Financing Current Assets

Blanket inventory liens.

Blanket inventory lien is a document that establishes the inventory as collateral for the loan.

The chief financial officer of Smith Glass Inc. follows the policy of matching the maturity of assets with the maturity of financing. The implications of this policy include all of the following EXCEPT that

Cash, receivables, and inventory should be financed with long-term debt or equity. Under this policy current assets are financed with current liabilities.

A compensating balance

Compensates a financial institution for services rendered by providing it with deposits of funds. Compensating balance provides a form of additional compensation to financial institutions.

The prime rate is the

Rate charged on business loans to borrowers with high credit ratings. Prime rate of interest is the rate financial institutions charge their customers with the highest credit rating. the effective rate on the bank loans of most firms is greater than the prime rate. The rate at which a bank borrows from the Federal Reserve central bank is the discount rate.

The Red Company has a revolving line of credit of $300,000 with a one-year maturity. The terms call for a 6% interest rate and a ½% commitment fee on the unused portion of the line of credit. The average loan balance during the year was $100,000. The annual cost of this financing arrangement is

$7,000; Annual cost of the arrangement is calculated as $7,000 (6% × $100,000) + [($300,000 - $100,000) × 1/2%)].

Loans involving inventory?

1. Blanket liens - involves a legal document that establishes inventory as collateral for a loan. 2. Trust receipts - an instrument that acknowledges that the borrower holds the inventory and the proceeds from sales will be put in trust for the lender. 3. Warehousing - involves storing inventory in a public warehouse under the control of the lender.

**71. Should CyberAge use trade credit and continue paying at the end of the credit period? a. Yes, if the cost of alternative short-term financing is less. b. Yes, if the firm's weighted-average cost of capital is equal to its weighted-average cost of trade credit. c. No, if the cost of alternative long-term financing is greater. d. Yes, if the cost of alternative short-term financing is greater.

71. (d) The requirement is to identify the statement that determines whether CyberAge should continue to use the trade credit. Answer (d) is correct because the company should continue to use the trade credit as long as the alternative cost of other forms of financing is higher. Answer (a) is incorrect because if alternative sources are less, the alternative should be used. Answer (b) is incorrect because in considering shortterm financing alternatives, it is the marginal cost of capital that is important, not the weighted-average cost of capital. Answer (c) is incorrect because if the cost of long-term financing is greater, the trade credit should be used.

Hagar Company's bank requires a compensating balance of 20% on a $100,000 loan. If the stated interest on the loan is 7%, what is the effective cost of the loan?

8.75%; The effective interest rate is equal to the interest paid, $7,000 ($100,000 × 7%) divided by the funds that are available, $80,000 (80% × $100,000). Therefore, the effective interest rate is equal to 8.75% ($7,000 ÷ $80,000).

Which of the following is not related to loans involving inventory? b. Blanket liens. c. Trust receipts. d. Warehousing.

Factoring. Factoring involves the sale of accounts receivable.

Matching the maturity of assets with the maturity of financing.

1. The seasonal expansion of cash, receivables, and inventory should be financed by short-term debt such as vendor payables and bank debt. 2. The minimum level of cash, receivables, and inventory required to stay in business can be considered permanent, and financed with long-term debt or equity. 3. Long-term assets, like plant and equipment, should be financed with long-term debt or equity.

If a firm borrows $500,000 at 10% and is required to maintain $50,000 as a minimum compensating balance at the bank, what is the effective interest rate on the loan?

11.1%; To calculate the effective interest rate on a loan with a compensating balance requirement. The interest rate is calculated with the following formula: Interest cost = 10% × $500,000 = 11.1% Funds available $500,000 - $50,000

On January 1, Scott Corporation received a $300,000 line of credit at an interest rate of 12% from Main Street Bank and drew down the entire amount on February 1. The line of credit agreement requires that an amount equal to 15% of the loan be deposited into a compensating balance account. What is the effective annual cost of credit for this loan arrangement?

14.12%; Effective interest rate is equal to the interest cost divided by the available funds. The interest cost is $36,000 ($300,000 × 12%), and the available funds is equal to $255,000 [$300,000 - (15% × $300,000)]. Therefore, the effective interest rate is 14.12% ($36,000/$255,000).

