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06 Short Term Financing Management KEY
Management Accounting (BSMA)
Foundation University (Philippines)
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Chapter 6 Short Term Financing Management
Answer Key
I. TRUE OR FALSE STATEMENTS Black – True; Red - False
- The use of short-term debt provides flexibility in financing since the firm is only paying interest when it is using the borrowed funds.
- A firm can reduce net working capital by substituting long-term financing, such as bonds, with short-term financing, such as one-year notes payable.
- Notes payable is a spontaneous source of financing.
- Increasing the use of short-term debt versus long-term debt financing will increase profit.
- Current liabilities have greater illiquidity risk due to the higher frequency that they have to be repaid or rolled over.
- Trade credit is a source of spontaneous financing.
- Short-term debt is frequently less expensive because it provides the borrower more security.
- Sources of financing repaid in six months to one year are usually categorized as long-term.
- Major sources of secured credit include commercial banks, finance companies, and factors.
- Inventory loans are considered an unsecured source of financing.
- The cost of trade credit varies directly with the size of the cash discount and inversely with the length of time between the end of the discount period and the final due date.
- The continual practice of stretching on trade credit is potentially a very useful source of short-term credit for the firm.
- The effective cost to the borrower of an unsecured bank loan is increased if a compensating balance is required.
- Minimizing working capital is accomplished by slowing down the cash conversion cycle.
- The conventional method for financing permanent levels of accounts receivable and inventory is accounts payable and accrued expenses.
- A firm should take the cash discount if the firm's cost of borrowing from the bank is greater than the cost of giving up a cash discount.
- If a firm anticipates stretching accounts payable, its cost of giving up a cash discount is reduced.
- The cost of giving up a cash discount on a credit purchase is the implied interest rate paid in order to delay payment for an additional number of days
- In giving up a cash discount, the amount of the discount that is given up is the interest being paid by a firm to keep its money by delaying payment for a number of days.
- A revolving credit agreement is a form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing.
II. MULTIPLE CHOICE QUESTIONS Encircle the letter that corresponds to the best answer.
Which of the following is a spontaneous source of financing? a. Accrued wages b. Preferred stock c. Trade credit d. Both a and c
Accounts receivable and inventory self-liquidate through the ______ cycle. a. spontaneous account b. net working capital c. cash conversion d. sales-to-receivables collection
Which of the following is considered a source of spontaneous financing? a. Trade credit
b. Inventories c. Accounts payable d. Both a and c
With regard to the hedging principle, which of the following assets should be financed with current liabilities? a. Minimum level of cash required for year-round operations b. Expansion of accounts receivable to meet seasonal demands c. Machinery used to produce a firm’s inventory d. Both a and b
Trade credit is an example of which of the following sources of financing? a. Spontaneous b. Temporary c. Permanent d. Both a and b
Which of the following is a spontaneous source of financing? a. Accounts payable b. Accounts payable and wages and salaries payable c. Accounts payable and inventories d. Accounts payable, wages and salaries payable, and accrued interest
Which of the following types of financing offers the firm the greatest degree of flexibility? a. Bonds b. Preferred stock c. Short-term lines of credit d. Long-term notes payable
Which of the following actions would improve a firm’s liquidity? a. Selling stock and reducing accounts payable b. Selling stock to purchase equipment c. Selling bonds and purchasing machinery d. Both a and c
As sales increase, a company needs more inventory and more employees resulting in ________. a. more accounts payable and accruals, and therefore increasing its spontaneous liabilities. b. less accounts payable and accruals, and therefore decreasing its spontaneous liabilities. c. more accounts payable and accruals, and therefore decreasing its spontaneous liabilities. d. less accounts payable and accruals, and therefore increasing its spontaneous liabilities.
A negative cash conversion cycle ________. a. means that the operating cycle exceeds the average inventory period. b. means that the average payment period exceeds the operating cycle. c. indicates that a firm is shortening its average payment period and lengthening its average collection period. d. indicates that a firm is shortening its average age of inventory and average payment period.
If a firm decides to take the cash discount that is offered on goods purchased on credit, the firm should a. pay as soon as possible. b. pay on the last day of the credit period. c. pay on or before the last day of the discount period. d. not take the discount no matter when the firm actually pays.
Smith & Smith Enterprises has a line of credit with National Bank that allows the company to borrow up to P350,000 at an interest rate of 15%. However, the firm must keep a compensating balance of 10% of any amount borrowed on deposit at the bank. The company does not normally keep a cash balance account with the bank. What is the effective annual cost of credit? a. 17% b. 17% c. 16. d. 16%
The Azurin Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with a 20% compensating balance. The term of the loan is 1 year. The effective cost of borrowing is (rounded to the nearest hundredth): a. 8%. b. 9%. c. 9%. d. 9%.
Salguero, Inc. can issue 3-month commercial paper with a face value of ₱1,000,000 for ₱980,000. Transaction costs will be ₱1,200. The effective annualized percentage cost of the financing, based on a 360-day year, will be: a. 8%. b. 8%. c. 8%. d. 9%.
When a company offers credit terms of 2/10, net 30, the annual interest cost, based on a 360-day year, is: a. 24%. b. 35%. c. 36%. d. 36%.
If a firm's credit terms require payment within 45 days but allow a discount of 2% if paid within 15 days (using a 360-day year), the approximate cost or benefit of the trade credit terms is: a. 14%. b. 16%. c. 20%. d. 24%.
