Chapter 8

Discussion Questions
8-1.

It is advisable to borrow in order to take a cash discount when the cost of borrowing is
less than the cost of forgoing the discount. If it cost us 36 percent to miss a discount, we
would be much better off finding an alternate source of funds for 8 to 10 percent.

8-2.

Larger firms tend to be in a net creditor position because they have the financial resources
to be suppliers to credit. The smaller firm must look to the larger manufacturer or
wholesaler to help carry the firm's financing requirements.

8-3.

The prime rate is the rate that a bank charges its most creditworthy customers. The
average customer can expect to pay one or two percent (or more) above prime. In
competitive markets banks may actually charge preferred customers less than prime.

8-4.

The use of a compensating balance or minimum required account balance allows the
banker to generate a higher return on a loan because not all funds are actually made
available to the borrower. A $125,000 loan with a $25,000 compensating balance
requirement means only $100,000 is being provided on a net basis. This benefit to the
lender need not be a disadvantage to the borrower. The borrower may, in turn, receive a
lower quoted interest rate and certain gratuitous services because of the compensating
balance requirement. Bankers have tended towards eliminating both compensating
balances and gratuitous services.

8-5.

The stated interest rate is the percentage rate unadjusted for time or method of repayment.
The annual interest rate is the true rate and considers all these variables. A 5 percent stated
rate for 90 days provides a 20 percent annual rate. The financial manager should recognize
the annual rate as the true cost of borrowing. An effective rate would include any
compounding effects over the relevant period.

8-6.

Commercial paper can be either purchased or issued by a corporation. To the extent one
corporation purchases another corporation's commercial paper as a short-term investment,
it is a current asset. Conversely, if a corporation issues its own commercial paper, it is a
current liability.

8-7.

In comparison to bank borrowing, commercial paper can generally be issued at below the
prime rate. Furthermore, there are no compensating balance requirements, though the firm
is required to maintain approved credit lines at a bank. Finally, there is a certain degree of
prestige associated with the issuance of commercial paper.

8-8.

A bankers acceptance offers the guarantee of payment from a chartered bank.

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8-9.

Major types of collateralized short-term loans include:

a. Pledging accounts receivable: borrowing with receivables as collateral.
b. Factoring account receivables: selling accounts at a discount to a finance company.
c. Borrowing with inventory as collateral through
(1) Blanket inventory lien-general claim against inventory or collateral. No specific
items are marked or designated.
(2) Trust receipt-borrower holds the inventory in trust for the lender. Each item is
marked and has a serial number. When the inventory is sold, the trust receipt is
canceled and the funds go into the lender's account.
(3) Warehousing-the inventory is physically identified, segregated, and stored
under the direction of an independent warehouse company that controls the
movement of the goods. If done on the premises of the warehousing firm, it is
termed public warehousing. An alternate arrangement is field warehousing
whereby the same procedures are conducted on the borrower's property.

8-10. A public offering backed by an asset (accounts receivable) as collateral. Essentially a firm
sells its receivables into the securities markets.
8-11. Hedging means to engage in a transaction that partially or fully reduces a prior risk
exposure. In selling a financial futures contract, if interest rates go up, one is able to buy
back the contract at a profit. This will help to offset the higher interest charges to a
corporation or other business entity. Hedging involves the matching of maturities of assets
and liabilities to reduce risk.

Internet Resources and Questions

1. www.me.org/produits_en/produits_d_inter_court_en.php
www.cme.com/products/index.cfm
2. www.moneysense.ca/eng/banking_credit/index.jsp

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Problems
8-1.

Cost of forgoing the cash discount

K DIS

d%
365

100% d% f date) - d date

a.

K DIS

2%
365

.1862 18.62%
100% 2% f 50 d 10

b.

K DIS

2%
365

.2980 29.80%
100% 2% f 40 d 15

c.

K DIS

3%
365

.3225 32.25%
100% 3% f 45 d 10

d.

K DIS

3%
365

.0664 6.64%
100% 3% f 180 d 10

8-2.

