Materials:

(CONT.) SAS
Lesson Objectives: References:
At the end of this module, I should be able to: Brigham, E. and Houston, J.
1. describe how the costs of trade credit, bank loans and (2013). Fundamentals of Financial
commercial paper are determined and how that information Management. Pasig City: Cengage
impacts decisions for financing working capital Learning Asia Pte. Ltd.
2. explain how companies use security to lower their costs of
short-term credit

Productivity Tip: Schedule doing practice drills similar to the ones in this module two more times this week.
Spacing your practice time will help you master the process!

A. LESSON PREVIEW/REVIEW
1) Introduction

In the two immediately preceding modules, we learned about the concept of working capital, its
components, effect on a firm’s profitability, credit policies companies set and the cash
conversion cycle. In this module, we will determine the cost of trade credit, bank loans and
commercial paper, and the ways a company uses security to lower their costs of short-term
credit.

2) Activity 1: What I Know Chart, part 1 (3 mins)

Try answering the questions below by writing your ideas under the first column What I Know. It’s
okay if you write key words or phrases that you think are related to the questions.

What I Know Questions: What I Learned (Activity 4)

What is a trade credit?

What is a promissory note?

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

B. MAIN LESSON
1) Activity 2: Content Notes

TRADE CREDIT

Trade credit is debt arising from credit sales and recorded as an account receivable by the seller and
as an account payable by the buyer.

There are two types of trade credit:

1. Free trade credit - the trade credit that is obtained without a cost, and it consists of all trade credit
that is available without giving up discounts. Given the credit term 2/10, net 30, the first 10 days of
purchases are free.
2. Costly trade credit - any trade credit over and above the free trade credit. Given the credit term
2/10, net 30, the period in excess of 10 days is not free because it would mean giving up the
discount.

Calculating the Nominal Annual Cost of Trade Credit

Suppose a company buys 20 microchips each day with a list price of P100 per chip on terms of 2/10,
net 30. Under those terms, the “true” price of the chips is P98 [computed as: 100 – (2% x P100) =
P98] because the chips can be purchased for only P98 by paying within 10 days. Thus, the P2 is
effectively a finance charge for paying beyond 10 days.

Suppose the said company operates 365 days in a year and buys 20 chips per day. If it takes the
discount, the total amount of purchase is P715,400 per year. If it does not take the discount, the total
cost of the chips will be P730,000. The difference of P14,600 is the annual cost of the trade credit.

To compute the Nominal Annual Cost of Trade Credit (NACTC), the following equation is used:
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 (%) 365
𝑁𝐴𝐶𝑇𝐶 = 100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 (%) 𝑥 𝐷𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

Suppose the company decides to delay payment until the 30th day, the NACTC is computed as
follows:
2 365 2 365
𝑁𝐴𝐶𝑇𝐶 = 100−2 𝑥 30−10 = 98 𝑥 20 = 37. 24%

Nominal Annual Cost of Trade Credit vs. Effective Annual Cost of Trade Credit or Effective
Annual Rate (EAR)

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

The nominal annual cost formula does not take account of compounding; and in effective annual
interest terms, the cost of trade credit is even higher.

The discount is equivalent to interest; and with terms of 2/10, net 30, the company gains the use of
funds for 30 – 10 = 20 days. So there are 365/20 = 18.25 “interest periods” per year.

The first term in the NACTC equation, (Discount %)/(100 – Discount %) = 0.02/0.98 = 0.0204, is the
periodic interest rate. That rate is paid 18.25 times each year, so the effective annual cost of trade
credit is 44.6%:
18.25
𝐸𝐴𝑅 = (1. 0204) − 1. 0 = 1. 4459 − 1 = 44. 6%

BANK LOANS

Bank loans are an important source of short-term financing for business organizations, evidenced by
promissory notes. A promissory note is a document specifying the terms and conditions of a loan,
including the amount, interest rate, and repayment schedule. Here are some of the key features of
most promissory notes:

1. Amount
2. Maturity
3. Interest rate
4. Frequency of principal and interest payments
5. Collateral or security for loans

Cost of Bank Loans

The costs of bank loans vary for different types of borrowers at any given point in time and for all
borrowers over time. Interest rates are higher for riskier borrowers, and rates are higher on smaller
loans because of the fixed costs involved in making and servicing loans. If a firm can qualify as a
“prime credit” because of its size and financial strength, it can borrow at the prime rate, which at one
time was the lowest rate banks charged.

Calculating the Effective Interest Rate on Bank Loans

Assuming the company has a loan of P10,000 at the prime rate of 5.25% with a 360-day year. If
interest is paid once a year, the nominal rate also will be the effective rate. However, if interest must
be paid monthly, the effective rate will be (1 + 0.0525/12)12 – 1 = 5.3782%.

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

Commercial Paper

Commercial paper is a promissory note issued by a large, strong firm—most often a financial
institution—that wants to borrow on a short-term basis. Commercial paper is sold primarily to other
business firms, insurance companies, pension funds, money market mutual funds, and banks and is
generally unsecured; but “asset-backed paper” secured by credit card debt and other small,
short-term loans has also been issued.

