Discussion Questions
1. Under what circumstances would it be advisable to borrow money to take a cash discount?
2. Discuss the relative use of credit between large and small firms. Which group is generally in the net creditor position, and why?
3. How have new banking laws influenced competition?
4. What is the prime interest rate? How does the average bank customer fare in regard to the prime interest rate?
5. What does LIBOR mean? Is LIBOR normally higher or lower than the U.S. prime interest rate?
6. What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporations?
7. A borrower is often confronted with a stated interest rate and an effective interest rate. What is the difference, and which one should the financial manager recognize as the true cost of borrowing?
8. Commercial paper may show up on corporate balance sheets as either a current asset or a current liability. Explain this statement.
9. What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage?
10. What is the difference between pledging accounts receivable and factoring accounts receivable?
11. What is an asset-backed public offering?
12. Briefly discuss three types of lender control used in inventory financing.
13. What is meant by hedging in the financial futures market to offset interest rate risks?
Problems
1. Compute the cost of not taking the following cash discounts.
a. 2/10, net 40.
b. 2/15, net 30.
c. 2/10, net 45.
d. 3/10, net 90.
2. Delilah's Haircuts can borrow from its bank at 13 percent to take a cash discount. The terms of the cash discount are 2/15, net 55. Should the firm borrow the funds?
3. Your bank will lend you $4,000 for 45 days at a cost of $50 interest. What is your effective rate of interest?
4. Your bank will lend you $3,000 for 50 days at a cost of $45 interest. What is your effective rate of interest?
5. I. M. Boring borrows $5,000 for one year at 13 percent interest. What is the effective rate of interest if the loan is discounted?
6. Ida Kline borrows $8,000 for 90 days and pays $180 interest. What is the effective rate of interest if the loan is discounted?
7. Mo and Chris's Sporting Goods, Inc., borrows $14,500 for 20 days at 12 percent interest. What is the dollar cost of the loan?
Use the formula:
Dollar cost of loan = Amount borrowed x Interest rate x Days loan is outstanding/Days in the year (360)
8. Sampson Orange Juice Company normally takes 20 days to pay for its average daily credit purchases of $6,000. Its average daily sales are $7,000, and it collects accounts in 28 days.
a. What is its net credit position? That is, compute its accounts receivable and accounts payable and subtract the latter from the former.
Accounts receivable = Average daily credit sales × Average collection period Accounts payable = Average daily credit purchases × Average payment period
b. If the firm extends its average payment period from 20 days to 35 days (and all else remains the same), what is the firm's new net credit position? Has it improved its cash flow?
9. Maxim Air Filters, Inc., plans to borrow $300,000 for one year. Northeast National Bank will lend the money at 10 percent interest and requires a compensating balance of 20 percent. What is the effective rate of interest?
10. Digital Access, Inc., needs $400,000 in funds for a project.
a. With a compensating balance requirement of 20 percent, how much will the firm need to borrow?
b. Given your answer to part a and a stated interest rate of 9 percent on the total amount borrowed, what is the effective rate on the $400,000 actually being used?
11. Carey Company is borrowing $200,000 for one year at 12 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. What is the effective rate of interest? What would the effective rate be if Carey were required to make 12 equal monthly payments to retire the loan? The principal, as used in Formula 8-6, refers to funds the firm can effectively utilize (Amount borrowed - Compensating balance).
12. Capone Child Care Centers, Inc., plans to borrow $250,000 for one year at 10 percent from the Chicago Bank and Trust Company. There is a 20 percent compensating balance requirement. Capone keeps minimum transaction balances of $18,000 in the normal course of business. This idle cash counts toward meeting the compensating balance requirement. What is the effective rate of interest?
13. The treasurer of Neiman Supermarkets is seeking a $30,000 loan for 180 days from Wrigley Bank and Trust. The stated interest rate is 10 percent and there is a 15 percent compensating balance requirement. The treasurer always keeps a minimum of $2,500 in the firm's checking account. These funds could count toward meeting any compensating balance requirement. What is the effective rate of interest on this loan?
14. Tucker Drilling Corp. plans to borrow $200,000. Northern National Bank will lend the money at one-half percentage point over the prime rate of 8½ percent (9 percent total) and requires a compensating balance of 20 percent. Principal in this case refers to funds that the firm can effectively use in the business.
What is the effective rate of interest? What would the effective rate be if Tucker Drilling were required to make four quarterly payments to retire the loan?
15. Your company plans to borrow $5 million for 12 months, and your banker gives you a stated rate of 14 percent interest. You would like to know the effective rate of interest for the following types of loans. (Each of the following parts stands alone.)
a. Simple 14 percent interest with a 10 percent compensating balance.
b. Discounted interest.
c. An installment loan (12 payments).
d. Discounted interest with a 5 percent compensating balance.
16. If you borrow $12,000 at $900 interest for one year, what is your effective interest rate for the following payment plans?
a. Annual payment.
b. Semiannual payments.
c. Quarterly payments.
d. Monthly payments.
17. Vroom Motorcycle Company is borrowing $30,000 from First State Bank. The total interest is $9,000. The loan will be paid by making equal monthly payments for the next three years. What is the effective rate of interest on this installment loan?
18. Mr. Paul Promptly is a very cautious businessman. His supplier offers trade credit terms of 3/10, net 70. Mr. Promptly never takes the discount offered, but he pays his suppliers in 60 days rather than the 70 days allowed so he is sure the payments are never late. What is Mr. Promptly's cost of not taking the cash discount?