Arbutus Ltd.

a. Accounts payable forgoing discount:

Annual purchases/365 Final due date
= $9,210,000/ 365 45 =
Accounts payable taking discount:
Annual purchases/365 Discount period
= $9,210,000/ 365 10 =
Additional financing available =

$1,135,480

252,329
$ 883,151

b. Cost of forgoing the cash discount

K DIS

2%
365

.2128 21.28%
100% 2% f 45 d 10

8-3.
a. COGS

Foundations of Fin. Mgt.

S. Pumpkins
= Average inventory turnover rate
= $630,000 8
= $5,040,000
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Average accounts payable = COGS/ 365 average payment period

= $5,040,000/ 365 45
= $621,370
b. Annual sales

8-4.

= Average A/R 365/Average collection period

= $520,250 365/30
= $6,329,708
Paul Promptly

K DIS

3%
365

.2258 22.58%
100% 3% f 60 d 10

In this problem, Mr. Promptly has the use of funds for only 50
extra days (60 10), instead of 60 extra days (70 10). Mr.
Promptlys suppliers are offering terms of 3/10, net 70. Mr.
Promptly is actually accepting terms of 3/10, net 60.
8-5.

Regis Clothiers
K DIS

2%
365

.1665 16.65%
100% 2% f 60 d 15

Regis should accept the banks terms and borrow at 11% to take
the cash discount. The cost of forgoing the discount is 16.65%.
8-6.

Treasury Bills
100 P 365
100 98.671 365

0.0540 5.40%
P
d
98.671
91

8-7.

Treasury Bills
100 P 365
100 98.097 365

0.0389 3.89%
P
d
98.097
182

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8-8.

McGriff Dog Food Company

a. Accounts receivable
= Average daily credit sales average collection period
= $10,000 25
= $250,000
Accounts payable
= Average daily credit purchases average payment period
= $9,000 20
= $180,000
Net credit position = Accounts receivable Account payable
Net credit position = $250,000 $180,000
= $70,000
b. Accounts receivable will remain at
Accounts payable = $9,000 32
Net credit position

$250,000
288,000
($38,000)

McGriff has improved its cash position and cash flow. Instead of extending
$79,000 more in credit (funds) than it is receiving, it has reversed the position
and is the net recipient of $38,000 in credit.

8-9.

Your Bank
R ANNUAL =

rEFF

I 365
$45
365

0.1095 10.95%
P
d
$3,000 50

$45
1

$3,000

8-10.

365
50

1 0.1148 11 .48%

I. M. Boring
One years interest = $5,000 0.13 = $650
RDIS =

I
365
$650
365

0.1495 14.95%
P-I
d
$5,000 $650 365

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8-11.

Simpson Orange Juice Company

a. Accounts receivable
= Average daily credit sales average collection period
= $7,000 28 =
$196,000
Accounts payable
= Average daily credit purchases average payment period
= $6,000 20 =
$120,000
Net credit position = Accounts receivable Account payable
Net credit position = $196,000 $120,000 = $76,000
b. Accounts receivable will remain at
Accounts payable = $6,000 35
Net credit position

$196,000
210,000
($14,000)

Simpson has improved its cash position and cash flow. Instead of extending
$76,000 more in credit (funds) than it is receiving, it has reversed the position
and is the net recipient of $14,000 in credit.

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8-12.

Carey Company

Annual rate of interest with 20% compensating balance:

RCOMP =

I
365
$24,000
365

0.15 15%
PB
d
$200,000 $40,000 365

OR:
RCOMP =

I
12%

0.15 15%
(1 c ) 1 .20

Installment loan with compensating balance:

RINSTALL =

2 Annual number of payments I

(Total number of payments 1) P

2 12 $24,000
$576,000

13 $160,000
(12 1) $200,000 $40,000
$576,000

$2,080,000
0.2769 27.69%

RINSTALL =

8-13.

Capone Child Care Centers, Inc.

