Week 5 Team Problem

Due 9:30 pm on Sunday (24 hour since I post the assignment )

Resource: Principles of Managerial Finance, Ch. 16

Complete the following case study: Integrative Case Casa Diseno p. 681 .( Chapter 16)

Only complete the YELLOW  HIGHLIGHTED AREA. ONLY DO the probelm highlighted in question D

I have copied and paste chapter 16 and highlighted my part of the assignment. remember it’s a team assignment.

 

16 Current Liabilities Management

Learning Goals

  • LG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms.
  • LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals.
  • LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans.
  • LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans.
  • LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral.
  • LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral.

Why This Chapter Matters to You

In your professional life

ACCOUNTING You need to understand how to analyze supplier credit terms to decide whether the firm should take or give up cash discounts; you also need to understand the various types of short-term loans, both unsecured and secured, that you will be required to record and report.

INFORMATION SYSTEMS You need to understand what data the firm will need to process accounts payable, track accruals, and meet bank loans and other short-term debt obligations in a timely manner.

MANAGEMENT You need to know the sources of short-term loans so that, if short-term financing is needed, you will understand its availability and cost.

MARKETING You need to understand how accounts receivable and inventory can be used as loan collateral; the procedures used by the firm to secure short-term loans with such collateral could affect customer relationships.

OPERATIONS You need to understand the use of accounts payable as a form of short-term financing and the effect on one’s suppliers of stretching payables; you also need to understand the process by which a firm uses inventory as collateral.

In your personal life

Management of current liabilities is an important part of your financial strategy. It takes discipline to avoid viewing cash and credit purchases equally. You need to borrow for a purpose, not convenience. You need to repay credit purchases in a timely fashion. Excessive use of short-term credit, particularly with credit cards, can create personal liquidity problems and, at the extreme, personal bankruptcy.

FastPay Getting Cash into the Hands of Online Media Companies

Digital advertising revenues hit $36.6 billion in 2012, a 15 percent increase over 2011, which was itself a record-breaking year. Online ads are everywhere, from Google search pages to YouTube videos to your Facebook News Feed. A challenge for the publishers of online ads is collecting money for those ads. The industry standard calls for publishers of online ads to send invoices within 30 days after an ad campaign is complete, and the advertiser then has 30 days or more to pay for the ad. Thus, companies that sell online advertising can accumulate large receivables balances, and collecting cash can be a slow process.

That’s where the company FastPay comes in. FastPay makes loans to publishers, ad-tech companies, and other digital media businesses based on those firms’ accounts receivable. FastPay lends up to $5 million per borrower, with the terms of the loan based on the quality of the receivable. For example, if Pepsi were to enter into an agreement with YouTube to place online ads in videos, FastPay would grant a loan to YouTube on relatively favorable terms because it views Pepsi as a good credit risk. One area in which FastPay is expanding rapidly is in making loans to Facebook Preferred Marketing Developers, a network of small and mediumsized businesses that builds advertising apps on Facebook, manages ad campaigns, and helps Facebook develop new marketing strategies.

Firms rely on a wide array of short-term financing vehicles. In this chapter, you’ll learn about the ways companies can use short-term finance to help maximize the wealth of their shareholders.

16.1 Spontaneous Liabilities

LG 1

LG 2

Spontaneous liabilities arise from the normal course of business. For example, when a retailer orders goods for inventory, the manufacturer of those goods usually does not demand immediate payment but instead extends a short-term loan to the retailer that appears on the retailer’s balance sheet under accounts payable. The more goods the retailer orders, the greater will be the accounts payable balance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addition, both are forms of unsecured short-term financing, short-term financing obtained without pledging specific assets as collateral. The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible.

spontaneous liabilities

Financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals.

unsecured short-term financing

Short-term financing obtained without pledging specific assets as collateral.

ACCOUNTS PAYABLE MANAGEMENT

Accounts payable are the major source of unsecured short-term financing for business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser.

Role in the Cash Conversion Cycle

The average payment period is the final component of the cash conversion cycle introduced in Chapter 15. The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In Chapter 15, we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is accounts payable management.

accounts payable management

Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier.

When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period.

Example 16.1

In 2013, Brown-Forman Corporation (BF), manufacturer of alcoholic beverage brands such as Jack Daniels, had annual revenue of $3.8 billion, cost of revenue of $1.8 billion, and accounts payable of $468 million. BF had an average age of inventory (AAI) of 168 days, an average collection period (ACP) of 55 days, and an average payment period (APP) of 136 days (BF’s purchases were $1.3 billion). Thus, the cash conversion cycle for BF was 87 days (168 + 55 − 136).

The resources BF had invested in this cash conversion cycle (assuming a 365-day year) were

Based on BF’s APP and average accounts payable, the daily accounts payable generated by BF is about $3.5 million ($0.48 billion ÷ 136). If BF were to increase its average payment period by 5 days, its accounts payable would increase by about $17.5 million (5 × $3.5 million). As a result, BF’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $17.5 million. Clearly, if this action did not damage BF’s credit rating, it would be in the company’s best interest.

Analyzing Credit Terms

The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases. Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment.

Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date.

Example 16.2

Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000 − (0.02 × $1,000)] by March 10, thereby saving $20.

Giving Up the Cash Discount If the firm chooses to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, when a firm gives up a discount, it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a loan, and the length of this loan is the number of additional days that the purchaser can delay payment to the seller. This cost can be illustrated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period).

cost of giving up a cash discount

The implied rate of interest paid to delay payment of an account payable for an additional number of days.

FIGURE 16.1 Payment Options

Payment options for Lawrence Industries

Example 16.3

My Finance Lab Solution Video

In Example 16.2, we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must pay an extra $20, or $1,000 rather than $980. In other words, if the firm pays on March 30, it will pay $980 (what it could have paid on March 10) plus $20. The extra $20 is like interest on a loan, and in this case the $980 is like the loan principal. Lawrence Industries owes $980 to its supplier on March 10, but the supplier is willing to accept $980 plus $20 in interest on March 30. Figure 16.1 shows the payment options that are open to the company.

To calculate the implied interest rate associated with giving up the cash discount, we simply treat $980 as the loan principal, $20 as the interest, and 20 days (the time from March 10 to March 30) as the term of the loan. Again, the tradeoff that Lawrence faces is that it can pay $980 on March 10 or $980 plus $20 in interest 20 days later on March 30. Therefore, the interest rate that Lawrence is paying by giving up the discount is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The general expression for calculating the annual percentage cost of giving up a cash discount can be expressed as1

Cost of giving up cash discount equals CD over 100% − CD × 365 over N (16.1)

1. Equation 16.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each alternative.

where

CD ; equals ; stated cash discount in percentage terms ; N ; equals ; number of days that payment can be delayed by giving up the cash discount ;

Substituting the values for CD (2%) and N (20 days) into Equation 16.1 results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)].

A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 16.1:

Approximate cost of giving up cash discount equals CD × 365 over N (16.2)

The smaller the cash discount, the closer the approximation to the actual cost of giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% [2% × (365 ÷ 20)].

Using the Cost of Giving Up a Cash Discount in Decision Making The financial manager must determine whether it is advisable to take a cash discount. A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other institution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier.

Example 16.4

Mason Products, a large building-supply company, has four possible suppliers, each offering different credit terms. Otherwise, their products and services are identical. Table 16.1 presents the credit terms offered by suppliers A, B, C, and D and the cost of giving up the cash discounts in each transaction. The approximation method of calculating the cost of giving up a cash discount (Equation 16.2) has been used. The cost of giving up the cash discount from supplier A is 36.5%; from supplier B, 4.9%; from supplier C, 21.9%; and from supplier D, 29.2%.

TABLE 16.1 Cash Discounts and Associated Costs for Mason Products

Supplier Credit terms Approximate cost of giving up a cash discount
A 2/10 net 30 EOM 36.5%
B 1/10 net 85 EOM  4.9
C 3/20 net 70 EOM 21.9
D 4/10 net 60 EOM 29.2

If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 6%, and if each of the suppliers is viewed separately, which (if any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier A, the firm takes the cash discount, because the cost of giving it up is 36.5%, and then borrows the funds it requires from its bank at 6% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of this action is less than the cost of borrowing money from the bank (4.9% versus 6%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the 6% cost of borrowing from the bank.

The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain bank borrowing costs. However, other factors relative to payment strategies may also need to be considered. For example, some firms, particularly small firms and poorly managed firms, routinely give up all discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions.

Effects of Stretching Accounts Payable

A strategy that is often employed by a firm is stretching accounts payable, that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduce the cost of giving up a cash discount.

stretching accounts payable

Paying bills as late as possible without damaging the firm’s credit rating.

Example 16.5

Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of giving up the cash discount, assuming payment on the last day of the credit period, was approximately 36.5% [2% × (365 ÷ 20)]. If the firm were able to stretch its account payable to 70 days without damaging its credit rating, the cost of giving up the cash discount would be only 12.2% [2% × (365 ÷ 60)]. Stretching accounts payable reduces the implicit cost of giving up a cash discount.

Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases.

Personal Finance Example 16.6

Jack and Mary Nobel, a young married couple, are in the process of purchasing a 50-inch HD TV at a cost of $1,900. The electronics dealer currently has a special financing plan that would allow them to either (1) put $200 down and finance the balance of $1,700 at 3% annual interest over 24 months, resulting in payments of $73 per month; or (2) receive an immediate $150 cash rebate, thereby paying only $1,750 cash. The Nobels, who have saved enough to pay cash for the TV, can currently earn 5% annual interest on their savings. They wish to determine whether to borrow or to pay cash to purchase the TV.

The upfront outlay for the financing alternative is the $200 down payment, whereas the Nobels will pay out $1,750 up front under the cash purchase alternative. So, the cash purchase will require an initial outlay that is $1,550 ($1,750 − $200) greater than under the financing alternative. Assuming that they can earn a simple interest rate of 5% on savings, the cash purchase will cause the Nobels to give up an opportunity to earn $155 (2 years × 0.05 × $1,550) over the 2 years.

If they choose the financing alternative, the $1,550 would grow to $1,705 ($1,550 + $155) at the end of 2 years. But under the financing alternative, the Nobels will pay out a total of $1,752 (24 months × $73 per month) over the 2-year loan term. The cost of the financing alternative can be viewed as $1,752, and the cost of the cash payment (including forgone interest earnings) would be $1,705. Because it is less expensive, the Nobels should pay cash for the TV. The lower cost of the cash alternative is largely the result of the $150 cash rebate.

ACCRUALS

The second spontaneous source of short-term business financing is accruals. Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. Because taxes are payments to the government, their accrual cannot be manipulated by the firm. However, the accrual of wages can be manipulated to some extent by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work. The pay period for employees who earn an hourly rate is often governed by union regulations or by state or federal law. However, in other cases, the frequency of payment is at the discretion of the company’s management.

accruals

Liabilities for services received for which payment has yet to be made.

in practice focus on ETHICS: Accruals Management

On June 2, 2010, Diebold, Inc., agreed to pay a $25 million fine to settle accounting fraud charges brought by the U.S. Securities and Exchange Commission (SEC). According to the SEC, the management of the Ohio-based manufacturer of ATMs, bank security systems, and electronic voting machines regularly received reports comparing the company’s earnings to analyst forecasts. When earnings were below forecasts, management identified opportunities, some of which amounted to accounting fraud, to close the gap.

“Diebold’s financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company’s bottom line,” SEC Enforcement Director Robert Khuzami said in a statement. “When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences.”a

A number of the SEC’s claims focused on premature revenue recognition. For example, Diebold was charged with improper use of “bill and hold” transactions. Under generally accepted accounting principles, revenue is typically recognized after a product is shipped. However, in some cases, sellers can recognize revenue before shipment for certain bill and hold transactions. The SEC claimed that Diebold improperly used bill and hold accounting to record revenue prematurely.

The SEC also claimed that Diebold manipulated various accounting accruals. Diebold was accused of understating liabilities tied to its Long Term Incentive Plan, commissions to be paid to sales personnel, and incentives to be paid to service personnel. Diebold temporarily reduced a liability account set up for payment of customer rebates. The company was also accused of overstating the value of inventory and improper inventory write-ups.

