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Unformatted text preview: CHAPTER 15B
The Cost of ShortTerm Financing
Multiple Choice: Conceptual
Shortterm financing
1. Answer: a Diff: E Firms generally choose to finance temporary assets with shortterm debt
because
a. Matching the maturities of assets and liabilities reduces risk.
b. Shortterm interest rates have traditionally been more stable than
longterm interest rates.
c. A firm which borrows heavily longterm is more apt to be unable to
repay the debt than the firm which borrows heavily shortterm.
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 shortterm financing that is primarily
used by large, financially stable companies.
c. Shortterm debt, while often cheaper than longterm 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 longterm securities.
d. The risk to the firm of borrowing using shortterm credit is usually
greater than with longterm debt. Added risk can stem from greater
variability of interest costs on shortterm debt.
e. Trade credit is often the largest source of shortterm credit. Shortterm 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 shortterm rather than with longterm
debt, but the use of shortterm debt would probably increase the
firm's risk.
b. Conservative firms generally use no shortterm debt and thus have
zero current liabilities.
c. A shortterm loan can usually be obtained more quickly than a longterm loan, but the cost of shortterm debt is likely to be higher
than that of longterm 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
nonfree 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 longterm 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 90day cycles based on a 360day
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 90day 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 360day 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 oneyear 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 360day 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% Addon 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 addon, oneyear installment loan, payable in 4 equal quarterly
payments.
What is the approximate (nominal) rate of interest on the
10.19 percent addon 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 shortterm bond.
The
firm's bank offers a twoyear 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 2year 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 “addon”,
oneyear 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 addon, oneyear 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 12month installment loan (monthly payments) with
9 percent addon 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, 1year 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 15B
Answers and Solutions
1. Shortterm 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.
Shortterm financing
Answer: a Diff: M 6. Under normal conditions the yield curve is upward sloping, thus, shortterm
interest
rates
are
lower
than
longterm
interest
rates.
Consequently, a firm financing with shortterm debt will pay less
interest than a firm financing with longterm debtincreasing its ROE.
However, a firm increases its risk by financing with shortterm debt
because such debt must be "rolled over" frequently, and the firm is
exposed to the volatility of shortterm 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 longterm 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 longterm financing is $320,000.
Longterm debt financing = Permanent cash assets + Fixed assets.
Permanent cash assets = Low end of total assets  Fixed assets
= $320,000  $260,000 = $60,000.
Longterm 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.
2year note:
0 I=?
1
2 Years



+100,000
FV = 118,810
2year 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. Addon 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 Addon =
= 0.2038 = 20.38%.
$12,000 / 2
19. EAR cost of trade credit Financial calculator solution: (longform 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 "addon" 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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