Chapter15b - CHAPTER 15-B The Cost of Short-Term Financing...

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Unformatted text preview: CHAPTER 15-B The Cost of Short-Term Financing Multiple Choice: Conceptual Short-term financing 1. Answer: a Diff: E Firms generally choose to finance temporary assets with short-term debt because a. Matching the maturities of assets and liabilities reduces risk. b. Short-term interest rates have traditionally been more stable than long-term interest rates. c. A firm which borrows heavily long-term is more apt to be unable to repay the debt than the firm which borrows heavily short-term. d. The yield curve has traditionally been downward sloping. e. Sales remain constant over the year, and financing requirements also remain constant. Commercial paper 2. Answer: d Diff: E Which of the following statements concerning commercial paper is false? a. Commercial paper is generally written for terms less than 270 days. b. Commercial paper generally carries an interest rate below the prime rate. c. Commercial paper is sold to money market mutual funds, as well as to other financial institutions and nonfinancial corporations. d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. e. Commercial paper is a type of unsecured promissory note issued by large, strong firms. Working capital financing 3. Answer: e Diff: E Which of the following statements is most correct? a. Trade credit is provided to a business only when purchases are made. b. Commercial paper is a form of short-term financing that is primarily used by large, financially stable companies. c. Short-term debt, while often cheaper than long-term debt, exposes a firm to the potential problems associated with rolling over loans. d. Both statements b and c are correct. e. All of the statements above are correct. Chapter 15b - Page 1 Working capital financing 4. Answer: a Diff: E Which of the following statements is incorrect? a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. b. Accruals represent a source of “free” financing in the sense that no explicit interest is paid on these funds. c. A conservative approach to working capital will result in all permanent assets being financed using long-term securities. d. The risk to the firm of borrowing using short-term credit is usually greater than with long-term debt. Added risk can stem from greater variability of interest costs on short-term debt. e. Trade credit is often the largest source of short-term credit. Short-term financing 5. Answer: a Diff: M Which of the following statements is most correct? a. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but the use of short-term debt would probably increase the firm's risk. b. Conservative firms generally use no short-term debt and thus have zero current liabilities. c. A short-term loan can usually be obtained more quickly than a longterm loan, but the cost of short-term debt is likely to be higher than that of long-term debt. d. If a firm that can borrow from its bank buys on terms of 2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. e. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but does not represent a real financial cost to your firm as long as the firm periodically pays off its entire balance. Choosing a bank 6. Answer: e Diff: M Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a. b. c. d. e. Convenience of location. Competitive cost of services provided. Size of the bank's deposits. Experience of personnel. Loyalty and willingness to assume lending risks. Chapter 15b - Page 2 Multiple Choice: Problems Maturity matching 7. $ 90,000 $260,000 $350,000 $410,000 $320,000 Cost of trade credit Diff: E 21.41% 22.07% 22.95% 23.48% 24.52% Cost of trade credit Answer: d Diff: E Dixie Tours Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 35 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal cost of its non-free trade credit? a. b. c. d. e. 17.2% 23.6% 26.1% 36.7% 50.6% Cost of trade credit 10. Answer: a A firm is offered trade credit terms of 3/15, net 45. The firm does not take the discount, and it pays after 67 days. What is the nominal annual cost of not taking the discount? a. b. c. d. e. 9. Diff: E Wildthing Amusement Company's total assets fluctuate between $320,000 and $410,000, while its fixed assets remain constant at $260,000. If the firm follows a maturity matching or moderate working capital financing policy, what is the likely level of its long-term financing? a. b. c. d. e. 8. Answer: e Answer: b Diff: E Your company has been offered credit terms on its purchases of 4/30, net 90. What will be the nominal cost of trade credit if your company pays on the 