Each of these activities allowed Diebold to inflate the company’s financial performance. According to the SEC’s complaint, Diebold’s fraudulent activities misstated reported pretax earnings by at least $127 million between 2002 and 2007. Two years prior to the settlement, Diebold restated earnings for the period covered by the charges.

The clawback provision of the 2002 Sarbanes-Oxley antifraud law requires executives to repay compensation they receive while their company misled shareholders. Diebold’s former CEO, Walden O’Dell, agreed to return $470,000 in cash, plus stock and options. The SEC is currently pursuing a lawsuit against two other former Diebold executives for their part in the matter.

Why might financial managers still be tempted to manage earnings when a clawback is a legitimate possibility?

aU.S. Securities and Exchange Commission, “SEC Charges Diebold and Former Executives with Accounting Fraud,” press release, June 2, 2010, www.sec.gov/news/press/2010/2010-93.htm.

Example 16.7

Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 × $400,000).

REVIEW QUESTIONS

16–1 What are the two major sources of spontaneous short-term financing for a firm? How do their balances behave relative to the firm’s sales?

16–2 Is there a cost associated with taking a cash discount? Is there any cost associated with giving up a cash discount? How do short-term borrowing costs affect the cash discount decision?

16–3 What is “stretching accounts payable”? What effect does this action have on the cost of giving up a cash discount?

16.2 Unsecured Sources of Short-Term Loans

LG 3

LG 4

Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are available to firms of all sizes; commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions.

BANK LOANS

Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is the short-term, self-liquidating loan. These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. In other words, the use to which the borrowed money is put provides the mechanism through which the loan is repaid, hence the term self-liquidating.

short-term, self-liquidating loan

An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid.

Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, through lines of credit, and through revolving credit agreements. Before we look at these types of loans, we consider loan interest rates.

Loan Interest Rates

The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often based on the prime rate of interest. The prime rate of interest (prime rate) is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent.

prime rate of interest (prime rate)

The lowest rate of interest charged by leading banks on business loans to their most important business borrowers.

Fixed- and Floating-Rate Loans Loans can have either fixed or floating interest rates. On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established, and the rate of interest is allowed to “float,” or vary, above prime as the prime rate varies until maturity. Generally, the increment above the prime rate will be lower on a floating-rate loan than on a fixed-rate loan of equivalent risk because the lender bears less risk with a floating-rate loan. Most short-term business loans are floating-rate loans.

fixed-rate loan

A loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity.

floating-rate loan

A loan with a rate of interest initially set at an increment above the prime rate and allowed to “float,” or vary, above prime as the prime rate varies until maturity.

Method of Computing Interest Once the nominal (or stated) annual rate is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to

Interest over Amount borrowed (16.3)

Most bank loans to businesses require the interest payment at maturity.

When interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than is requested (and less than they must repay). Loans on which interest is paid in advance are called discount loans. The effective annual rate for a discount loan, assuming a 1-year period, is calculated as

discount loan

Loan on which interest is paid in advance by being deducted from the amount borrowed.

Interest over Amount borrowed − Interest (16.4)

Paying interest in advance raises the effective annual rate above the stated annual rate.

Example 16.8

Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10,000 for the year. At the end of the year, Wooster will write a check to the lender for $11,000, consisting of the $1,000 interest as well as the return of the $10,000 principal. Substituting into Equation 16.3 reveals that the effective annual rate is therefore

$1,000 over $10,000 equals 10.0%

If the money is borrowed at the same stated annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 − $1,000). The effective annual rate in this case is

$1,000 over $10,000 − $1,000 equals $1,000 over $9,000 equals 11.1%

In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).

Single-Payment Notes

A single-payment note can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.

single-payment note

A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period.

Example 16.9

Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank B. The loans were incurred on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate was set at 1 1 over 2% above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at 7 1 over 2% (6% prime rate + 1 1 over 2% increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × (7 1 over 2, × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000).

Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate, or EAR, by using Equation 5.10. Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1:

The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.

Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000).

Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:

Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.

Personal Finance Example 16.10

Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.

Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable-rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:

  • 60 days from today the prime rate will rise by 1%.
  • 90 days from today the prime rate will rise another 1 over 2%.
  • 150 days from today the prime rate will drop by 1%.

Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.

  • Fixed-Rate Loan: Total interest cost over 180 days
  • Variable-Rate Loan: The applicable interest rate would begin at 9% (8% + 1%) and remain there for 60 days. Then the applicable rate would rise to 10% (9% + 1%) for the next 30 days and then to 10.50% (10% + 0.50%) for the next 60 days. Finally, the applicable rate would drop to 9.50% (10.50% − 1%) for the final 30 days.

Total interest cost over 180 days

Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, Megan should take the variable-rate loan. By doing so, she will save about $38 ($1,480 − $1,442) in interest cost over the 180 days.

Lines of Credit

A line of credit is an agreement between a commercial bank and a business, specifying the amount of unsecured short-term borrowing that the bank will make available to the firm over a given period of time. It is similar to the agreement under which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is not a guaranteed loan; rather, it indicates that if the bank has sufficient funds available, it will allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is the maximum amount the firm can owe the bank at any point in time.

line of credit

An agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.

When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma balance sheet, and recent financial statements. If the bank finds the customer acceptable, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the creditworthiness of a customer each time it borrows money within the year.

Interest Rates The interest rate on a line of credit is normally stated as a floating rate: the prime rate plus a premium. If the prime rate changes, the interest rate charged on new as well as outstanding borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the premium (interest increment) above prime and vice versa.

Operating-Change Restrictions In a line-of-credit agreement, a bank may impose operating-change restrictions, which give it the right to revoke the line if any major changes occur in the firm’s financial condition or operations. The firm is usually required to submit up-to-date, and preferably audited, financial statements for periodic review. In addition, the bank typically needs to be informed of shifts in key managerial personnel or in the firm’s operations before changes take place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the proposed changes and the firm makes them anyway, the bank has the right to revoke the line of credit.

operating-change restrictions

Contractual restrictions that a bank may impose on a firm’s financial condition or operations as part of a line-of-credit agreement.

Compensating Balances To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a compensating balance equal to a certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20 percent. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower.

compensating balance

A required checking account balance equal to a certain percentage of the amount borrowed from a bank under a line-of-credit or revolving credit agreement.

Example 16.11

My Finance Lab Solution Video

Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of-credit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus, it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 × $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 ÷ $800,000), which is 2.5% more than the stated rate of 10%.

If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 ÷ $900,000). Thus, a compensating balance raises the cost of borrowing only if it is larger than the firm’s normal cash balance.

Annual Cleanups To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an annual cleanup. In these cases, the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period ensures that short-term loans do not turn into long-term loans.

annual cleanup

The requirement that for a certain number of days during the year borrowers under a line of credit carry a zero loan balance (that is, owe the bank nothing).

All the characteristics of a line-of-credit agreement are negotiable to some extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of maintaining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce a line of credit that is suitable to both borrower and lender.

Revolving Credit Agreements

A revolving credit agreement is nothing more than a guaranteed line of credit. It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of credit. It is not uncommon for a revolving credit agreement to be for a period greater than 1 year.2 Because the bank guarantees the availability of funds, a commitment fee is normally charged on a revolving credit agreement. This fee often applies to the average unused balance of the borrower’s credit line. It is normally about 0.5 percent of the average unused portion of the line.

revolving credit agreement

A line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of money.

commitment fee

The fee that is normally charged on a revolving credit agreement; it often applies to the average unused portion of the borrower’s credit line.

Example 16.12

REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on the average unused balance. Because the average unused portion of the committed funds was $500,000 ($2 million − $1.5 million), the commitment fee for the year was $2,500 (0.005 × $500,000). Of course, REH also had to pay interest on the actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 7.67% [($112,500 + $2,500) ÷ $1,500,000]. Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint because the availability of funds is guaranteed.

2. Many authors classify the revolving credit agreement as a form of intermediate-term financing, defined as having a maturity of 1 to 7 years, but we do not use the intermediate-term financing classification; only short-term and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-credit agreements.

COMMERCIAL PAPER

Commercial paper is a form of financing that consists of short-term, unsecured promissory notes issued by firms with a high credit standing. Generally, only large firms of unquestionable financial soundness are able to issue commercial paper. Most commercial paper issues have maturities ranging from 3 to 270 days. Although there is no set denomination, such financing is generally issued in multiples of $100,000 or more. A large portion of the commercial paper today is issued by finance companies; manufacturing firms account for a smaller portion of this type of financing. Businesses often purchase commercial paper, which they hold as marketable securities, to provide an interest-earning reserve of liquidity. For further information on recent use of commercial paper, see the Focus on Practice box.

commercial paper

A form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing.

Interest on Commercial Paper

in practice focus on PRACTICE: The Ebb and Flow of Commercial Paper

The difficult economic and credit environment in the post–September 11 era, combined with historically low interest rates and a deep desire by corporate issuers to reduce exposure to refinancing risk, had a depressing effect on commercial paper volumes from 2001 through 2003. According to the Federal Reserve, U.S. nonfinancial commercial paper, for example, declined 68 percent over the 3-year period, from $315.8 billion outstanding at the beginning of 2001 to $101.4 billion by December 2003. In addition to lower volume, credit quality of commercial paper declined over the same period, with the ratio of downgrades outpacing upgrades 17 to 1 in 2002.

In 2004, signs emerged that the volume and rating contraction in commercial paper was finally coming to an end. The most encouraging of them was the pickup in economic growth, which spurs the need for short-term debt to finance corporate working capital. Although commercial paper is typically used to fund working capital, it is often boosted by a sudden surge of borrowing activity for other strategic activities, such as mergers and acquisitions and long-term capital investments. According to Federal Reserve Board data, at the end of July 2004, total U.S. commercial paper outstanding was $1.33 trillion.

By 2006, commercial paper surged to $1.98 trillion, an increase of 21.5 percent over 2005 levels. However, after peaking at $2.22 trillion, the tide changed in response to the credit crisis that began in August 2007. According to Federal Reserve data, as of October 1, 2008, the commercial paper market had contracted to $1.6 trillion, a reduction of nearly 28 percent, and new issues virtually dried up for several weeks. With much of the commercial paper outstanding at the start of the credit crisis coming up for renewal, the Federal Reserve began operating the Commercial Paper Funding Facility (CPFF) on October 27, 2008. The CPFF was intended to provide a liquidity backstop to U.S. issuers of commercial paper and, thereby, increase the availability of credit in short-term capital markets. CPFF allowed for the Federal Reserve Bank of New York to finance the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers.

Even with the CPFF up and running, companies that were worried about their ability to roll over their outstanding commercial paper every few weeks turned to long-term debt to meet their liquidity needs. Merrill Lynch & Co. and Bloomberg data showed that to manage short-tem liability risk, companies were paying as much as $75 million in additional annual interest to swap long-term debt for $1 billion of 30-day commercial paper.

With the recession in the rearview mirror and short-term credit markets working again, the CPFF was closed on February 1, 2010. But three years later, the commercial paper market was still far smaller than it had been before the financial crisis. In March 2013, the Federal Reserve reported that the total amount of commercial paper outstanding was a little more than $1 trillion, about half the size of the market in 2007 before the crisis.

What factors contribute to an expansion of the commercial paper market? What factors cause a contraction in the commercial paper market?

Commercial paper is sold at a discount from its par, or face, value. The size of the discount and the length of time to maturity determine the interest paid by the issuer of commercial paper. The actual interest earned by the purchaser is determined by certain calculations, illustrated by the following example.

Example 16.13

My Finance Lab Solution Video

Bertram Corporation, a large shipbuilder, has just issued $1 million worth of commercial paper that has a 90-day maturity and sells for $990,000. At the end of 90 days, the purchaser of this paper will receive $1 million for its $990,000 investment. The interest paid on the financing is therefore $10,000 on a principal of $990,000. The effective 90-day rate on the paper is 1.01% ($10,000 ÷ $990,000). Assuming that the paper is rolled over each 90 days throughout the year (that is, 365 ÷ 90 = 4.06 times per year), the effective annual rate for Bertram’s commercial paper, found by using Equation 5.10, is 4.16% [(1 + 0.0101)4.06 − 1].