Annual rate of interest:

I
365
$25,000
365

PB
d
$250,000 $32,000 * 365
0.1147 11.47%

RCOMP =

*Compensating balance = 20% $250,000 = $50,000

Normal funds =
18,000
Restricted compensating balance =
$32,000

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8-14.

Hi-Cost Supermarkets
Annual rate of interest:

I
365
$1,479 *
365

PB
d
$30,000 $2,000 * * 180
0.1071 10.71%

RCOMP =

* (10% $30,000) 180/365 =

**Compensating balance = 15% $30,000 =
Normal funds =
Restricted compensating balance =
8-15.

$1,479
$4,500
2,500
$2,000

Tucker Drilling Corp.

Annual rate of interest with 20% compensating balance:
Interest = $20,000 (0.08 + 0.5) = $17,000:
$17,000/ ($200,000 $40,000)
= $17,000/ $160,000
= 0.10625 = 10.625%

8-16.

Your Company

a. simple interest with a 10% compensating balance:

I
365
$700,000 *
365

PB
d
$5,000,000 $500,000 * * 365
0.1556 15.56%

RCOMP =

* $5,000,000 0.14 =
** $5,000,000 0.10 =

Foundations of Fin. Mgt.

$700,000
$500,000

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b. discounted interest:
I
365
$700,000
365

P-I
d
$5,000,000 $700,000 365
0.1628 16.28%

RDIS =

c. an installment loan with 12 payments:

2 12 $700,000
$16,800,000

(12 1) $5,000,000 13 $5,000,000

$16,800,000

$65,000,000
0.2585 25.85%

RINSTALL =

d. discounted interest with a 5% compensating balance:

$700,000/ ($5,000,000 $700,000 $250,000)
= $700,000/ $4,050,000
= 0.1728 = 17.28%
8-17.

Your borrowing

a. $900/ 12,000 = 7.5%

Use formula 86 for b, c, and d.
b.

RINSTALL =

2 2 $900
$3,600

0.1000 10.00%
(3) $12,000 $36,000

c.

RINSTALL =

2 4 $900
$7,200

0.1200 12.00%
(5) $12,000 $60,000

d.

RINSTALL =

2 12 $900
$21,600

0.1385 13.85%
(13) $12,000 $156,000

8-18.

Vroom Motorcycle Company

RINSTALL =

2 Annual number of payments I

(Total number of payments 1) P

RINSTALL =

2 1 2 $9,000
$216,000

0.1946 19.46%
(36 1) $30,000 $1,110,000

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8-19.

Morrisette Records
Annualized yield on discounted paper:
100 P 365
100 98.512 365

0.0735 7.35%
P
d
98.512
75

Effective annual yield = 7.57%

rEFF

100 98.512
1

98.512

8-20.

365
75

1 0.0757 7.57%

Bankers Acceptance
100 P 365
100,000 97,285 365

0.1132 11.32%
P
d
97,285
90

Effective annual yield = 11.81%

FV = 100,000 PV = 97,285 (neg.)
CPT % i =?

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PMT = 0

N = 90/ 365

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8-21.

Blue Grass Filters

a. Cost of forgoing the cash discount:

K DIS

d%
365

100% d% f date) - d date

K DIS

2%
365

.1241 12.41%
100% 2% f 75 d 15

Effective annual yield = 13.08%

Choose the bank at 11%.
b. No security requirements
More convenient and more readily available
No life story required
8-22.

The Ogden Timber Company

Cost of forgoing the cash discount:
K DIS

d%
365

100% d% f date) - d date

K DIS

2%
365

.1862 18.62%
100% 2% f 50 d 10

We use 50 days instead of 35 days as the final due date because Ogdens
suppliers have effectively made this the due date even though the stated due
date is 35 days.
Annual rate of interest; 25% compensating balance requirement:
RCOMP =

I
15%

0.20 20%
(1 c) 1 0.25

The annual cost of the loan, 20%, is more than the cost of passing up the
discount, 18.62%. Ogden Timber Company should continue to pay in 50 days
and pass up the discount.

8-23.