If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year. a. 24.00% b. 37.11% c. 36.00%

31.81%; The requirement is to calculate the cost of not taking a trade discount. The formula for computing the interest = Discount percent × 360 days 100% - Discount percent Total pay period - Discount period 3% × 360 days = 31.81% 100% - 3% 45 days - 10 days

56. Gild Company has been offered credit terms of 3/10, net 30. Using a 365-day year, what is the nominal cost of not taking advantage of the discount if the firm pays on the 35th day after the purchase? a. 14.2% b. 32.2% c. 37.6% d. 45.2%

56. (d) The requirement is to calculate the cost of not taking a trade discount. The cost is calculated with the following formula: Discount percent × 365 days 100% - Discount percent Total pay period - Discount period Answer (d) is correct because the discount percentage is 3%, the total pay period is 35 days, and the discount period is 15 days. Therefore, the nominal cost is calculated as follows: 3% × 365 days = 45.2% 100% - 3% 35 days - 10 days

57. Newton Corporation is offered trade credit terms of 3/15, net 45. The firm does not take advantage of the discount, and it pays the account after 67 days. Using a 365-day year, what is the nominal annual cost of not taking the discount? a. 18.2% b. 21.71% c. 23.48% d. 26.45%

57. (b) The requirement is to calculate the cost of not taking a trade discount. The cost is calculated with the following formula: Discount percent × 365 days 100% - Discount percent Total pay period - Discount period Answer (b) is correct because the discount percentage is 3%, the total pay period is 67 days, and the discount period is 15 days. Therefore, the nominal cost is calculated as follows: 3% × 365 days = 21.71% 100% - 3% 67 days - 15 days

A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?

6.44%; The effective interest is 6.44%. The effective interest rate is determined by calculating the net interest expense, which is $15,000 ($250,000 × 6%) minus the interest income from the compensating balance $500 ($25,000 × 2%) equals $14,500. Then, this amount is divided by the amount of money that the firm has available, $250,000 - $25,000 compensating balance. Thus, the effective interest rate is 6.44% ($14,500/$225,000).

Items 70 and 71 are based on the following information: CyberAge Outlet, a relatively new store, is a café that offers customers the opportunity to browse the Internet or play computer games at their tables while they drink coffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee shirts, and computer accessories. CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge's two major vendors, including average monthly purchases and credit terms. Vendor Average monthly purchases Credit terms Web Master $25,000 2/10, net 30 Softidee 50,000 5/10, net 90 **70. Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company's weighted-average annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is a. 27.0% b. 25.2% c. 28.0% d. 30.2%

70. (b) The requirement is to calculate the weightedaverage annual interest rate for trade credit. If the company does not pay Web Master within the discount period, it will incur interest costs of $500 ($25,000 × 2%). This results in an annualized interest rate of 36.7347% [($500 ÷ $24,500) × 360 days ÷ (30 - 10 days)]. If the company does not pay the Softidee account during the discount period, it will incur interest cost of $2,500 ($50,000 × 5%). This results in an annualized interest rate of 23.6842% [($2,500 ÷ $47,500) × 360 days ÷ (90 - 10 days)]. To determine the weighted-average interest rate, we must first determine the average amount borrowed. For Web Master, this is equal to $24,500 × (20 days ÷ 360 days) = $1,361.11, and for Softidee, it is equal to $47,500 × (80 days ÷ 360 days) = $10,555.56. Therefore, the weighted-average interest rate is equal to 25.2% {[(36.7347% × $1,361.11) + (23.6842% × $10,555.56)] ÷ ($1,361.11 + $10,555.56)}. Answer (a) is incorrect because it uses weights of $25,000 and $50,000. Answer (c) is incorrect because it is based on weights of $24,500 and $47,500. Answer (d) is incorrect because it is the unweighted-average of the two rates.

Elan Corporation is considering borrowing $100,000 from a bank for one year at a stated interest rate of 9%. What is the effective interest rate to Elan if this borrowing is in the form of a discount note?