An interesting characteristic of commercial paper is that its interest cost is normally 2 percent to 4 percent below the prime rate. In other words, firms are able to raise funds more cheaply by selling commercial paper than by borrowing from a commercial bank. The reason is that many suppliers of short-term funds do not have the option, as banks do, of making low-risk business loans at the prime rate. They can invest safely only in marketable securities such as Treasury bills and commercial paper.

Although the stated interest cost of borrowing through the sale of commercial paper is normally lower than the prime rate, the overall cost of commercial paper may not be less than that of a bank loan. Additional costs include various fees and flotation costs. Also, even if it is slightly more expensive to borrow from a commercial bank, it may at times be advisable to do so to establish a good working relationship with a bank. This strategy ensures that when money is tight, funds can be obtained promptly and at a reasonable interest rate.

Matter of fact

Lending Limits

Commercial banks are legally prohibited from lending amounts in excess of 15 percent (plus an additional 10 percent for loans secured by readily marketable collateral) of the bank’s unim-paired capital and surplus to any one borrower. This restriction is intended to protect depositors by forcing the commercial bank to spread its risk across a number of borrowers. In addition, smaller commercial banks do not have many opportunities to lend to large, high-quality business borrowers.

INTERNATIONAL LOANS

In some ways, arranging short-term financing for international trade is no different from financing purely domestic operations. In both cases, producers must finance production and inventory and then continue to finance accounts receivable before collecting any cash payments from sales. In other ways, however, the short-term financing of international sales and purchases is fundamentally different from that of strictly domestic trade.

International Transactions

The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to exchange rate risk. A U.S.-based company that exports goods and has accounts receivable denominated in a foreign currency faces the risk that the U.S. dollar will appreciate in value relative to the foreign currency. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar will depreciate. Although exchange rate risk can often be hedged by using currency forward, futures, or options markets, doing so is costly and is not possible for all foreign currencies.

Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms.

Financing International Trade

Several specialized techniques have evolved for financing international trade. Perhaps the most important financing vehicle is the letter of credit, a letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country.

letter of credit

A letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met.

Firms that do business in foreign countries on an ongoing basis often finance their operations, at least in part, in the local market. A company that has an assembly plant in Mexico, for example, might choose to finance its purchases of Mexican goods and services with peso funds borrowed from a Mexican bank. This practice not only minimizes exchange rate risk but also improves the company’s business ties to the host community. Multinational companies, however, sometimes finance their international transactions through dollar-denominated loans from international banks. The Eurocurrency loan markets allow creditworthy borrowers to obtain financing on attractive terms.

Transactions between Subsidiaries

Much international trade involves transactions between corporate subsidiaries. A U.S. company might, for example, manufacture one part in an Asian plant and another part in the United States, assemble the product in Brazil, and sell it in Europe. The shipment of goods back and forth between subsidiaries creates accounts receivable and accounts payable, but the parent company has considerable discretion about how and when payments are made. In particular, the parent can minimize foreign exchange fees and other transaction costs by “netting” what affiliates owe each other and paying only the net amount due rather than having both subsidiaries pay each other the gross amounts due.

REVIEW QUESTIONS

16–4 How is the prime rate of interest relevant to the cost of short-term bank borrowing? What is a floating-rate loan?

16–5 How does the effective annual rate differ between a loan requiring interest payments at maturity and another, similar loan requiring interest in advance?

16–6 What are the basic terms and characteristics of a single-payment note? How is the effective annual rate on such a note found?

16–7 What is a line of credit? Describe each of the following features that are often included in these agreements: (a) operating-change restrictions, (b) compensating balance, and (c) annual cleanup.

16–8 What is a revolving credit agreement? How does this arrangement differ from the line-of-credit agreement? What is a commitment fee?

16–9 How do firms use commercial paper to raise short-term funds? Who can issue commercial paper? Who buys commercial paper?

16–10 What is the important difference between international and domestic transactions? How is a letter of credit used in financing international trade transactions? How is “netting” used in transactions between subsidiaries?

16.3 Secured Sources of Short-Term Loans

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When a firm has exhausted its sources of unsecured short-term financing, it may be able to obtain additional short-term loans on a secured basis. Secured short-term financing has specific assets pledged as collateral. The collateral commonly takes the form of an asset, such as accounts receivable or inventory. The lender obtains a security interest in the collateral through the execution of a security agreement with the borrower that specifies the collateral held against the loan. In addition, the terms of the loan against which the security is held form part of the security agreement. A copy of the security agreement is filed in a public office within the state, usually a county or state court. Filing provides subsequent lenders with information about which assets of a prospective borrower are unavailable for use as collateral. The filing requirement protects the lender by legally establishing the lender’s security interest.

secured short-term financing

Short-term financing (loan) that has specific assets pledged as collateral.

security agreement

The agreement between the borrower and the lender that specifies the collateral held against a secured loan.

CHARACTERISTICS OF SECURED SHORT-TERM LOANS

Although many people believe that holding collateral as security reduces the risk that a loan will default, lenders do not usually view loans in this way. Lenders recognize that holding collateral can reduce losses if the borrower defaults, but the presence of collateral has no impact on the risk of default. A lender requires collateral to ensure recovery of some portion of the loan in the event of default. What the lender wants above all, however, is to be repaid as scheduled. In general, lenders prefer to make less risky loans at lower rates of interest than to be in a position in which they must liquidate collateral.

Collateral and Terms

Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.

Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral.

percentage advance

The percentage of the book value of the collateral that constitutes the principal of a secured loan.

The interest rate that is charged on secured short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both.

Institutions Extending Secured Short-Term Loans

The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. Commercial finance companies are lending institutions that make only secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits.

commercial finance companies

Lending institutions that make only secured loans—both short-term and long-term—to businesses.

Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services.

USE OF ACCOUNTS RECEIVABLE AS COLLATERAL

Two commonly used means of obtaining short-term financing with accounts receivable are pledging accounts receivable and factoring accounts receivable. Actually, only a pledge of accounts receivable creates a secured short-term loan; factoring really entails the sale of accounts receivable at a discount. Although factoring is not actually a form of secured short-term borrowing, it does involve the use of accounts receivable to obtain needed short-term funds.

Pledging Accounts Receivable

A pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral.

pledge of accounts receivable

The use of a firm’s accounts receivable as security, or collateral, to obtain a short-term loan.

The Pledging Process When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral.

After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage.

Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a lien, which is a publicly disclosed legal claim on the collateral.

lien

A publicly disclosed legal claim on loan collateral.

Notification Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a notification basis, the customer is notified to remit payment directly to the lender.

nonnotification basis

The basis on which a borrower, having pledged an account receivable, continues to collect the account payments without notifying the account customer.

notification basis

The basis on which an account customer whose account has been pledged (or factored) is notified to remit payment directly to the lender (or factor).

Matter of fact

Receivables Trading

Founded in 2007, the Receivables Exchange is an online marketplace where organizations such as hedge funds and commercial banks looking for short-term investments can bid on receivables pledged by small, medium-sized, and large companies from a wide range of industries. Companies that need cash put their receivables up for auction on the Receivables Exchange, and investors bid on them. In its first few years of operation, the Receivables Exchange provided funding of more than $1 billion to companies selling their receivables. The Receivables Exchange attracted the attention of the NYSE Euronext, which purchased a minority stake in the company in 2011.

Pledging Cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing.

Factoring Accounts Receivable

Factoring accounts receivable involves selling them outright, at a discount, to a financial institution. A factor is a financial institution that specializes in purchasing accounts receivable from businesses. Although it is not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with accounts receivable as collateral.

factoring accounts receivable

The outright sale of accounts receivable at a discount to a factor or other financial institution.

factor

A financial institution that specializes in purchasing accounts receivable from businesses.

Factoring Agreement A factoring agreement normally states the exact conditions and procedures for the purchase of an account. The factor, like a lender against a pledge of accounts receivable, chooses accounts for purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to be on a continuing basis, the factor will actually make the firm’s credit decisions because this will guarantee the acceptability of accounts. Factoring is normally done on a notification basis, and the factor receives payment of the account directly from the customer. In addition, most sales of accounts receivable to a factor are made on a nonrecourse basis, meaning that the factor agrees to accept all credit risks. Thus, if a purchased account turns out to be uncollectible, the factor must absorb the loss.

nonrecourse basis

The basis on which accounts receivable are sold to a factor with the understanding that the factor accepts all credit risks on the purchased accounts.

Matter of fact

Quasi Factoring

The use of credit cards such as MasterCard, Visa, and Discover by consumers has some similarity to factoring because the vendor that accepts the card is reimbursed at a discount for purchases made with the card. The difference between factoring and credit cards is that cards are nothing more than a line of credit extended by the issuer, which charges the vendors a fee for accepting the cards. In factoring, the factor does not analyze credit until after the sale has been made; in many cases (except when factoring is done on a continuing basis), the initial credit decision is the responsibility of the vendor, not the factor that purchases the account.

Typically, the factor is not required to pay the firm until the account is collected or until the last day of the credit period, whichever occurs first. The factor sets up an account similar to a bank deposit account for each customer. As payment is received or as due dates arrive, the factor deposits money into the seller’s account, from which the seller is free to make withdrawals as needed.

In many cases, if the firm leaves the money in the account, a surplus will exist on which the factor will pay interest. In other instances, the factor may make advances to the firm against uncollected accounts that are not yet due. These advances represent a negative balance in the firm’s account, on which interest is charged.

Factoring Cost Factoring costs include commissions, interest levied on advances, and interest earned on surpluses. The factor deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the commissions. The commissions are typically stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The interest levied on advances is generally 2 to 4 percent above the prime rate. It is levied on the actual amount advanced. The interest paid on surpluses is generally between 0.2 and 0.5 percent per month.

Although its costs may seem high, factoring has certain advantages that make it attractive to many firms. One is the ability it gives the firm to turn accounts receivable immediately into cash without having to worry about repayment. Another advantage is that it ensures a known pattern of cash flows. In addition, if factoring is undertaken on a continuing basis, the firm can eliminate its credit and collection departments.

USE OF INVENTORY AS COLLATERAL

Inventory is generally second to accounts receivable in desirability as short-term loan collateral. Inventory normally has a market value that is greater than its book value, which is used to establish its value as collateral. A lender whose loan is secured with inventory will probably be able to sell that inventory for at least book value if the borrower defaults on its obligations.

The most important characteristic of inventory being evaluated as loan collateral is marketability. A warehouse of perishable items, such as fresh peaches, may be quite marketable, but if the cost of storing and selling the peaches is high, they may not be desirable collateral. Specialized items, such as moon-roving vehicles, are also not desirable collateral because finding a buyer for them could be difficult. When evaluating inventory as possible loan collateral, the lender looks for items with very stable market prices that have ready markets and that lack undesirable physical properties.

Floating Inventory Liens

A lender may be willing to secure a loan under a floating inventory lien, which is a claim on inventory in general. This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. Inventories of items such as auto tires, screws and bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. The interest charge on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often require floating liens as extra security on what would otherwise be an unsecured loan. Floating-lien inventory loans may also be available from commercial finance companies.

floating inventory lien

A secured short-term loan against inventory under which the lender’s claim is on the borrower’s inventory in general.

Trust Receipt Inventory Loans

A trust receipt inventory loan often can be made against relatively expensive automotive, consumer durable, and industrial goods that can be identified by serial number. Under this agreement, the borrower keeps the inventory, and the lender may advance 80 to 100 percent of its cost. The lender files a lien on all the items financed. The borrower is free to sell the merchandise but is trusted to remit the amount lent, along with accrued interest, to the lender immediately after the sale. The lender then releases the lien on the item. The lender makes periodic checks of the borrower’s inventory to make sure that the required collateral remains in the hands of the borrower. The interest charge to the borrower is normally 2 percent or more above the prime rate.

trust receipt inventory loan

A secured short-term loan against inventory under which the lender advances 80 to 100 percent of the cost of the borrower’s relatively expensive inventory items in exchange for the borrower’s promise to repay the lender, with accrued interest, immediately after the sale of each item of collateral.