Secured Loans

Companies may find that they can borrow only if they put up collateral to protect the lender or that
securing the loan enables them to borrow at a lower rate. A secured loan is a loan backed by
collateral, such as movable or immovable properties of the borrower. Land, buildings, and equipment
are good forms of collateral; but they are generally used to secure long-term loans rather than
short-term working capital loans. Therefore, most secured short-term business loans use accounts
receivable and inventories as collateral.

2) Activity 3: Skill-building Activities

Let’s practice! After completing each exercise, you may refer to the Key to Corrections for
feedback. Try to complete each exercise before looking at the feedback.

Exercise 1: Lamar Lumber buys P8 million of materials (net of discounts) on terms of 3/5, net
60; and it currently pays after 5 days and takes discounts. Lamar plans to expand, which will
require additional financing. If Lamar decides to forgo discounts, how much additional credit
could it get and what would be the nominal and effective cost of that credit? If the company
could get the funds from a bank at a rate of 10%, interest paid monthly, based on a 365-day
year, what would be the effective cost of the bank loan? Should Lamar use bank debt or
additional trade credit? Explain.

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

Exercise 2: Why is some trade credit called free while other credit is called costly? If a firm buys
on terms of 2/10, net 30, pays at the end of the 30th day, and typically shows P300,000 of
accounts payable on its balance sheet, would the entire P300,000 be free credit, would it be
costly credit, or would some be free and some costly? Explain your answer. No calculations are
necessary.

3) Activity 4: What I Know Chart, part 2

It’s time to answer the questions in the What I Know chart in Activity 1. Log in your answers in
the table.

4) Activity 5: Check for Understanding

Encircle the letter of the correct answer.

23. Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days. Out of
convenience, your firm is not taking discounts, but is paying after 20 days, instead of waiting
until Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30
is approximately 37 percent. But since your firm is not taking discounts and is paying on Day
20, what is the effective annual cost of your firm’s current practice, using a 365-day year?

a. 36.7%
b. 105.4%
c. 73.4%
d. 43.6%
e. 109.0%

24. Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole
supplier. The supplier offers trade credit under the following terms: 2/15, net 50 days. If Hayes
chooses to pay on time but not to take the discount, what is the average level of the company’s
accounts payable, and what is the effective annual cost of its trade credit? (Assume a 365-day
year.)

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

a. $208,333; 17.81%
b. $416,667; 17.54%
c. $416,667; 27.43%
d. $625,000; 17.54%
e. $625,000; 23.45%

(The following data apply 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 that you will repay in
12 equal monthly installments, beginning at the end of the first month.

3. How large are your monthly payments?

a. $6,250
b. $7,000
c. $7,500
d. $5,250
e. $6,875

4. 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%

C. LESSON WRAP-UP
1) Activity 6: Thinking about Learning

Congratulations for finishing this module! Shade the number of the module that you finished.

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

Did you have challenges learning the concepts in this module? If none, which parts of the module
helped you learn the concepts?

__________________________________________________________________________________
___________________________

Some question/s I want to ask my teacher about this module is/are:

______________________________________

__________________________________________________________________________________
___________________________

KEY TO CORRECTIONS

Answers to Skill-Building Exercises

Exercise 1:

Purchases = P8,000,000; terms = 3/5 net 60; currently pays on Day 5 and takes discounts.
Forgoes discounts; additional credit = ?

P8,000,000/365 x 55 days = P1,205,479.45.

Nominal cost of trade credit = = 3.09% x 6.6364 = 20.52%.
Effective cost of trade credit = (1 + 3/97)365/55 – 1 = 1.2240 – 1 = 22.40%.
Bank loan: 10%, interest paid monthly

EAR = (1 + 0.10/12)12 – 1 = 1.1047 – 1 = 10.47%.

Because the effective cost of the bank loan is less than half the effective cost of the trade credit,
the bank loan should be used.

Exercise 2:

Trade credit is the debt arising from credit sales and recorded as an account receivable by the
seller and as an account payable by the buyer. Free trade credit is the credit received during

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 Course Code: Financial Management
Student Activity Sheet Module #12

Name: _________________________________________________________ Class number: ____

Section: ____________ Schedule: __________________________________ Date: ___________

the discount period, while the costly trade credit is the credit taken in excess of free trade credit,
whose cost is equal to the discount lost. With credit terms of 2/10, net 30 and the firm pays on
the 30th day, then some of the trade credit would be free and some would be costly. With an
accounts payable balance of P300,000, then the free trade credit would be P100,000 and the
costly trade credit would be P200,000. The free trade credit represents the 10 days of
purchases that would qualify for the discount, while the costly trade credit represents the
additional 20 days of purchases that do not qualify for the discount.

4) Activity 5: Check for Understanding

. EAR cost of trade credit Answer: e

Calculate the nominal percentage, which is the nominal annual cost:

Nominal cost = × = 0.0204 x 36.5 = 0.7449 ≈ 74.5%.

Calculate the effective annual rate (EAR):

Numerical solution:
EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05% ≈ 109%.

2. EAR cost of trade credit Answer: e

The company pays every 50 days or 365/50 = 7.3 times per year. Thus, the average accounts
payable are $4,562,500/7.3 = $625,000. The effective cost of trade credit can be found as
follows:
EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%.

3. Add-on loan payments Answer: e

The monthly payments would be:

Monthly payment = = $6,875.

4. Nominal add-on interest rate Answer: d

Approximate rate = = 20%.

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