Tolentino, Inc. buys on terms of 2/10, net 30 days. It does not take discounts, and it typically pays 35 days after the invoice date. Net purchases amount to P720,000 per year. What is the nominal annual cost of its non-free trade credit? a. 14%. b. 16%. c. 20%. d. 24%.
Assume that the current borrowing rate is at 15%. Which of the following discounts should the firm take? a. 2/10, net/ b. 1/15, net/ c. 3/10, net/ d. 1/10, net/
PROBLEMS
6.
Assume that Lasaleta company purchase P5,000 worth of supplies every 60 days and never take the trade discount of 2/10 net 60. 1. How much the company could save each (360-day) year if the company took the discount? P 2. What is the effective annualized (365 days) cost of foregoing a trade credit discount of 3/10 net 45? 32%
6.
.
Required: 1. What is the annual cost associated with each financing arrangement? 2. Discuss some considerations other than cost that may influence management’s decision between factoring and a commercial bank loan.
6.
Carmen Traders, Inc. needs ₱100,000 to pay a supplier’s invoice for merchandise purchased with terms of 2/10, net 30. The company wants to pay on the 10th day of the credit term so it can avail of the 2% discount. The funds needed can be raised by obtaining a short-term loan from a bank which agrees to grant a 30-day loan at 12% discounted interest per annum. The bank requires that a compensating balance of 10% be maintained in the borrower’s non-interest earning deposit account.
Required:
1 Commercial bank loans Amount loaned P250,000 x 75% 187,500. Discount P187,500 x ( 9%/12 months) (1,406) Compensating balance = P187,500 x 20% (37,500) Amount received 148,593. Annual costs: Interest expense P187,500 x 9% 16,875. Credit department costs P4,000 x 12 months 48,000. Bad debts 2% x P250,000 x 12 months 60,000. Total annual costs 124,875.
Factoring Amount loaned P250,000 x 85% 212,500. Factoring commission P250,000 x 3% (8,750) Prepaid interest (P212,500 - P8,750) x 9%/12 (1,528 ) Amount received 202,222. Annual Costs Annual Commissions P8,750 x 12 105,000. Annual Interest P203,750 x 9% 18,337. Total annual costs 123,337.
2 The annual factoring costs are slightly lower than the cost of bank loan and the factor is willing to advance greater amount. However, the elimination of the credit department could reduce the firm's options in the future.
- The loan proceeds would be ₱______________________. (Round-off to 2 d.)
Compensating Balance = 15% of Loan
= ₱100,000 x 15%
= ₱15,000 less: DD ₱10,000 ₱5,000.
LOAN
PROCEEDS = ₱100,000 - ₱5,000.
= ₱95,000.
- The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2 d.)
INT = ₱100,000 x 7% x 12 /
= ₱7,500 - NOT DISCOUNTED, will be repaid at end of term
- The effective annual interest rate on the loan is ________% (Round-off to 2 d.)
APR = x 1
₱100,000 - ₱5,000 12 /
= 7%
₱7,500.
B. If the firm normally keeps almost no money in its checking account. Loan proceeds: ₱100,000.
- The interest to be repaid on the amount borrowed would be ₱______________________. (Round-off to 2 d.)
INT = ₱117,647 x 7%
= ₱8,823.
BONUS: The amount borrowed would be ₱______________________. (Round-off to 2 d.)
B = ₱100,000 / (100% - 15%)
B = ₱100,000 / 85%
B = ₱117,647.
Compensating Balance = 15% of Loan
= ₱117,647 x 15%
= ₱17,647.
LOAN
PROCEEDS = ₱117,647 - ₱17,647.
= ₱100,000.
- The effective annual interest rate on the loan is ________% (Round-off to 2 d.)
APR =
₱117,647 - ₱17,647.
= 8%
₱8,823.
6.
A retailer’s terms of trade are 3/10, n/45 with a particular supplier. (assume a 360-day year)
Required: What is the cost on an annual basis of not taking the discount? 31%
6.
A company obtained a short-term bank loan of P250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a 20% compensating balance in its checking account. Ordinarily, the company maintains a balance of P25,000 in its checking account for transactions purposes.
Required: What is the effective interest rate of the loan? 6%
6.
NOP Co. has agreed to the following loan proposal by a bank: ▪ Stated interest rate of 10% on a one-year discounted note ▪ 15% of the loan as compensating balance with zero-interest current account to be maintained with the bank. ▪ The loan will have net proceeds of P1,500,000.
Required: 1. How much is the principal amount of the loan? P2,000, 2. What is the effective interest rate of the loan? 13%
6.
Quennie Company recently borrowed P500,000 from a bank. The bank loan is for a period of 120 days at an annual rate of 6%. (assume a 360-day year).
Required: 1. How much is the total interest expense for this loan? P10, 2. What is the effective annual rate? 6%
6.
GHI Company has a revolving line of credit of P300,000 with a one-year maturity. The terms call for a 6% interest rate and a ½% commitment fee on the unused portion of the credit line. The average loan balance during the year was P100,000.
Required: How much is the annual cost (in pesos) of this financing arrangement? P7,
06 Short Term Financing Management KEY
Course: Management Accounting (BSMA)
University: Foundation University (Philippines)
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