Trust receipt loans are often made by manufacturers’ wholly owned financing subsidiaries, known as captive finance companies, to their customers. Captive finance companies are especially popular in industries that manufacture consumer durable goods because they provide the manufacturer with a useful sales tool. For example, General Motors Acceptance Corporation, the financing subsidiary of General Motors, grants these types of loans to its dealers. Trust receipt loans are also available through commercial banks and commercial finance companies.

Warehouse Receipt Loans

A warehouse receipt loan is an arrangement whereby the lender, which may be a commercial bank or finance company, receives control of the pledged inventory collateral, which is stored by a designated agent on the lender’s behalf. After selecting acceptable collateral, the lender hires a warehousing company to act as its agent and take possession of the inventory.

warehouse receipt loan

A secured short-term loan against inventory under which the lender receives control of the pledged inventory collateral, which is stored by a designated warehousing company on the lender’s behalf.

Two types of warehousing arrangements are possible. A terminal warehouse is a central warehouse that is used to store the merchandise of various customers. The lender normally uses such a warehouse when the inventory is easily transported and can be delivered to the warehouse relatively inexpensively. Under a field warehouse arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged collateral. Regardless of the type of warehouse, the warehousing company places a guard over the inventory. Only on written approval of the lender can any portion of the secured inventory be released by the warehousing company.

The actual lending agreement specifically states the requirements for the release of inventory. As with other secured loans, the lender accepts only collateral that it believes to be readily marketable and advances only a portion—generally 75 to 90 percent—of the collateral’s value. The specific costs of warehouse receipt loans are generally higher than those of any other secured lending arrangements because of the need to hire and pay a warehousing company to guard and supervise the collateral. The basic interest charged on warehouse receipt loans is higher than that charged on unsecured loans, generally ranging from 3 to 5 percent above the prime rate. In addition to the interest charge, the borrower must absorb the costs of warehousing by paying the warehouse fee, which is generally between 1 and 3 percent of the amount of the loan. The borrower is normally also required to pay the insurance costs on the warehoused merchandise.

REVIEW QUESTIONS

16–11 Are secured short-term loans viewed as more risky or less risky than unsecured short-term loans? Why?

16–12 In general, what interest rates and fees are levied on secured short-term loans? Why are these rates generally higher than the rates on unsecured short-term loans?

16–13 Describe and compare the basic features of the following methods of using accounts receivable to obtain short-term financing: (a) pledging accounts receivable and (b) factoring accounts receivable. Be sure to mention the institutions that offer each of them.

16–14 For the following methods of using inventory as short-term loan collateral, describe the basic features of each, and compare their use: (a) floating lien, (b) trust receipt loan, and (c) warehouse receipt loan.

Summary

FOCUS ON VALUE

Current liabilities represent an important and generally inexpensive source of financing for a firm. The level of short-term (current liabilities) financing employed by a firm affects its profitability and risk. Accounts payable and accruals are spontaneous liabilities that should be carefully managed because they represent free financing. Notes payable, which represent negotiated short-term financing, should be obtained at the lowest cost under the best possible terms. Large, well-known firms can obtain unsecured short-term financing through the sale of commercial paper. On a secured basis, the firm can obtain loans from banks or commercial finance companies, using either accounts receivable or inventory as collateral.

The financial manager must obtain the right quantity and form of current liabilities financing to provide the lowest-cost funds with the least risk. Such a strategy should positively contribute to the firm’s goal of maximizing the stock price.

REVIEW OF LEARNING GOALS

LG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms. The major spontaneous source of short-term financing is accounts payable. They are the primary source of short-term funds. Credit terms may differ with respect to the credit period, cash discount, cash discount period, and beginning of the credit period. Cash discounts should be given up only when a firm in need of short-term funds must pay an interest rate on borrowing that is greater than the cost of giving up the cash discount.

LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals. Stretching accounts payable can lower the cost of giving up a cash discount. Accruals, which result primarily from wage and tax obligations, are virtually free.

LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans. Banks are the major source of unsecured short-term loans to businesses. The interest rate on these loans is tied to the prime rate of interest by a risk premium and may be fixed or floating. It should be evaluated by using the effective annual rate. Whether interest is paid when the loan matures or in advance affects the rate. Bank loans may take the form of a single-payment note, a line of credit, or a revolving credit agreement.

LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans. Commercial paper is an unsecured IOU issued by firms with a high credit standing. International sales and purchases expose firms to exchange rate risk. Such transactions are larger and of longer maturity than domestic transactions, and they can be financed by using a letter of credit, by borrowing in the local market, or through dollar-denominated loans from international banks. On transactions between subsidiaries, “netting” can be used to minimize foreign exchange fees and other transaction costs.

LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral. Secured short-term loans are those for which the lender requires collateral, which are usually current assets such as accounts receivable or inventory. Only a percentage of the book value of acceptable collateral is advanced by the lender. These loans are more expensive than unsecured loans. Commercial banks and commercial finance companies make secured short-term loans. Both pledging and factoring involve the use of accounts receivable to obtain needed short-term funds.

LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral. Inventory can be used as short-term-loan collateral under a floating lien, a trust receipt arrangement, or a warehouse receipt loan.

Opener-in-Review

In the chapter opener, you learned about FastPay, a company that lends to online ad publishers based on advertising receivables. Suppose that you are running a business that relies on online ad revenues. It typically takes 60 days to collect from your customers and convert receivables into cash. FastPay offers you $150,000 in cash in exchange for the right to collect $155,000 in receivables from a particular customer. You have a bank line of credit that allows you to borrow on a short-term basis at an annual interest rate of 7 percent. Should you borrow on the credit line or accept the offer from FastPay?

Self-Test Problem

(Solutions in Appendix)

LG 1 LG 2

ST16–1 Cash discount decisions The credit terms for each of three suppliers are shown in the following table. (Note: Assume a 365-day year.)

Supplier Credit terms
X 1/10 net 55 EOM
Y 2/10 net 30 EOM
Z 2/20 net 60 EOM
  • a. Determine the approximate cost of giving up the cash discount from each supplier.
  • b. Assuming that the firm needs short-term financing, indicate whether it would be better to give up the cash discount or take the discount and borrow from a bank at 15% annual interest. Evaluate each supplier separately using your findings in part a.
  • c. Now assume that the firm could stretch its accounts payable (net period only) by 20 days from supplier Z. What impact, if any, would that have on your answer in part b relative to this supplier?

Warm-Up Exercises

All problems are available in MyFinanceLab.

LG 1

E16–1Lyman Nurseries purchased seeds costing $25,000 with terms of 3/15 net 30 EOM on January 12. How much will the firm pay if it takes the cash discount? What is the approximate cost of giving up the cash discount, using the simplified formula?

E16–2Cleaner’s, Inc., is switching to paying employees every 2 weeks rather than weekly and will therefore “skip” 1 week’s pay. The firm has 25 employees who work a 60-hour week and earn an average wage of $12.50 per hour. Using a 10% rate of interest, how much will this change save the firm annually?

LG 2

E16–3Jasmine Scents has been given two competing offers for short-term financing. Both offers are for borrowing $15,000 for 1 year. The first offer is a discount loan at 8%, and the second offer is for interest to be paid at maturity at a stated interest rate of 9%. Calculate the effective annual rates for each loan, and indicate which loan offers the better terms.

LG 3

E16–4Jackson Industries has borrowed $125,000 under a line-of-credit agreement. Although the company normally maintains a checking account balance of $15,000 in the lending bank, this credit line requires a 20% compensating balance. The stated interest rate on the borrowed funds is 10%. What is the effective annual rate of interest on the line of credit?

LG 3

E16–5Horizon Telecom sold $300,000 worth of 120-day commercial paper for $298,000. What is the dollar amount of interest paid on the commercial paper? What is the effective 120-day rate on the paper?

LG 4

Problems

All problems are available in MyFinanceLab.

LG 1

P16–1Payment dates Determine when a firm must pay for purchases made and invoices dated on November 25 under each of the following credit terms:

  • a. net 30 date of invoice
  • b. net 30 EOM
  • c. net 45 date of invoice
  • d. net 60 EOM
P16–2Cost of giving up cash discounts Determine the cost of giving up the cash discount under each of the following terms of sale. (Note: Assume a 365-day year.)

LG 1

  • a. 2/10 net 30
  • b. 1/10 net 30
  • c. 1/10 net 45
  • d. 3/10 net 90
  • e. 1/10 net 60
  • f. 3/10 net 30
  • g. 4/10 net 180
P16–3Credit terms Purchases made on credit are due in full by the end of the billing period. Many firms extend a discount for payment made in the first part of the billing period. The original invoice contains a type of shorthand notation that explains the credit terms that apply. (Note: Assume a 365-day year.)

LG 1

  • a. Write the shorthand expression of credit terms for each of the following:
    Cash discount Cash discount period Credit period Beginning of credit period
    1% 15 days 45 days date of invoice
    2 10 30 end of month
    2  7 28 date of invoice
    1 10 60 end of month
  • b. For each of the sets of credit terms in part a, calculate the number of days until full payment is due for invoices dated March 12.
  • c. For each of the sets of credit terms, calculate the cost of giving up the cash discount.
  • d. If the firm’s cost of short-term financing is 8%, what would you recommend in regard to taking the discount or giving it up in each case?
P16–4Cash discount versus loan Joanne Germano works in an accounts payable department of a major retailer. She has attempted to convince her boss to take the discount on the 1/15 net 65 credit terms most suppliers offer, but her boss argues that giving up the 1% discount is less costly than a short-term loan at 7%. Prove to whoever is wrong that the other is correct. (Note: Assume a 365-day year.)

LG 1

Personal Finance Problem

LG 2

P16–5Borrow or pay cash for an asset Bob and Carol Gibbs are set to move into their first apartment. They visited Furniture R’Us, looking for a dining room table and buffet. Dining room sets are typically one of the more expensive home furnishing items, and the store offers financing arrangements to customers. Bob and Carol have the cash to pay for the furniture, but it would definitely deplete their savings, so they want to look at all their options.

The dining room set costs $3,000, and Furniture R’Us offers a financing plan that would allow them to either (1) put 10% down and finance the balance at 4% annual interest over 24 months or (2) receive an immediate $200 cash rebate, thereby paying only $2,800 cash to buy the furniture.

Bob and Carol currently earn 5.2% annual interest on their savings.

  • a. Calculate the cash down payment for the loan.
  • b. Calculate the monthly payment on the available loan. (Hint: Treat the current loan as an annuity and solve for the monthly payment.)
  • c. Calculate the initial cash outlay under the cash purchase option.
  • d. Assuming that they can earn a simple interest rate of 5.2% on savings, what will Bob and Carol give up (opportunity cost) over the 2 years if they pay cash?
  • e. What is the cost of the cash alternative at the end of 2 years?
  • f. Should Bob and Carol choose the financing or the cash alternative?
P16–6Cash discount decisions Prairie Manufacturing has four possible suppliers, all of which offer different credit terms. Except for the differences in credit terms, their products and services are virtually identical. The credit terms offered by these suppliers are shown in the following table. (Note: Assume a 365-day year.)

LG 1 LG 2

Supplier Credit terms
J 1/5 net 30 EOM
K 2/20 net 80 EOM
L 1/15 net 60 EOM
M 3/10 net 90 EOM
  • a. Calculate the approximate cost of giving up the cash discount from each supplier.
  • b. If the firm needs short-term funds, which are currently available from its commercial bank at 9%, and if each of the suppliers is viewed separately, which, if any, of the suppliers’ cash discounts should the firm give up? Explain why.
  • c. Now assume that the firm could stretch by 30 days its accounts payable (net period only) from supplier M. What impact, if any, would that have on your answer in part b relative to this supplier?
P16–7Changing payment cycle On accepting the position of chief executive officer and chairman of Muse, Inc., Dominic Howard changed the firm’s weekly payday from Monday afternoon to the following Friday afternoon. The firm’s weekly payroll was $100 million, and the cost of short-term funds was 5%. If the effect of this change was to delay check clearing by 1 week, what annual savings, if any, were realized?