35th day after receiving the invoice? a. 30% b. 300% c. 3% d. 87% e. 156% Chapter 15b - Page 3 Discount interest face value 11. $111,000 $100,000 $112,360 $ 89,000 $108,840 Discount interest face value Answer: a Diff: E 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. b. c. d. e. $61,856 $67,531 $60,000 $68,182 $67,423 Loan agreement cost 13. Diff: E 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. b. c. d. e. 12. Answer: c Answer: b Diff: E Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small banks. The firm paid an annual commitment fee of onehalf of one percent of the unused balance of the loan commitment. On the used portion of the loan, Inland paid 1.5 percent above prime for the funds actually borrowed on an annual, simple interest basis. The prime rate was at 9 percent for the year. If Inland borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar cost of the loan agreement for one year? a. b. c. d. e. $560,000 $650,000 $540,000 $900,000 $675,000 Chapter 15b - Page 4 Accounts payable balance 14. Answer: e Your firm buys on credit terms of 2/10, net 45, and it always pays on Day 45. If you calculate that this policy effectively costs your firm $157,500 each year, what is the firm's average accounts payable balance? a. b. c. d. e. $1,234,000 $ 75,000 $ 157,500 $ 625,000 $ 750,000 EAR cost of trade credit 15. Diff: M Answer: e Diff: M 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 around 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 360-day year? a. 36.7% b. 105.4% c. 73.4% d. 43.6% e. 106.9% Cost of trade credit 16. Answer: e Diff: M Hayes Hypermarket purchases $5 million in goods over a one-year period from its sole supplier. The supplier offers trade credit under the following terms: 2/15 net 45. 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 cost of its trade credit? (Assume a 360-day year.) a. b. c. d. e. Average Average Average Average Average accounts accounts accounts accounts accounts payable payable payable payable payable = = = = = $208,333; $416,667; $416,667; $625,000; $625,000; effective effective effective effective effective cost cost cost cost cost of of of of of credit credit credit credit credit = = = = = 17.81% 17.54% 27.43% 17.54% 27.43% Chapter 15b - Page 5 Permanent assets financing 17. 0%; the rates are equal. 1.2% 1.0% 1.8% 0.6% Add-on interest loan Answer: d Diff: M 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 approximate (nominal) rate of interest on the 10.19 percent add-on loan? a. b. c. d. e. 5.10% 10.19% 12.00% 20.38% 30.57% EAR cost of trade credit 19. Diff: M Wicker Corporation is determining whether to support $100,000 of its permanent current assets with a bank note or a short-term bond. The firm's bank offers a two-year note where the firm will receive $100,000 and repay $118,810 at the end of two years. The firm has the option to renew the loan at market rates. Alternatively, Wicker can sell 8.5 percent coupon bonds with a 2-year maturity and $1,000 par value at a price of $973.97. How many percentage points lower is the interest rate on the less expensive debt instrument? a. b. c. d. e. 18. Answer: c Answer: d Diff: E A firm is offered trade credit terms of 2/8, net 45. The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? a. b. c. d. e. 21.63% 13.35% 22.95% 15.65% 18.70% Chapter 15b - Page 6 EAR discounted loan 20. 10.7% 12.0% 12.5% 13.6% 14.1% Effective annual rate Answer: d Diff: E 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. b. c. d. e. 9.50% 10.19% 15.99% 16.98% 20.38% Effective annual rate 22. Diff: E 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. b. c. d. e. 21. Answer: d Answer: c Diff: E 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. b. c. d. e. 16.22% 17.97% 17.48% 18.67% 18.00% Chapter 15b - Page 7 Effective annual rate 23. Answer: e Diff: E 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 compensating balance. 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? a. b. c. d. e. 8.00% 7.23% 7.67% 8.43% 8.30% Chapter 15b - Page 8 CHAPTER 15-B Answers and Solutions 1. Short-term financing Answer: a Diff: E 2. Commercial paper Answer: d Diff: E 3. Working capital financing Answer: e Diff: E 4. Working capital financing Answer: a Diff: E 5. Statement a is incorrect, and therefore the right answer. Commercial paper is a type of unsecured promissory note issued by large, strong firms. Statements b, c, d, and e are all accurate statements. Short-term financing Answer: a Diff: M 6. Under normal conditions the yield curve is upward sloping, thus, shortterm interest rates are lower than long-term interest rates. Consequently, a firm financing with