The Ogden Timber Company (Continued)

Annual rate of interest; 10% compensating balance requirement:
RCOMP =

I
15%

0.1667 16.67%
(1 c) 1 0.10

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The answer now changes. The annual cost of the loan, 16.67%, is less than
the cost of passing up the discount. Ogden Timber Company should borrow
the funds and take the discount.

8-24.

Bosworth Petroleum

a. Annual rate on bank loan:

R ANNUAL =

I 365
$8,100
365

0.0986 9.86%
P
d
$500,000 60

b. Cost of forgoing cash discount

K DIS

2%
365

.1241 12.41%
100% 2% f 70 d 10

c. Yes, because the cost of borrowing is less than the cost of losing the
discount.
Amount to be borrowed =

d.

e.

Amount needed
(1 c)

$500,000 $500,000

$625,000
(1 .20)
.80

I
365
$13,000
365

PB
d
$625,000 $125,000 60
0.1582 15.82%

RCOMP =

No, do not borrow with a compensating balance of 20 percent since the annual
rate is greater than the cost of forgoing the cash discount.

8-25.
a.

Rockford Filing Ltd.

Annual commitment fee

= 0.01 $1,000,000
= $10,000

Interest expense

= $1,000,000 10% 45/365

= $12,328.77

Annual rate of interest:

I
365
$10,000 $12,328.77 * 365

P
d
$1,000,000
45
0.1811 18.11 %

R ANNUAL =

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*Note: The interest cost also includes the commitment fee.

b. Cost of forgoing the cash discount:
K DIS

2%
365

.1655 16.55%
100% 2% f 60 d 15

c. Discounted commercial paper

100 P 365
1.25
365

0.1027 10.27%
P
d
100 1.25 45

Choose the commercial paper. It is the cheapest alternative.

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8-26.

Bernies Macs

a. Annual commitment fee

Interest expense

= $4,750
= $600,000 7% 60/365
= $6,904.11

Annual rate of interest:

I
365
$4,750 $6,904.11 * 365

P
d
$600,000
60
0.1182 11 .82%

R ANNUAL =

*Note: The interest cost also includes the commitment fee.

b. Cost of forgoing the cash discount:
K DIS

2%
365

.1241 12.41%
100% 2% f 90 d 30

d. Discounted commercial paper

100 P 365
1.91
365

0.1185 11.85%
P
d
100 1.91 60

Choose the bank loan. It is the cheapest alternative.

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8-27.

Nanaimo Shipping Company

a. Bankcorp of B.C.
Annual interest rate

2 4 $10,000
( 4 1) $100,000 $20,000 $10,000
0.2286 22.86%

RINSTALL =

Victoria Bank
Annual interest rate

2 12 $10,000
(12 1) $100,000 $10,000
0.2051 20.51%

RINSTALL =

Choose Victoria Bank since it has the lowest annual interest rate.
b. The numerators stay the same as in part (a) but the denominator
increases to reflect the use of more money because compensating
balances are already maintained at both banks.
Bankcorp of B.C.
Annual interest rate

2 4 $10,000
( 4 1) $100,000 $10,000
0.1778 17.78%

RINSTALL =

Victoria Bank
Annual interest rate

2 12 $10,000
(12 1) $100,000
0.1846 18.46%

RINSTALL =

c. The compensating balance assumption changed interest rates as

follows:
Interest rate
With compensating balance
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Bankcorp
22.86%

Victoria
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Without compensating balance

Difference in cost

17.78
5.08%

18.46
2.05%

Yes. If compensating balances are maintained at both banks in the

normal course of business, then Bankcorp of B.C. should be chosen
over Victoria Bank. The annual cost of its loan will be less.

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8-28.

Alberta Oil Supplies

a.

0 - 30 days
B
D
G
L
Total
loan %
loan

Amount
$ 80,000
10,000
40,000
60,000
190,000
90%
$171,000

Total
loan %
loan

Amount
$ 50,000
250,000
25,000
325,000
80%
$260,000

Total
loan %
loan

Amount
$ 15,000
200,000
215,000
70%
$150,500

31 - 40 days
A
E
J

41-45 days
I
K

Maximum Loan = $171,000 + $260,000 + $150,500

= $581,500
b. Loan balances
Interest, 15% annual
One month's interest

Foundations of Fin. Mgt.