LG 2

P16–8Spontaneous sources of funds, accruals When Tallman Haberdashery, Inc., merged with Meyers Men’s Suits, Inc., Tallman’s employees were switched from a weekly to a biweekly pay period. Tallman’s weekly payroll amounted to $750,000. The cost of funds for the combined firms is 11%. What annual savings, if any, are realized by this change of pay period?

LG 2

P16–9Cost of bank loan Data Back-Up Systems has obtained a $10,000, 90-day bank loan at an annual interest rate of 15%, payable at maturity. (Note: Assume a 365-day year.)

LG 3

  • a. How much interest (in dollars) will the firm pay on the 90-day loan?
  • b. Find the 90-day rate on the loan.
  • c. Annualize your result in part b to find the effective annual rate for this loan, assuming that it is rolled over every 90 days throughout the year under the same terms and circumstances.

Personal Finance Problem

P16–10Unsecured sources of short-term loans John Savage has obtained a short-term loan from First Carolina Bank. The loan matures in 180 days and is in the amount of $45,000. John needs the money to cover start-up costs in a new business. He hopes to have sufficient backing from other investors in 6 months. First Carolina Bank offers John two financing options for the $45,000 loan: a fixed-rate loan at 2.5% above prime rate or a variable-rate loan at 1.5% above prime.

LG 3

Currently, the prime rate of interest is 6.5%, and the consensus interest rate forecast of a group of economists is as follows: Sixty days from today the prime rate will rise by 0.5%; 90 days from today the prime rate will rise another 1%; 180 days from today the prime rate will drop by 0.5%.

Using the forecast prime rate changes, answer the following questions.

  • a. Calculate the total interest cost over 180 days for a fixed-rate loan.
  • b. Calculate the total interest cost over 180 days for a variable-rate loan.
  • c. Which is the lower-interest-cost loan for the next 180 days?
P16–11Effective annual rate A financial institution made a $4 million, 1-year discount loan at 6% interest, requiring a compensating balance equal to 5% of the face value of the loan. Determine the effective annual rate associated with this loan. (Note: Assume that the firm currently maintains $0 on deposit in the financial institution.)

LG 3

P16–12Compensating balances and effective annual rates Lincoln Industries has a line of credit at Bank Two that requires it to pay 11% interest on its borrowing and to maintain a compensating balance equal to 15% of the amount borrowed. The firm has borrowed $800,000 during the year under the agreement.

LG 3

  • a. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains no deposit balances at Bank Two.
  • b. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains $70,000 in deposit balances at Bank Two.
  • c. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains $150,000 in deposit balances at Bank Two.
  • d. Compare, contrast, and discuss your findings in parts a, b, and c.
P16–13Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $150,000 for 6 months. State Bank has offered to lend the funds at a 9% annual rate subject to a 10% compensating balance. (Note: Weathers currently maintains $0 on deposit in State Bank.) Frost Finance Co. has offered to lend the funds at a 9% annual rate with discount-loan terms. The principal of both loans would be payable at maturity as a single sum.

LG 3

  • a. Calculate the effective annual rate of interest on each loan.
  • b. What could Weathers do that would reduce the effective annual rate on the State Bank loan?
P16–14Integrative: Comparison of loan terms Cumberland Furniture wishes to establish a prearranged borrowing agreement with a local commercial bank. The bank’s terms for a line of credit are 3.30% over the prime rate, and each year the borrowing must be reduced to zero for a 30-day period. For an equivalent revolving credit agreement, the rate is 2.80% over prime with a commitment fee of 0.50% on the average unused balance. With both loans, the required compensating balance is equal to 20% of the amount borrowed. (Note: Cumberland currently maintains $0 on deposit at the bank.) The prime rate is currently 8%. Both agreements have $4 million borrowing limits. The firm expects on average to borrow $2 million during the year no matter which loan agreement it decides to use.

LG 3

  • a. What is the effective annual rate under the line of credit?
  • b. What is the effective annual rate under the revolving credit agreement? (Hint: Compute the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of.)
  • c. If the firm does expect to borrow an average of half the amount available, which arrangement would you recommend for the borrower? Explain why.
P16–15Cost of commercial paper Commercial paper is usually sold at a discount. Fan Corporation has just sold an issue of 90-day commercial paper with a face value of $1 million. The firm has received initial proceeds of $978,000. (Note: Assume a 365-day year.)

LG 4

  • a. What effective annual rate will the firm pay for financing with commercial paper, assuming that it is rolled over every 90 days throughout the year?
  • b. If a brokerage fee of $9,612 was paid from the initial proceeds to an investment banker for selling the issue, what effective annual rate will the firm pay, assuming that the paper is rolled over every 90 days throughout the year?
P16–16Accounts receivable as collateral Kansas City Castings (KCC) is attempting to obtain the maximum loan possible using accounts receivable as collateral. The firm extends net-30-day credit. The amounts that are owed KCC by its 12 credit customers, the average age of each account, and the customer’s average payment period are as shown in the following table.

LG 5

Customer Account receivable Average age of account Average payment period of customer
A $37,000 40 days 30 days
B  42,000 25 50
C  15,000 40 60
D   8,000 30 35
E  50,000 31 40
F  12,000 28 30
G  24,000 30 70
H  46,000 29 40
I   3,000 30 65
J  22,000 25 35
K  62,000 35 40
L  80,000 60 70
  • a. If the bank will accept all accounts that can be collected in 45 days or less as long as the customer has a history of paying within 45 days, which accounts will be acceptable? What is the total dollar amount of accounts receivable collateral? (Note: Accounts receivable that have an average age greater than the customer’s average payment period are also excluded.)
  • b. In addition to the conditions in part a, the bank recognizes that 5% of credit sales will be lost to returns and allowances. Also, the bank will lend only 80% of the acceptable collateral (after adjusting for returns and allowances). What level of funds would be made available through this lending source?
P16–17Accounts receivable as collateral Springer Products wishes to borrow $80,000 from a local bank using its accounts receivable to secure the loan. The bank’s policy is to accept as collateral any accounts that are normally paid within 30 days of the end of the credit period as long as the average age of the account is not greater than the customer’s average payment period. Springer’s accounts receivable, their average ages, and the average payment period for each customer are shown in the following table. The company extends terms of net 30 days.

LG 5

Customer Account receivable Average age of account Average payment period of customer
A $20,000 10 days 40 days
B   6,000 40 35
C  22,000 62 50
D  11,000 68 65
E   2,000 14 30
F  12,000 38 50
G  27,000 55 60
H  19,000 20 35
  • a. Calculate the dollar amount of acceptable accounts receivable collateral held by Springer Products.
  • b. The bank reduces collateral by 10% for returns and allowances. What is the level of acceptable collateral under this condition?
  • c. The bank will advance 75% against the firm’s acceptable collateral (after adjusting for returns and allowances). What amount can Springer borrow against these accounts?
P16–18Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed the accounts receivable of Scientific Software, Inc. The bank has chosen eight accounts totaling $134,000 that it will accept as collateral. The bank’s terms include a lending rate set at prime plus 3% and a 2% commission charge. The prime rate currently is 8.5%.

LG 3 LG 5

  • a. The bank will adjust the accounts by 10% for returns and allowances. It then will lend up to 85% of the adjusted acceptable collateral. What is the maximum amount that the bank will lend to Scientific Software?
  • b. What is Scientific Software’s effective annual rate of interest if it borrows $100,000 for 12 months? For 6 months? For 3 months? (Note: Assume a 365-day year and a prime rate that remains at 8.5% during the life of the loan.)
P16–19Factoring Blair Finance factors the accounts of the Holder Company. All eight factored accounts are shown in the following table, with the amount factored, the date due, and the status on May 30. Indicate the amounts that Blair should have remitted to Holder as of May 30 and the dates of those remittances. Assume that the factor’s commission of 2% is deducted as part of determining the amount of the remittance.

LG 5

Account Amount Date due Status on May 30
A $200,000 May 30 Collected May 15
B   90,000 May 30 Uncollected
C  110,000 May 30 Uncollected
D   85,000 June 15 Collected May 30
E  120,000 May 30 Collected May 27
F  180,000 June 15 Collected May 30
G   90,000 May 15 Uncollected
H   30,000 June 30 Collected May 30
P16–20Inventory financing Raymond Manufacturing faces a liquidity crisis: It needs a loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firm’s accounts receivable are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Note: Assume a 365-day year.)

LG 1 LG 6

  • (1) City-Wide Bank will make a $100,000 trust receipt loan against the finished goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
  • (2) Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month period at an annual interest rate of 13%.
  • (3) Citizens’ Bank and Trust will lend $100,000 against a warehouse receipt on the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be levied against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.
  • a. Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
  • b. Which plan do you recommend? Why?
  • c. If the firm had made a purchase of $100,000 for which it had been given terms of 2/10 net 30, would it increase the firm’s profitability to give up the discount and not borrow as recommended in part b? Why or why not?
P16–21ETHICS PROBLEM Rancco, Inc., reported total sales of $73 million last year, including $13 million in revenue (labor, sales to tax-exempt entities) exempt from sales tax. The company collects sales tax at a rate of 5%. In reviewing its information as part of its loan application, you notice that Rancco’s sales tax payments show a total of $2 million in payments over the same time period. What are your conclusions regarding the financial statements that you are reviewing? How might you verify any discrepancies?

LG 2

Spreadsheet Exercise

Your company is considering manufacturing protective cases for a popular new smart-phone. Management decides to borrow $200,000 from each of two banks, First American and First Citizen. On the day that you visit both banks, the quoted prime interest rate is 7%. Each loan is similar in that each involves a 60-day note, with interest to be paid at the end of 60 days.

The interest rate was set at 2% above the prime rate on First American’s fixed-rate note. Over the 60-day period, the rate of interest on this note will remain at the 2% premium over the prime rate regardless of fluctuations in the prime rate.

First Citizen sets its interest rate at 1.5% above the prime rate on its floating-rate note. The rate charged over the 60 days will vary directly with the prime rate.

TO DO

Create a spreadsheet to calculate and analyze the following for the First American loan:

  • a. Calculate the total dollar interest cost on the loan. Assume a 365-day year.
  • b. Calculate the 60-day rate on the loan.
  • c. Assume that the loan is rolled over each 60 days throughout the year under identical conditions and terms. Calculate the effective annual rate of interest on the fixed-rate, 60-day First American note.

Next, create a spreadsheet to calculate the following for the First Citizen loan:

  • d. Calculate the initial interest rate.
  • e. Assuming that the prime rate immediately jumps to 7.5% and after 30 days it drops to 7.25%, calculate the interest rate for the first 30 days and the second 30 days of the loan.
  • f. Calculate the total dollar interest cost.
  • g. Calculate the 60-day rate of interest.
  • h. Assume that the loan is rolled over each 60 days throughout the year under the same conditions and terms. Calculate the effective annual rate of interest.
  • i. Which loan would you choose, and why?

My Finance Lab

Visit www.myfinancelab.com for Chapter Case: Selecting Kanton Company’s Financing Strategy and Unsecured Short-Term Borrowing Arrangement, Group Exercises, and numerous online resources.

Integrative Case 7 Casa de Diseño

In January 2015, Teresa Leal was named treasurer of Casa de Diseño. She decided that she could best orient herself by systematically examining each area of the company’s financial operations. She began by studying the firm’s short-term financial activities.

Casa de Diseño, located in southern California, specializes in a furniture line called “Ligne Moderna.” Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Moderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores. Casa de Diseño’s manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.

Casa de Diseño entered the plastic-furniture market in late 2007. The company markets its plastic-furniture products as indoor–outdoor items under the brand name “Futuro.” Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firm’s sales and profits in 2014. Casa de Diseño anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.

Leal has decided to study the firm’s cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseño purchases all its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseño usually receives credit terms of net 30. An analysis of Casa de Diseño’s accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39 days.

Next, Leal studied the production cycle and inventory policies. Casa de Diseño tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done by Furniture Age, the trade association journal, was 83 days.

Casa de Diseño sells to all its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days. Investigation of the trade association’s and California manufacturers’ averages showed that the same collection period existed where net-60 credit terms were given. Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseño were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.