short-term debt will pay less interest than a firm financing with long-term debt--increasing its ROE. However, a firm increases its risk by financing with short-term debt because such debt must be "rolled over" frequently, and the firm is exposed to the volatility of short-term rates. The other statements are false. Choosing a bank Answer: e Diff: M 7. Maturity matching Answer: e Diff: E A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. Thus, since the minimum balance that total assets approach is $320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000. The likely level of long-term financing is $320,000. Long-term debt financing = Permanent cash assets + Fixed assets. Permanent cash assets = Low end of total assets - Fixed assets = $320,000 - $260,000 = $60,000. Long-term debt financing = $60,000 + $260,000 = $320,000. 8. Cost of trade credit Nominal percentage cost = 9. Diff: E Answer: d Diff: E Answer: b Diff: E 3% 360 × = 21.41%. 97% 52 Cost of trade credit Nominal percentage cost = 10. Answer: a 360 2% = 36.7%. × 98% 35 - 15 Cost of trade credit 4% Nominal percentage cost = 96% 360 = 300%. 5 Chapter 15b - Page 9 11. Discount interest face value Answer: c Diff: E Funds required 1.0 - Nominal rate (decimal) $100,000 $100,000 = = = $112,359.55 ≈ $112,360. 1.0 - 0.11 0.89 Face value = 12. Discount interest face value Answer: a Diff: E Convert the annual rate to a periodic rate (quarterly) 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 13. in Loan agreement cost Diff: E Answer: b the Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%. Cost of unused portion: $4,000,000 × 0.005 = $ 20,000 Cost of used portion: $6,000,000 × 0.105 = 630,000 Total cost of loan agreement $650,000 14. Accounts payable balance Approximate percentage cost = Accounts payable = 15. Answer: e Diff: M 2% 360 × = 0.2099 ≈ 21%. 98% 35 $157,500 = $750,000. 0.21 EAR cost of trade credit Answer: e Diff: M Calculate the nominal percentage, which is the nominal annual cost: 2% 360 days × = 0.0204 × 36 = 0.7344 = 73.44%. Nominal cost = 100% − 2% 20 − 10 Calculate the effective annual rate (EAR): Numerical solution: EAR = (1.0204) 36 - 1.0 = 2.0689 - 1.0 = 106.89% ≈ 106.9%. Financial calculator solution: (EAR) Inputs: P/YR = 36; NOM% = 73.44. Output: 16. Cost of trade credit EFF% = 106.89% ≈ 106.9%. Answer: e Diff: M The correct answer is e. The company pays every 45 days or 360/45 = 8 times per year. Thus, the average accounts payable are $5,000,000/8 = $625,000. The effective cost of trade credit can be found as follows: EAR = (1 + 2%/98%) 360/30 - 1 = 1.2743 - 1 = 0.2743 = 27.43%. 17. Permanent assets financing Chapter 15b - Page 10 Answer: c Diff: M Time lines: Note that the cash flows viewed from the firm's perspective involve inflows at time 0, and repayment of coupon and/or maturity value in the future. 2-year note: 0 I=? 1 2 Years | | | +100,000 FV = -118,810 2-year bond: 0I=? | +973.97 1 | -85 2 Years | -85 FV = -1,000 Financial calculator solution: Banknote: Inputs: N = 2; PV = 100,000; PMT = 0; FV = -118,810. Output: I = 9.0%. Bond: Inputs: N = 2; PV = -973.97; PMT = 85; FV = 1,000. Output: I = 10.0%. The difference is 10.0% - 9.0% = 1.0%. 18. Add-on interest loan Answer: d Diff: M Answer: d Diff: E Total to be repaid = $12,000(1.1019) = $13,222.80. Interest = $13,222.80 - $12,000 = $1,222.80. $1,222.80 Approximate rate Add-on = = 0.2038 = 20.38%. $12,000 / 2 19. EAR cost of trade credit Financial calculator solution: (long-form solution) Calculate the interest rate per period Periodic rate = 2/98 = 2.04%. Calculate the number of compounding periods Number of compounding periods = 360/50 = 7.20. Use periodic rate and compounding periods to determine the nominal rate 2.04% × 7.2 = 14.69%. Calculate EAR using interest rate conversion feature Inputs: NOM% = 14.69; P/YR = 7.20. Output: EFF% = EAR = 15.65%. 20. EAR discounted loan Answer: d annual Diff: E Chapter 15b - Page 11 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 I=? 13,636.36 - 1,636.36 discount interest 12,000.00 1 -13,636.36 With a financial calculator, enter N = 1, PV = 12,000, PMT = 0, FV = -13,636.36 , and solve for I/YR = 13.64% ≈ 13.6%. 21. Effective annual rate 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 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 Alternative 1: Chapter 15b - Page 12 Answer: e Diff: E Face amount of loan = $75,000/(1 - 0.07 - 0.10) = $90,361.45 ≈ $90,361. 0 I=? 90,361 - 6,325 discount interest - 9,036 comp. balance 75,000 1 -90,361 + 9,036 -81,325 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%. Chapter 15b - Page 13 ...
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