9.89%; The effective interest rate is calculated by dividing the total amount of interest by the amount of funds available. In this case, the interest is equal to $9,000 ($100,000 × 9%) and the funds available are $91,000 ($100,000 - $9,000). Thus the interest rate is 9.89% ($9,000/$91,000).

If a firm is offered credit terms of 2/10, net 30 on its purchases. Sound cash management practices would mean that the firm would pay the account on which of the following days? a. Day 2 and 30. b. Day 2 and 10. c. d. Day 30.

Day 10. The requirement is to evaluate credit terms to made sound cash management decisions. A firm should take advantage of the cash discount and pay on the last day of the discount period, which is day 10. "2" is the amount of the percentage discount; not the discount period. If a firm pays bills on the final due date, it will not have taken advantage of cash discounts which are very lucrative.

Assume that Williams Corp is financed with a heavy reliance on short-term debt and short-term rates have increased. How do these facts impact the interest expense, net income, and financial risk for Williams Corp?

Interest expense --> Increases Net income --> Decreases Financial risk --> Increase The requirement is to analyze the impact upon a firm of rising short-term interest rates. A heavy reliance on short-term debt means that interest expense and the related net income will be variable and this increases the financial risk of the firm. If short-term interest rates increase then interest expense will increase which will cause a related decrease in net income.

An advantage of the use of long-term debt as opposed to short-term debt to finance current assets is

It decreases the risk of the firm. Financing with long-term as opposed to short-term debt reduces the risk of the firm. Long-term debt does not have to be repaid as soon as short-term debt. Long-term debt is generally more costly than short-term debt. The debt covenants are usually more restrictive in long-term debt agreements. Early payment of long-term debt can result in prepayment penalties.

The London Interbank Offered Rate (LIBOR) represents an example of a

Nominal rate. LIBOR, like the prime rate, is an example of a nominal rate. It is adjusted for inflation risk, but not credit risk. LIBOR is a short-term rate.

The following forms of short-term borrowings are available to a firm: +Floating lien +Factoring +Revolving credit +Chattel mortgages +Bankers' acceptances +Lines of credit +Commerical paper The forms of short-term borrowing that are unsecured credit are

Revolving credit, bankers' acceptances, line of credit, and commercial paper. Revolving credit agreements, bankers' acceptances, lines of credit, and commercial paper all represent unsecured obligations. Floating liens and chattel mortgages are secured. Factoring agreements and chattel mortgages are secured.

Which form of asset financing involves the public offering of debt collateralized by a firm's accounts receivables?

Securitization of assets - the offering of debt collateralized by a firm's accounts receivable.

A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate, but the terms of the loans vary. Which of the following combinations of loan terms will be most attractive for the borrowing firm?

Simple interest, no compensating balance. Simple interest with no compensating balance is the most favorable terms from an effective interest basis. Discount interest and/or a compensating balance increase the effective interest rate on the loan.

With respect to the use of commercial paper by an industrial firm, which one of the following statements is most likely to be true?

The commercial paper has a maturity of 60-270 days. Commercial paper is normally issued with a short maturity period, usually 2 to 9 months. Commercial paper is issued by the corporation. Commercial paper is unsecured. Commercial paper is typically issued by large corporations.

A company obtaining short-term financing with trade credit will pay a higher percentage financing cost, everything else being equal, when

The supplier offers a longer discount period. If the discount period is longer, the days of extra credit obtained by forgoing the discount are fewer. This makes the trade credit more costly. Lower the discount percentage, the lower the opportunity cost of forgoing the discount and using the trade credit financing. Percentage financing cost is unaffected by the purchase price of the items.

Which of the following financial instruments generally provides the largest source of short-term credit for small firms?

Trade credit. Trade credit is the largest source of short-term financing for most small firms. It occurs automatically with the purchase of goods and services. Installment loans and Commercial paper are not the largest source of short-term financing for most small firms. Mortgage bonds are a source of long-term financing.

Trust receipts

Trust receipt is an instrument that acknowledges that the borrower holds a collateralized inventory and that proceeds from the sale will be put in trust for the lender.

Warehousing.

Warehousing is the storage of inventory in a public warehouse that can only be removed with the lender's permission.