$581,500
0.0125 per month
$ 7,269

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8-29.

Towers Arcades
Bank cost:
Interest: $560,000 10% 1/12 =
Processing charge = $800,000 .5% =
Factor cost:
Interest: $560,000 11% 1/12 =
Processing fee = $800,000 2% =
Less credit department savings =

$ 4,667
4,000
$ 8,667
$ 5,133
16,000
(15,000)
$ 6,133

Choose the factor.

8-30.

Thornton Pipe and Steel Company

a. Sales price: December Treasury bond contract

(Sale takes place in July)
Purchase price, December Treasury bond contract:
(10% price decline)
.9 $105,000 =
Gain per contract
Number of contracts
Profit on futures contracts$ 52,500

$105,000
94,500
10,500
5

b. Profit occurred because the bond value fell due to increasing rates. This

meant the subsequent purchase price was less than the initial sales price.
c. Increased interest cost
Profit from hedging
Net cost

$60,800
52,500

$ 8,300

$8,300
Net cost
0.1365 13.65%
$60,800

The net cost is 13.65%. This means 86.35% of the increased interest cost was
hedged away.
d. If interest rates went down, there would be a loss on the futures contracts.
The lower interest rates would lead to higher bond prices and a purchase
price that exceeded the original sales price.

8-31.

Foundations of Fin. Mgt.

Fresh and Fruity Foods, Inc.

(Short-term Financing)
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Purpose:
The student must focus on accounts receivable as an investment
(use of funds) and the financial advantages of reducing the commitment to
this asset. At the same time the firm is also considering reductions to its
accounts payable balance in order to take cash discounts. This alternative will
call for additional bank financing and comparative costs must be carefully
assessed. The case utilizes many calculations that are covered in the text, but
places them in a more complex, decision oriented framework.
Suggested Questions:
a. Using the data in the income statement and the balance sheet that follow,
compute the companys average collection period (ACP) in days. Use a 365day year when calculating sales per day.
b. Compute the cost, as a percent, that the company is paying for not taking the
suppliers discounts. (The suppliers terms are 2/10, net 60; but note from the
bottom of the balance sheet that Fresh & Fruity has been taking 67 days to
pay its suppliers).
c. Assume Alice Plummers first initiative to offer a 10 percent discount was
implemented, and the companys average collection period dropped to 32
days. If net sales per day remained the same, as Alice expects, what would be
the new accounts receivable balance? How much cash was freed up by the
reduction in accounts receivable? What is the new accounts payable balance
if the money is used to pay off suppliers?
d. As a result of Alices first initiative described in part c, Fresh & Fruity is able
to take advantage of the 2 percent discount on one-third of its purchases (see
the income statement). What will be the cash discount figure on the income
statement? What effect does this have on net income (after taxes)? The
simplest way to get this figure is to multiply the cash discount figure by (1
Tax rate) and add this figure to the net income aftertax figure on the income
statement. Also what is the effect on the return-on-sales ratio shown toward
the bottom of the balance sheet? Consider the effect on the return-on-equity
ratio as well.
e. Alices second initiative calls for Fresh & Fruity to obtain a bank loan of a
sufficient size to enable the company to take all suppliers discounts. What is
the minimum size of this loan? Hint: To take all suppliers discounts, the
average payment period must be 10 days, and net purchases will be Purchases
(Purchases from Figure 1 .02). Assume all this happens, and solve the
following formula for the new accounts payable balance, using:
Accounts payable = Average payment period Purchase per day*
Now compare the accounts payable you just solved with the new accounts
payable balance you found in part c. The difference is the size of the loan that
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is required.
f. Assume Fresh & Fruity obtains an 8 percent loan for one year in the amount
you solved in part e, and it reduces its accounts payable balance accordingly.
Now the company is taking 2 percent discounts on all purchases and paying 8
percent a year on the loan balance. What is the net gain from taking the
discounts and paying the interest on a before-tax basis? (on an aftertax basis?)
g. (Optional) Suppose the 8 percent loan that Fresh & Fruity obtained was a
discount loan, and the bank further required a 20 percent compensating
balance of the full loan amount. What is the annual rate of interest to Fresh &
Fruity? How does this compare to your answer in question b for the cost of
not taking a cash discount?
Answers