19. The Ogden Timber Company buys from its suppliers on terms of 2/10, net 35. Ogden has not been utilizing the discount offered and has been taking 50 days to pay its bills. The suppliers seem to accept this payment pattern, and Ogden's credit rating has not been hurt.
Mr. Wood, Ogden Timber Company's vice-president, has suggested that the company begin to take the discount offered. Mr. Wood proposes that the company borrow from its bank at a stated rate of 15 percent. The bank requires a 25 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement. Do you agree with Mr. Wood's proposal?
20. In problem 19, if the compensating balance requirement were 10 percent instead of 25 percent, would you change your answer? Do the appropriate calculation.
21. Bosworth Petroleum needs $500,000 to take a cash discount of 2/10, net 70. A banker will loan the money for 60 days at an interest cost of $8,100.
a. What is the effective rate on the bank loan?
b. How much would it cost (in percentage terms) if Bosworth did not take the cash discount, but paid the bill in 70 days instead of 10 days?
c. Should Bosworth borrow the money to take the discount?
d. If the banker requires a 20 percent compensating balance, how much must Bosworth borrow to end up with the $500,000?
e. What would be the effective interest rate in part d if the interest charge for 60 days were $13,000? Should Bosworth borrow with the 20 percent compensating balance? (There are no funds to count against the compensating balance requirement.)
22. Columbus Shipping Company is negotiating with two banks for a $100,000 loan. Bankcorp of Ohio requires a 20 percent compensating balance, discounts the loan, and wants to be paid back in four quarterly payments. Cleveland Bank requires a 10 percent compensating balance, does not discount the loan, but wants to be paid back in 12 monthly installments. The stated rate for both banks is 10 percent. Compensating balances and any discounts will be subtracted from the $100,000 in determining the available funds in part a.
a. Which loan should Columbus accept?
b. Recompute the effective cost of interest, assuming Columbus ordinarily maintains
$20,000 at each bank in deposits that will serve as compensating balances.
c. How much did the compensating balances inflate the percentage interest costs? Does your choice of banks change if the assumption in part b is correct?
23. Texas Oil Supplies sells to the 12 accounts listed below.
|
Account
|
Receivable Balance Outstanding
|
Average Age of the Account over the Last Year
|
|
A
|
................
|
$ 50,000
|
....................
|
35 days
|
|
B
|
................
|
80,000
|
....................
|
25
|
|
C
|
................
|
120,000
|
....................
|
47
|
|
D
|
................
|
10,000
|
....................
|
15
|
|
E
|
................
|
250,000
|
....................
|
35
|
|
F
|
................
|
60,000
|
....................
|
51
|
|
G
|
................
|
40,000
|
....................
|
18
|
|
H
|
................
|
180,000
|
....................
|
60
|
|
I
|
................
|
15,000
|
....................
|
43
|
|
J
|
................
|
25,000
|
....................
|
33
|
|
K
|
................
|
200,000
|
....................
|
41
|
|
L
|
................
|
60,000
|
....................
|
28
|
J&J Financial Corporation will lend 90 percent against account balances that have averaged 30 days or less; 80 percent for account balances between 30 and 40 days; and 70 percent for account balances between 40 and 45 days. Customers that take over 45 days to pay their bills are not considered as adequate accounts for a loan.
The current prime rate is 7 percent, and J&J Financial Corporation charges 2 percent over prime to Texas Oil Supplies as its annual loan rate.
a. Determine the maximum loan for which Texas Oil Supplies could qualify.
b. Determine how much one month's interest expense would be on the loan balance determined in part a.
24. The treasurer for Thornton Pipe and Steel Company wishes to use financial futures to hedge her interest rate exposure. She will sell five Treasury futures contracts at $105,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.4 percent. If they increase to 8.5 percent, assume the value of the contracts will go down by 10 percent. Also if interest rates do increase by 1.1 percent, assume the firm will have additional interest expense on its business loans and other commitments of $60,800. This expense, of course, will be separate from the futures contracts.
a. What will be the profit or loss on the futures contract if interest rates go to 8.5 percent?
b. Explain why a profit or loss took place on the futures contracts.
c. After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of $60,800? What percent of this increased cost did the treasurer effectively hedge away?
d. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.
Comprehensive Problem.
Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The small chemical company needs to borrow $500,000.
The bank offers a rate of 8 ¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9¾ percent with additional fees of $5,500 to cover services the bank is providing. In either case the rate on the loan is floating (changes as the prime interest rate changes).
The loan would be for one year.
a. Which loan carries the lower effective rate? Consider fees to be the equivalent of other interest.
b. If the loan with a 20 percent compensating balance requirement were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowed minus the compensating balance.)
c. Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about installment payments and use the loan cost from part a.
If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds to take the discount?
d. Assume the firm actually takes 80 days to pay its bills and would continue to do so in the future if it did not take the cash discount. Should the company take the cash discount?
e. Because the interest rate on the loans is floating, it can go up as interest rates go up. Assume that the prime rate goes up by 2 percent and the quoted rate on the loan goes up the same amount. What would then be the effective rate on the loan with compensating balances? Convert the interest to dollars as the first step in your calculation.
f. In order to hedge against the possible rate increase described in part e, the Midland Chemical Co. decides to hedge its position in the futures market. Assume it sells $500,000 worth of 12- month futures contracts on Treasury bonds. One year later, interest rates go up 2 percent across the board and the Treasury bond futures have gone down to $488,000. Has the firm effectively hedged the 2 percent increase in interest rates on the bank loan as described in part e? Determine the answer in dollar amounts.