Casa de Diseño was spending an estimated $26,500,000 per year on operating-cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2015. Her concern was whether the firm’s cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseño’s cash conversion cycle. (Note: Assume a 365-day year, and assume that the operating-cycle investment per dollar of payables, inventory, and receivables is the same.)

TO DO

  • a. Assuming a constant rate for purchases, production, and sales throughout the year, what are Casa de Diseño’s existing operating cycle (OC), cash conversion cycle (CCC), and resource investment need?
  • b. If Leal can optimize Casa de Diseño’s operations according to industry standards, what will Casa de Diseño’s operating cycle (OC), cash conversion cycle (CCC), and resource investment need to be under these more efficient conditions?
  • c. In terms of resource investment requirements, what is the cost of Casa de Diseño’s operational inefficiency?
  • d.
    • (1)If in addition to achieving industry standards for payables and inventory the firm can reduce the average collection period by offering credit terms of 3/10 net 60, what additional savings in resource investment costs will result from the shortened cash conversion cycle, assuming that the level of sales remains constant?
    • (2) If the firm’s sales (all on credit) are $40,000,000 and 45% of the customers are expected to take the cash discount, by how much will the firm’s annual revenues be reduced as a result of the discount?
    • (3) If the firm’s variable cost of the $40,000,000 in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings that will result from this reduced investment, assuming that sales remain constant.
    • (4) If the firm’s bad-debts expenses decline from 2% to 1.5% of sales, what annual savings will result, assuming that sales remain constant?
    • (5) Use your findings in parts (2) through (4) to assess whether offering the cash discount can be justified financially. Explain why or why not.
  • e. On the basis of your analysis in parts a through d, what recommendations would you offer Teresa Leal?
  • f. Review for Teresa Leal the key sources of short-term financing, other than accounts payable, that she may consider for financing Casa de Diseño’s resource investment need calculated in part b. Be sure to mention both unsecured and secured sources.
 
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Investing

Chapter 05

The Stock Market

 

Multiple Choice Questions

1. High Color Detergent is issuing new shares of stock which will trade on NASDAQ. If Sue purchases 300 of these shares, the trade will occur in which one of the following markets?

A. primary
B. secondary
C. third
D. fourth
E. over-the-counter

 

2. Wilson just placed an order with his broker to purchase 500 of the outstanding shares of GE. This purchase will occur in which one of the following markets?

A. primary
B. secondary
C. third
D. fourth
E. fifth

 

3. Hi-Tek Shoes is a private firm that has decided to issue shares of stock to the general public. This stock issue will be referred to as a(n):

A. open-end sale
B. break-out issue
C. public service offering
D. initial public offering
E. initial trial issue

 

4. A firm that specializes in arranging financing for companies is called a(n):

A. floor broker
B. investment banking firm
C. investment dealer
D. private broker
E. marketing firm

 

5. The process of purchasing newly issued shares from the issuer and reselling those shares to the general public is called:

A. underwriting
B. capitalizing
C. securing
D. brokering
E. deploying

 

6. The financing provided for new ventures that are frequently high-risk investments is referred to as “venture _______”.

A. capital
B. leverage
C. risk funds
D. funding
E. investing

 

7. Marco Painting Supplies is a publicly-traded firm with 250,000 shares of stock outstanding. If the firm issues an additional 10,000 shares, those shares will be referred to as a(n):

A. supplemental offering.
B. seasoned equity offering.
C. initial public offer.
D. market expansion offer.
E. after-market underwriting.

 

8. Under the provisions of a general cash offer, shares of stock are offered to:

A. underwriters on a guaranteed sale basis only.
B. current shareholders prior to being offered to the general public.
C. institutional investors only.
D. the issuer’s employees on a cash purchase basis only.
E. the general public on a “first-come” basis.

 

9. A public offering of securities which are offered first to current shareholders is called a(n):

A. existing shareholder offer.
B. limited offer.
C. rights offer.
D. venture offer.
E. preference offer.

 

10. The difference between the price an underwriter pays an issuer and the underwriter’s offering price is called the:

A. spread.
B. margin.
C. offer differential.
D. firm commitment.
E. underwriting capital.

 

11. When a group of underwriters jointly work together to sell a new issue of securities, the underwriters form a(n):

A. underwriting cartel.
B. market union.
C. venture capital association.
D. Dutch market.
E. syndicate.

 

12. When an underwriting syndicate purchases an entire issue of new securities and accepts the risk of unsold shares, the underwriting is known as a _____ underwriting.

A. Dutch auction
B. full-fledge
C. firm commitment
D. best efforts
E. guaranteed sale

 

13. When the issuer assumes the risk for any shares the underwriters cannot sell, the underwriting is known as a _____ underwriting.

A. Dutch auction
B. partial
C. firm commitment
D. best efforts
E. pro-rata

 

14. When the price of newly issued shares is determined by competitive bidding the underwriting is known as a _____ underwriting.

A. Dutch auction
B. market-priced
C. seasoned
D. best efforts
E. rights

 

15. Which one of the following is the federal agency which regulates the financial markets in the U.S.?

A. Treasury Department
B. National Association of Securities Dealers
C. Over the Counter Commission
D. Federal Reserve
E. Securities and Exchange Commission

 

16. The document that must be prepared in order to receive approval for a stock offering is called a:

A. tombstone.
B. prospectus.
C. offering agreement.
D. regulatory report.
E. offering paper.

 

17. A preliminary document provided to investors who are interested in a stock offering is called a(n):

A. prospectus.
B. inquiry form.
C. draft offer.
D. green shoe.
E. red herring.

 

18. A securities dealer is a(n):

A. intermediary who arranges trades between a buyer and a seller.
B. trader who buys and sells from his or her inventory.
C. firm which charges a commission for arranging a transaction.
D. person who buys securities for his or her own account on an exchange floor.
E. trader who transacts business on behalf of a securities issuer.

 

19. Which one of the following best describes a broker?

A. intermediary who arranges trades between a buyer and a seller
B. trader who buys and sells from his or her inventory
C. firm which charges a commission for arranging a transaction
D. person who buys securities for his or her own account on an exchange floor
E. trader who transacts business on behalf of a securities issuer

 

20. Which one of the following prices will an individual investor receive if he or she sells shares of Microsoft?

A. bid
B. ask
C. issue
D. offer
E. Dutch

 

21. Which one of the following prices will an investor pay to purchase shares of stock that are currently outstanding?

A. issue
B. option
C. bid
D. ask
E. primary

 

22. The profit a dealer makes on a purchase and resale of shares of stock is called the:

A. margin.
B. bid.
C. float.
D. offer.
E. spread.

 

23. A private equity fund: I. is set up as a limited partnership II. usually use a 2/20 fee structure III. place no constraints on manager compensation IV. typically have a stated life of 7 to 10 years

A. I and II only
B. I and III only
C. I, II and III only
D. I, II and IV only
E. I, II, III, and IV

 

24. Which of the following is correct regarding the compensation paid to private equity fund managers?

A. Managers typically receive 20% of fund profits but no separate management fee.
B. Managers typically receive a high percentage management fee but no portion of fund profits.
C. Management compensation is usually subject to a “clawback” provision to limit the performance fees.
D. “Carried interest” refers to the interest fund managers earn on performance fees.
E. Fees paid to fund managers do not reduce the net return of the fund.

 

25. An owner of a trading license on the NYSE is called a:

A. broker.
B. shareholder.
C. member.
D. trader.
E. dealer.

 

26. An NYSE Supplemental Liquidity Provider: I. can trade the same stocks as designated market makers II. can trade only from offices outside the exchange III. must quote bid or ask quotes a certain % of the day IV. are paid 30 cents per 100 shares traded

A. I and II only
B. I, II and III only
C. I and III only
D. I, II, and IV only
E. I, II, III and IV

 

27. The party who serves as a dealer for a few securities on an exchange floor and is obligated to maintain an orderly market for those securities is called a:

A. floor trader.
B. designated market maker.
C. floor broker.
D. member.
E. house broker.

 

28. A trading floor broker:

A. is a NYSE member who trades on the floor for his or her personal account.
B. executes orders on behalf of commission brokers in exchange for a fee.
C. executes customers’ orders in exchange for a commission.
D. trades a limited number of securities and is obligated to maintain an orderly market for those securities.
E. is any party who owns a NYSE trading license.

 

29. The NYSE’s Super Display Book is an electronic system which:

A. maintains the historical records of each customer’s trading activity.
B. transmits the latest market information to the news media.
C. allows floor traders to execute trades via cell phones.
D. tracks the activity on an exchange floor to ensure regulatory compliance.
E. is based on NYSE’s ARCA electronic trading engine.

 

30. A NYSE member who trades only for his or her own account is called a(n):

A. floor trader.
B. specialist.
C. individual broker.
D. floor broker.
E. house broker.

 

31. The location on an exchange floor where a particular security trades is called a(n):

A. specialist’s post.
B. broker’s terminal.
C. floor spot.
D. exchange spot.
E. market pit.

 

32. You want to sell shares of stock at the current price. Which type of order should you place?

A. limit
B. post
C. market
D. short
E. stop

 

33. An order to buy shares of stock at a stated price or less is called a _____ order.

A. limit
B. stop
C. market
D. short
E. bid

 

34. An order to sell that involves a preset trigger point is called a _____ order.

A. limit
B. day
C. stop
D. short
E. market

 

35. A market centered on dealers buying and selling for their own inventories is called a(n):

A. exchange floor.
B. SuperDot.
C. OTC market.
D. subscriber market.
E. Big Board.

 

36. Which one of the following describes an ECN?

A. Web site used by investors to trade directly with other investors
B. Web site limited to use by professional brokers and dealers
C. computerized trading floor
D. communications network used by specialists
E. cellular trading network

 

37. Inside quotes are the:

A. highest asked and lowest bid quotes offered by securities dealers.
B. highest bid and lowest asked quotes offered by securities dealers.
C. latest prices at which corporate insiders have purchased or sold securities.
D. bid and asked prices which are offered only to institutional traders or large private investors.
E. latest price at which a security traded.

 

38. The off-exchange market in which exchange-listed securities trade is referred to as the _____ market.

A. independent
B. secondary
C. fourth
D. third
E. primary

 

39. The market where individual investors directly trade exchange-listed securities with other individual investors is referred to as the _____ market.

A. home
B. independent
C. third
D. fourth
E. SuperDot

 

40. Which of the following types of indexes is a stock market index in which stocks are held in proportion to their share price?

A. balanced
B. market-weighted
C. dollar-weighted
D. price-weighted
E. value-weighted

 

41. When stocks are held in an index in proportion to their total company market value, the index is:

A. dollar-weighted.
B. front-weighted.
C. back-weighted.
D. price-weighted.
E. value-weighted.

 

42. An index is valued on a daily basis. However, some stocks in this particular index have not traded recently. As a result, this index suffers from index:

A. fatigue.
B. devaluation.
C. flatness.
D. staleness.
E. weighting.

 

43. Which one of the following statements concerning the NYSE is correct?

A. The NYSE was created based on the Walnut Tree Agreement.
B. The average daily trading volume on the NYSE in 2007 was approximately one billion shares.
C. The NYSE and NASDAQ merged in 2007.
D. The NYSE is part of a firm that also operates a stock exchange in Amsterdam.
E. The NYSE merged with NASDAQ in 2007.

 

44. Which of the following are common sources of venture capital? I. private individuals II. NASDAQ III. university endowment funds IV. insurance companies

A. I and II only
B. III and IV only
C. I, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV

 

45. Which one of the following statements concerning venture capital is correct?

A. Venture capital is frequently provided in stages with each stage financed by a different venture capitalist.
B. Most venture capitalists are passive investors.
C. The founders of a firm generally realize substantial payoffs as soon as the firm receives venture financing.
D. Venture capitalists generally compete with banks to find projects to finance.
E. Well established firms tend to absorb most of the available venture capital.