a. Average collection period

= Accounts receivable/ Average daily credit sales
Accounts receivable
= $209,686
Average daily credit sales
= $1,179,000/ 365
= $3,230
Average collection period
= $209,686/ $3,230
= 64.92 days
b. Cost of forgoing the cash discount:
K DIS

2%
365

.1307 13.07%
100% 2% f 67 d 10

The formula tells us that Fresh and Fruity is effectively paying 13.07%
interest to delay paying the discounted amount for 57 days (the 67 days on
which they pay less the 10 day discount period).

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c. Average collection period Average daily credit sales

= New accounts receivable
32 $3,230 = $103,360
Freed-up cash = Old accounts receivable
New accounts receivable

$209,686
103,360
$106,326

Old accounts payable

Funds from accounts receivable
New accounts payable
d. Purchases (Figure 1)
1/3 exposed to purchase discount
2% purchase discount savings

$180,633
106,326
$ 74,307
$969,000
$323,000
$ 6,460

With the firm in a 33 percent tax bracket, a savings of $6,460 will produce
$4,328 in aftertax income. The answer is equal to the cost savings (1 - T).

$6,460 (1 .33) = $6,460 (.67) = $4,328

This means total income will now be:
Old income
New aftertax income
Total aftertax income

$50,623
4,328
$54,951

Return on sales will be:

Net income (aftertax)/ Sales

= $54,951/ $1,179,000
= 0.0466 = 4.66%

This, of course, represents an improvement over the old figure of

4.29%.
Return on equity will be:
Net income (aftertax)/ Equity

= $54,951/ $123,600
= 44.46%

This, also, represents an improvement over the old ratio of 40.96%. (Note:
This firm has a particularly high return on equity because of rapid asset
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turnover and high current liabilities). If the added profit is included in equity,
the return is 42.95% ($54,951/ $127,928).

e. Accounts payable = Average payment period Purchases per day

Average payment period = 10 days
Purchases per day
= [969,000 (.02 969,000)]/365
= [969,000 $19,380]/ 365
= $2,602
Accounts payable
= 10 $2,602
= $26,020
Accounts payable from question c
$74,307
Accounts payable from question e
26,020
Size of loan required
$48,287
This is the size of the loan required to take all cash discounts in 10
days.
f. The cost is the 8 percent interest on the bank loan of $48,287 or
$3,863. The gain is the cash discounts taken of $19,380. The net
gain before tax is $15,517 ($19,380 $3,863).
On an aftertax basis this translates to a gain of $10,396 ($15,517
0.67).
g. First determine the amount of funds on which interest must be
paid.
$48,287 (.08 $48,287) (.20 $48,287)
= $48,287 $3,863 $9,657
= $34,767
Then divide the interest payment by this value.
Interest/ Useable funds
$3,863/ $34,767 = 0.1111 or 11.11%
The cost goes up from 8% to 11.11%. However, this value is still less than the
cost of forgoing the cash discount of 13.07%, computed in part (b). Thus, it is
advantageous to borrow and take the cash discount.

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6/E Cdn. Block, Hirt, Short

Note: Alert students may point out that Fresh & Fruity still needs $48,287 in
cash no matter what kind of loan it is. Therefore if the interest is to be
charged on a discounted basis, and a compensating balance is required, Fresh
& Fruity must borrow a larger amount to make up for it. Solve for the larger
amount using algebra where L is the larger amount.

L (.08 L) (.20 L)
L .08L .20L
L .28L
.72L
L
L

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S-228

= $48,287
= $48,287
= $48,287
= $48,287
= $48,287/ .72
= $67,065

6/E Cdn. Block, Hirt, Short