 

46. How long is the “lock-up” period that is commonly found in an IPO underwriting contract?

A. one month
B. three months
C. six months
D. one year
E. eighteen months

 

47. Which one of the following can be assumed when the SEC approves an IPO registration?

A. The securities offering will provide value to the shareholders.
B. The issuer is financially sound.
C. The issuer will remain solvent.
D. All rules have been followed to allow for full disclosure of information.
E. The stock price is set at a level which will allow shareholders to earn a positive rate of return.

 

48. Which one of the following transactions occurs in the primary market?

A. sale of stock by Shareholder A to Shareholder B
B. gift of shares from a grandmother to her granddaughter
C. sale of newly issued shares by the issuer to a shareholder
D. sale of shares in the third market
E. purchase of shares by a dealer from a shareholder

 

49. Trevor currently owns 545,000 shares of ABC stock. He will sell those shares for $17.10 a share. He is also willing to purchase additional shares for $17.07 a share. Trevor is a securities:

A. broker.
B. representative.
C. underwriter.
D. floor broker.
E. dealer.

 

50. Anna is an individual investor. She purchases shares at the _____ price and sells at the _____ price.

A. asked; bid
B. average; asked
C. bid; asked
D. bid; average
E. asked; average

 

51. What is the current structure of the NYSE?

A. general partnership
B. limited partnership
C. non-profit organization
D. publicly traded corporation
E. government agency

 

52. In 2007, NYSE Holdings merged with which one of the following?

A. NASDAQ
B. AMEX
C. Chicago Stock Exchange
D. London Stock Exchange
E. Euronext, N.V.

 

53. In order to currently trade on the floor of the NYSE, members must:

A. be registered as a floor trader
B. own a seat
C. purchase a trading license
D. be a specialist
E. be designated as a floor broker

 

54. Which one of the following has the greatest duty to provide liquidity to the financial market?

A. floor broker
B. independent broker
C. dealer
D. designated market maker
E. floor trader

 

55. The SuperDOT system has lessened the role of which one of the following?

A. personal financial advisers
B. floor traders
C. specialists
D. floor brokers
E. underwriters

 

56. Which one of the following statements related to the NYSE Hybrid market is correct?

A. Floor brokers operate both electronically and in person.
B. The Hybrid system replaces the market specialists.
C. The automated system works better than the specialist for stocks with minimal liquidity.
D. The automated system will only replace the specialist in times of market duress.
E. Investors can automatically trade an unlimited number of shares.

 

57. To be listed on the NYSE, a firm must have at least:

A. 2,500 shareholders
B. 100,000 shares traded on an average day
C. 1.5 million shares held by the public
D. $75 million in market value for an IPO
E. pre-tax aggregate earnings of $10 million in the previous 3 years

 

58. Lucas wants to sell 9,000 shares of stock and places a market order. The floor broker is unable to arrange the sale with another floor broker so the specialist agrees to “stop” the stock. What has the specialist agreed to do?

A. cancel the order
B. place the order into the order book to hold until an order to buy 9,000 shares is received
C. purchase the shares if no other buyer is readily available
D. sell the shares to the next available buyer regardless of the price received
E. sell the shares at the end of the trading day at the best price available at that time

 

59. The duties of a specialist include which of the following? I. maintain an orderly market II. offer a higher bid price than the floor brokers III. provide liquidity to the market IV. purchase all shares offered as limit sells

A. I and III only
B. II and III only
C. I, II, and III only
D. I, III, and IV only
E. I, II, III, and IV

 

60. Faith placed an order to sell 7,500 shares of stock she currently owned. As soon as the order reached the trading floor, the shares were immediately sold. Which type of order did Faith place?

A. limit
B. day
C. market
D. short
E. stop

 

61. Steve placed a limit order to sell 500 shares of stock at $14 a share. Which of the following does Steve know for sure? I. His order will execute but the time of execution is unknown. II. His order may never execute. III. He will receive exactly $7,000 if his order executes. IV. He could receive more, but not less, than $14 a share.

A. I and III only

 
ORDER THIS PAPER OR A SIMILAR ONE WITH PRO WRITING TUTORS AND GET AN AMAZING DISCOUNT"

Acct 212: Copy 2 of Fall D 2019 chpter 20

Problem 20-1A Production cost flow and measurement; journal entries L.O. P1, P2, P3, P4

[The following information applies to the questions displayed below.]

Edison Company manufactures wool blankets and accounts for product costs using process costing. The following information is available regarding its May inventories.

 

  Beginning Inventory   Ending Inventory  
  Raw materials inventory $ 60,000   $ 41,000  
  Goods in process inventory   449,000     521,500  
  Finished goods inventory   610,000     342,001  

 

The following additional information describes the company’s production activities for May.

 

       
  Raw materials purchases (on credit) $ 250,000  
  Factory payroll cost (paid in cash)   1,850,300  
  Other overhead cost (Other Accounts credited)   82,000  
  Materials used      
       Direct $ 200,500  
       Indirect   50,000  
  Labor used      
       Direct $ 1,060,300  
       Indirect   790,000  
  Overhead rate as a percent of direct labor   115 %
  Sales (on credit) $ 3,000,000  

 

The predetermined overhead rate was computed at the beginning of the year as 115% of direct labor cost.

 

\\\\\ rev: 11_02_2011

references

1.

value: 2.00 points

 

 

Problem 20-1A Part 1

Required:
1(a) Compute the cost of products transferred from production to finished goods. (Omit the “$” sign in your response.)

 

  Cost of products transferred $

 

1(b) Compute the cost of goods sold. (Omit the “$” sign in your response.)

 

  Cost of goods sold $

rev: 10_31_2011

check my work eBook Links (4) references

 

2.

value: 5.00 points

 

 

Problem 20-1A Part 2

2(a) Prepare journal entry dated May 31 to record the raw materials purchases. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(b) Prepare journal entry dated May 31 to record the direct materials usage. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(c) Prepare journal entry dated May 31 to record the indirect materials usage. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(d) Prepare journal entry dated May 31 to record the payroll costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(e) Prepare journal entry dated May 31 to record the direct labor costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(f) Prepare journal entry dated May 31 to record the indirect labor costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(g) Prepare journal entry dated May 31 to record the other overhead costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(h) Prepare journal entry dated May 31 to record the overhead applied. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(i) Prepare journal entry dated May 31 to record the goods transferred from production to finished goods.(Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       

 

2(j) Prepare journal entry dated May 31 to record the sale of finished goods. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
May 31      
       
       
       
   
Fairfax Company uses weighted-average process costing to account for its production costs. Direct labor is added evenly throughout the process. Direct materials are added at the beginning of the process. During September, the company transferred 760,000 units of product to finished goods. At the end of September, the goods in process inventory consists of 203,000 units that are 90% complete with respect to labor. Beginning inventory had $438,165 of direct materials and $188,540 of direct labor cost. The direct labor cost added in September is $3,582,260, and the direct materials cost added is $2,932,335.

references

3.

value: 2.00 points

 

 

Problem 20-2A Part 1

Required:
1(a) Determine the equivalent units of production with respect to direct labor.

 

  Equivalent units  

 

1(b) Determine the equivalent units of production with respect to direct materials.

 

  Equivalent units  

check my work eBook Links (2) references

 

4.

value: 2.00 points

 

 

Problem 20-2A Part 2

2. Compute both the direct labor cost and the direct materials cost per equivalent unit. (Round your answers to 2 decimal place. Omit the “$” sign in your response.)

 

  Per equivalent unit
  Direct labor cost $
  Direct materials cost $

check my work eBook Links (2) references

 

5.

value: 2.00 points

 

 

Problem 20-2A Part 3

3(a) Compute both direct labor cost and direct materials cost assigned to units completed and transferred out. (Due to rounding of cost per unit, the total costs accounted for in the cost summary may not equal to sum of all the costs given in the problem. Round your per unit costs to 2 decimal places and final answers to the nearest dollar amount.)

   

  Cost transferred out
  Direct materials $
  Direct labor $

 

3(b) Compute both direct labor cost and direct materials cost assigned to ending goods in process inventory. (Due to rounding of cost per unit, the total costs accounted for in the cost summary may not equal to sum of all the costs given in the problem. Round your per unit costs to 2 decimal places and final answers to the nearest dollar amount.)

 

  Costs of ending goods in process
  Direct materials $
  Direct labor $

Problem 20-3A Journalizing in process costing; equivalent units and costs L.O. C2, P1, P2, P3

[The following information applies to the questions displayed below.]

Li Company produces large quantities of a standardized product. The following information is available for its production activities for January.

 

               
  Raw materials         Factory overhead incurred      
  Beginning inventory $ 16,000     Indirect materials used $ 80,500  
  Raw materials purchased (on credit)   280,000     Indirect labor used   40,000  
  Direct materials used   (171,500 )   Other overhead costs   159,920  
           
  Indirect materials used   (80,500 )   Total factory overhead incurred $ 280,420  
     
  Ending Inventory $ 44,000          
         
          Factory overhead applied      
  Factory payroll            (140% of direct labor cost)      
  Direct labor used $ 200,300     Total factory overhead applied $ 280,420  
           
  Indirect labor used   40,000          
         
  Total payroll cost (paid in cash) $ 240,300          
         
Additional information about units and costs of production activities follows.

 

               
  Units       Costs        
  Beginning goods in process inventory 2,600     Beginning goods in process inventory        
  Started 26,000          Direct materials $ 3,000    
  Ending goods in process inventory 4,900          Direct labor   3,500    
             Factory overhead   4,000    
           
            $ 10,500
  Status of ending goods in process inventory       Direct materials added       171,500
     Materials—Percent complete 90  %   Direct labor added       200,300
     Labor and overhead—Percent complete 75  %   Overhead applied (140% of direct labor)       280,420
           
        Total costs     $ 662,720
           
        Ending goods in process inventory     $ 92,911
During January, 22,000 units of finished goods are sold for $160 cash each. Cost information regarding finished goods follows.

 

       
  Beginning finished goods inventory $ 150,000  
  Cost transferred in   569,809  
  Cost of goods sold   (598,390 )
 
  Ending finished goods inventory $ 121,419  
 

references

6.

value: 5.00 points

 

 

Problem 20-3A Part 1

Required:
1(a) Prepare journal entry dated January 31 to record the purchase of raw materials. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(b) Prepare journal entry dated January 31 to record the direct materials usage. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(c) Prepare journal entry dated January 31 to record the indirect materials usage. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(d) Prepare journal entry dated January 31 to record the factory payroll costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(e) Prepare journal entry dated January 31 to record the direct labor costs used in production. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(f) Prepare journal entry dated January 31 to record the indirect labor costs. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(g) Prepare journal entry dated January 31 to record the other overhead costs—credit Other Accounts.(Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(h) Prepare journal entry dated January 31 to record the overhead applied. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       

 

1(i) Prepare journal entry dated January 31 to record the goods transferred to finished goods. (Omit the “$” sign in your response.)
Date General Journal Debit Credit
Jan. 31      
       

 

1(j) Prepare journal entries dated January 31 to record the sale of finished goods. (Omit the “$” sign in your response.)

 

Date General Journal Debit Credit
Jan. 31      
       
       
       
       

check my work eBook Links (4) references

 

7.

value: 5.00 points

 

 

Problem 20-3A Part 2

2. Prepare a process cost summary report for this company, showing costs charged to production, units cost information, equivalent units of production, cost per EUP, and its cost assignment and reconciliation. (Due to rounding of cost per unit, the total costs accounted for in the cost summary may not equal to sum of all the costs given in the problem. Round your cost per EUP answers to 2 decimal places and consider the same in the other calculations. Round other answers to the nearest dollar amount. Omit the “$” sign in your response.)

 

LI COMPANY
Process Cost Summary
For Month Ended January 31
  Costs Charged to Production    
  Costs of beginning goods in process    
  $  
     
     
   
    $
  Costs incurred this period    
  $  
     
     
   
     
   
  Total costs to account for   $
   

 

Unit cost information
Units to account for   Units accounted for  
       
       
   
  Total units to account for     Total units accounted for  
   

 

Equivalent units of production Direct Materials Direct Labor Factory Overhead
   EUP  EUP  EUP
   EUP  EUP  EUP
 
  Equivalent units of production  EUP  EUP  EUP
 

 

Cost per EUP Direct Materials Direct Labor Factory Overhead
  $   $   $  
             
 
  Total costs $   $   $  
     EUP      EUP    EUP
 
  Cost per EUP $  Per EUP $  Per EUP $  Per EUP
 

 

Cost assignment and reconciliation
  Costs transferred out    
  $  
     
     
   
    $
  Costs of ending goods in process    
  $  
     
     
   
     
   
  Total costs to account for   $
   

roblem 20-5A Process cost summary, equivalent units, cost estimates L.O. C2, C3, P4

[The following information applies to the questions displayed below.]

Ogden Co. manufactures a single product in one department. All direct materials are added at the beginning of the manufacturing process. Direct labor and overhead are added evenly throughout the process. The company uses monthly reporting periods for its weighted-average process cost accounting. During October, the company completed and transferred 24,600 units of product to finished goods inventory. Its 4,200 units of beginning goods in process consisted of $20,800 of direct materials, $203,300 of direct labor, and $100,040 of factory overhead. It has 3,000 units (100% complete with respect to direct materials and 90% complete with respect to direct labor and overhead) in process at month-end. After entries to record direct materials, direct labor, and overhead for October, the company’s Goods in Process Inventory account follows.

 

  Goods in Process Inventory     Acct. No.133
Date Explanation Debit Credit Balance
Oct.  1   Balance     324,140
31   Direct materials 504,900   829,040
31   Direct labor 1,224,300   2,053,340
31   Applied overhead 963,840   3,017,180

references

8.

value: 5.00 points

 

 

Problem 20-5A Part 1

1. Prepare the company’s process cost summary for October using the weighted-average method. (Due to rounding of cost per unit, the total costs accounted for in the cost summary may not equal to sum of all the costs given in the problem. Round your cost per EUP answers to 2 decimal places and consider the same in the other calculations. Round other answers to the nearest dollar amount. Omit the “$” sign in your response.)

 

OGDEN CO.
Process Cost Summary
For Month Ended October 31
  Costs Charged to Production    
  Costs of beginning goods in process    
  $  
     
     
   
    $
  Costs incurred this period    
  $  
     
     
   
     
   
  Total costs to account for   $
   

 

Unit cost information
Units to account for   Units accounted for  
       
       
   
  Total units to account for     Total units accounted for  
   

 

Equivalent units of production Direct Materials Direct Labor Factory Overhead
   EUP  EUP  EUP
      EUP  EUP  EUP
 
  Equivalent units of production  EUP  EUP  EUP
 

 

Cost per EUP Direct Materials Direct Labor Factory Overhead
  $ $ $
       
 
  Total costs $ $ $
    EUP   EUP   EUP
 
  Cost per EUP $  per EUP $  per EUP $  per EUP
 

 

Cost assignment and reconciliation
  Costs transferred out    
  $  
     
     
   
    $
  Costs of ending goods in process    
  $  
     
     
   
     
   
  Total costs to account for   $
   

check my work eBook Links (3) references

 

9.

value: 2.00 points

 

 

Problem 20-5A Part 2

2. Prepare the journal entry dated October 31 to transfer the cost of completed units to finished goods inventory. (Omit the “$” sign in your response.)

 

 
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Working Capital Simulation: Managing Growth Assignment fin/57

RUNNING HEAD: Managing Growth Simulation 1

Managing Growth Simulation 2

Managing Growth Simulation

FIN/571

Managing Growth Simulation

Introduction

The complete course has reveled us the great idea to influence our trends and intelligence while analyzing the entire details of Sunflower Nutraceuticals (SNC) company followed with all the decisions of the company which tends to increase their working capital and maximizing the overall organizational growth potentially with respect to time, as we have figured out the data and change in numbers below which reflects the growth annually. Moreover in addition to various details of the SNC firm we have also examined various decisions which took place in each of the phase of SNC’s simulation which has an estimated values to figure out the results, secondly the paper also describes how SNC’s decisions are influenced with respect to their working capital followed with the final step of evaluating the general affects associated with the limited access of financial mix.

Sunflower Nutraceuticals (SNC) Background

No wonder SNC is a privately owned Nutraceuticals company , more over one can say it is a wide distributor which provides all the vital dietary supplements such as herbs for women’s, vitamins, and minerals for all the consumers (mainly women’s), distributors and retailers. (Harvard Business School Publishing, 2012). Once the business was initiated after 2006, SNC expanded their operations and came up with various retail outlets in the nutraceutical industry and moreover has been successful while introducing their own brands of sports drinks, vitamins for teenagers, metabolism- boosting powders, etc and various other products from a same product line which enable to enhance the metabolism system of humans.

Although being potential to grow as one of the major nutraceutical distributors in the, they are still struggling to break even and one more than one occasion have been forced to exceed the company’s credit line ($1,00,000) to finance their payroll and other operational needs. Because of their somewhat restrictive financing options, they are only able to use a small percentage (approx. 10%) to evaluate and invest in new business expansion which resembles great opportunities in other retail markets across the globe.

Phase 1 of SNC’s Simulation (Years 2013-2015)

During the initial phase of the simulation, they presented four major opportunities which could be helpful for their company to maximize their growth, those opportunities includes-

I. Discontinuing their Poorer Selling Nutraceutical Products – since they have more than 100 products, some of those products can be dropped off SNC’s inventory because they are outdated. Reducing or discounting those items will allow SNC to a) reduce its DSI to approximately 3 months, b) cut its EBIT by 50k approximately, c) drop sales to 1mm, and d) create more inventory space for the popular products. Doing this will rationalize the SNC’s SKU count.

II. Leveraging their Supplier Discount – SNC is considering an offer to add Atlantic Wellness (a large successful food chain) to their nutraceutical product line. The company considered and accepted the Atlantic Wellness contract as it allows them to increase company sales almost doubled for 2mm. In addition to their contract offer with Atlantic Wellness, SNC also considered the acceptance of Ayurveda Naturals with the contract offer which was favorable to SNC as it payment terms reflected a net gain of approximately 50. They could have lower its AP if it was related to pay of Ayurveda Naturals within a month and that payment can rise a discount of almost 2% on some of their raw materials.

III. Acquiring a New Client – SNC acquired a new client by acquiring the services of health food giant Atlantic Wellness to their nutraceutical products line. This decision increased SNC’s EBIT by approximately 200,000 and thus their sales figures by 4mm. Although SNC’s sales and EBIT figures increased, their net working capital and profit margins will remain at current figures.

Additionally, acquiring Atlantic Wellness as a client will help increase SNC’s sales significantly, but those increase sales does not come without a cost as the increase sales will come at the sacrifice of inventory and accounts receivable. Sacrificing inventory and accounts receivable is not a good deal for SNC because of their current cash position as SNC must keep a minimum of $3 lakh on hand to meet their company’s operational needs. However, there is a positive lining for SNC as the risk of inventory and accounts receivable could be balanced by negotiating a profitable deal with merchant Ayurveda Natural.

IV. Limiting their Receivable Accounts – Since Super Sports Centers account for 20% of SNC’s sales figures, those receivable accounts takes the company approximately 200 days to pay and those 200 days is well above the normal 90-day average. To resolve this issue, SNC could drop Super Sports Centers and improve their DSO number, but that come at a cost as SNC’s sales would drop $2mm.

Phase 2 of SNC’s Simulation (Years 2016-2018)

During phase two of the simulation, SNC was presented with three different opportunities and those opportunities include:

I. Expansion of SNC’s Online Presence – Since SNC would like to expand their operations into new retail markets its company was presented with an opportunity to partner with Golden Years Nutracueticals so that they could reach a larger, more diverse consumer base.From 2016-2018, this partnership reduced SNC’s DSO figures because its web sales began to be collected more rapidly from few days almost 7 to 2 days throughout the duration of 2016-2018. Also SNC also saw about 10%, increase in their sales from 2016-2018. This was an ideal opportunity for SNC as it will allow them to increase their sales with having little-to-no effect on the company’s working capital.

II. Take up Big-Box Contributions – SNC established a partnership with sales giant Mega-Mart, and that decision allowed SNC to see increase in sales of 25%, 10%, and 5% approximately during 2016-2018. Additionally, this decision dropped SNC’s from about 1%, however, their bills were paidon time causing SNC’s DSO to drop. Beginning with a partnership with Mega-Mart is a good idea. However, this partnership will drop margins and reduce SNC’s EBIT.

III. Create a Private Label Product – SNC has a partnership with Fountain of Youth Spas, and Fountain of Youth Spas want SNC to develop their own private label product so that SNC can expand their nutraceutical products line and increase their sales and consumer base. Doing this would increase SNC’s 2016-2018 sales by 5%, 4%, and 3% approximately. Additionally, it will also increase margin by 2% while increasing SNC’s DSO’s and DSI. This partnership will allow SNC to increase their EBIT while slightly raising their accounts receivable figures.

Phase 3 of SNC’s Simulation (Years 2019-2021)

During phase three of SNC’s simulation, there were three opportunities for SNC to consider, and those opportunities include:

I. Adapt a Global Expansion Plan– SNC acquired a new Latin America client (Viva Familia), which helped SNC expand their business operations into Latin America. SNC’s partnership with Viva Familia allowed SNC to decrease their DSO for a couple of days because Viva Familia will cover delivery charges. However, this new partnership increased the company’s DSI by two days, and it also increased SNC’s sales by 2% with margins remaining parallel to current business.

II. Renegotiate Current Supplier Credit Terms – SNC want to renegotiate its credit terms with other vendors so they used their main vendor Dynasty Enterprises (located in China) as leverage (suppose SNC needed a 3% discount for payment in 10 days) with other vendors. SNC could use their negotiation tactics with other vendors because their main vendor, Dynasty Enterprise offered SNC profitable terms of 2/10 with a net of 30. This reduces SNC’s costs of sales by 200k and their AR by 800k.

III. Acquire a High-Risk Client – Midwest Miracles is a potential high-risk client for SNC because of Midwest Miracles excessive debt and risky financial situation. However, acquiring this client will increase the sales of future prospects of SNC sales by approximately 30% in 2019. Midwest Miracles is a potential risk for SNC as their company has lesser chance of going bankrupt as compared with the recovery. Other effects of this client, includes a likely increase in DSO by 190 days, and higher fees with a longer than average invoice pay-period.

SNC’s Final Metrics Results

Final Metrics Results (Figures Reflect 2013-2021) Estimated values:

· EBIT (202% Increase): Figure went from $440 to $1,330,

· Sales (27% Increase): Figure went from $10k to $12,672

· Net Income (412% Increase): Figure went from $156 to $798

· Free Cash Flow (124% Increase): Figure went from $365 to $798

· Total Firm Value (56% Increase): Figure went from $3,248 to $5,082

General Effects of Limited Access to Financing

There are several general effects that limited access to financing can have several effects on entrepreneurs trying to start or grow his or her businesses. For example, limited access to financing can lead to 1) higher interest rates on a business loans or credit fees. 2) Force a business to face a complicated and expensive entry (registration costs, policies, equipment fees, etc.) and exit procedures(Parrino, Kidwell, & Bates, 2012). C) Limit the amount of growth (profits, SME, consumer/client base, etc.) a company can have in that new market. D) Make it more challenging (longer and more expensive process) to implement property and intellectual rights of privately owned and developed brand products.

Conclusion

Finally while concluding the entire paper would like to say that SNC simulation reflected us the challenging ways of handling the managing growth and capital of an organization in our present scenario. Especially it is found in the business market where we can find a company with limited financial power or take on business partnerships because they cannot support financially with their credit line or resources as they are more than their estimated budgets. Hence you must say that really managing a company while handling all the competitors in the market is really a difficult task to be performed in a best possible way along with the acceptance of all the updated trends in our community.

References

Harvard Business Publishing. (2012). Working capital simulation: managing growth. Retrieved October 28, 2013 from, http://forio.com/simulate/harvard/working-capital/simulation/?#page=dashboard.

Parrino, R., Kidwell, D. S, & Bates, T. W. (2012). Fundamentals of corporate finance (2nd ed). Hoboken, NJ: Wiley. Retrieved October 28, 2013 from, FIN/571 Foundations of Corporate Finance student website at the University of Phoenix (UOPX).

 
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