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Chapter 18

Working Capital Management

18-1. As was done in Checkpoint 18.1 in the text, we can evaluate Deere & Co.’s liquidity using net
working capital and the current ratio. Net working capital is simply the difference between current
assets and current liabilities, while the current ratio can be found as (using 2008 as an example):

 current assets 
current ratio =  
 current liabilities 
 $9,197,400 
=  = 0.61.
 $15,083,300 

Since Deere’s current ratio is less than 1, its current assets are less than its current liabilities; this,
then, implies that its net working capital is negative.
Here are the values for Deere for 2006–2008:

A B C=A-B D = A/B
CA CL net working capital current ratio
2006 $7,152,900 $12,787,500 ($5,634,600) 0.559
2007 $9,920,100 $15,921,500 ($6,001,400) 0.623
2008 $9,197,400 $15,083,300 ($5,885,900) 0.610

All of Deere’s net working capital values for this period are negative. While the magnitude of
2008’s is smaller than 2007’s, it is still higher than 2006’s initial value. Looking at Deere’s
accounts for 2007 and 2008, we see that Deere’s cash fell very slightly, but its short-term
investments completely disappeared (Deere didn’t have any of these in 2006, either). Net
receivables rose; inventory rose significantly. These last two accounts were extremely influential
on the company’s liquidity position. Deere might want to tighten up its credit policy (to reduce
accounts receivable) and investigate its inventory position.
There are some issues on the current liability side, too. Deere’s accounts payable doubled in 2008,
its short-term debt fell slightly, and its other current liabilities disappeared. Deere’s A/P increase
undoubtedly helped fund its increases in inventory and A/R. However, ominously, the dollar
increase in A/P is much larger than the increases in these two CA accounts.
Overall, Deere’s liquidity position is fairly consistent: Net working capital is negative throughout
the period, with the current ratio improving slightly in 2007.

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Solutions to End of Chapter Problems—Chapter 18 445

We can visualize Deere’s situation as follows:

$19,000,000 0.800

0.700
$14,000,000

0.600

$9,000,000
current assets
current liabilities
0.500
net working capital
current ratio
$4,000,000

0.400

($1,000,000) 2006 2007 2008


0.300

($6,000,000) 0.200

18-2. This question is similar to 18-1, and we will use the same two relationships: net working capital =
current assets − current liabilities, and current ratio = (current assets/current liabilities). However,
we will note significant differences between Deere’s situation in the last problem and Microsoft’s
in this one: Microsoft’s net working capital is always positive, so that its current ratio is always
greater than 1.
Here are the liquidity measures for Microsoft:

A B C=A-B D = A/B
CA CL net working capital current ratio
2006 $49,010,000 $22,442,000 $26,568,000 2.184
2007 $40,168,000 $23,754,000 $16,414,000 1.691
2008 $43,242,000 $29,886,000 $13,356,000 1.447

Thus, if I were the lead banker evaluating Microsoft’s line of credit, I would say that Microsoft is
quite liquid, although its liquidity is declining (see below).
While Microsoft is more liquid that Deere (from Problem 18-1), Microsoft’s position is not as stable
as Deere’s. While Deere’s current ratio (while less than 1) is fairly stable, Microsoft’s is declining
steadily. Its CA have increased slightly in 2008 from 2007 (while they are much lower than 2006’s):
Cash is up and accounts receivable are up, but short-term investments are down very significantly.
The only issue of real concern for CA is the increase in net receivables. However, on the CL side,
the increase in accounts payable—almost double in 2008 from 2007—should be evaluated.

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446 Titman/Keown/Martin • Financial Management, Eleventh Edition

Here’s how Microsoft’s situation looks graphically:


$54,000,000 3.000

$44,000,000 2.500

$34,000,000 2.000

current assets
current liabilities
$24,000,000 1.500
net working capital
current ratio

$14,000,000 1.000

$4,000,000 0.500

2006 2007 2008

($6,000,000) 0.000

18-3. Temporary assets are current assets that will be liquidated—and not replaced—within one year.
An example is a seasonal increase in inventories, which is exactly what we have in part (a).
Accounts receivable increases can also be temporary, as long as they are liquidated (and not
replaced) within the year. In part (c), we have an increase in A/R, but since these come from an
increase in the firm’s customer base, we wouldn’t expect this increase to disappear within the
year. Instead, we’d expect those accounts that were paid within the year to be replaced with new
charges from the newly larger customer base. We will therefore classify this A/R increase as
permanent.
Permanent assets also include fixed assets. Since our firm will keep its truck (from part b) for five
years, we will classify that as permanent.
(a) seasonal increase in inventory: TEMPORARY
(b) purchase of new truck that will last for 5 years: PERMANENT
(c) increase in A/R from increase in customer base: PERMANENT
(See Panel A of Figure 18.1.)

18-4. Spontaneous sources of financing are created automatically as the firm conducts business. For
example, if a firm buys raw materials from a supplier and charges them to their trade account, it
has just generated an increase in accounts payable. This is exactly what happens in situation (b)
here. On the other hand, temporary sources of financing are also short-term, but they are created
by a specific decision to raise funding—for example, by a decision to get a short-term loan from
a bank, or to issue commercial paper in the money market. Permanent financing sources are
intermediate- and long-term debt and equity sources, such as the 4-year bank loan in part (a) and
the common stock issue in part (c).
(a) 4-year bank loan: PERMANENT
(b) increase in inventory charges to trade credit: SPONTANEOUS
(c) new common stock issue: PERMANENT
(See Panel B of Figure 18.1.)

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Solutions to End of Chapter Problems—Chapter 18 447

18-5. Network Solutions’ cash conversion cycle is the difference between its operating cycle and its
accounts payable deferral period—that is, the length of time between its payment to suppliers for
its inventory (when it experiences a cash outflow) and its receipt of cash from its customers (the
resulting cash inflow). We can visualize the firm’s operating and cash conversion cycles using a
schematic like the one found in the text’s Figure 18.3:

inventory inventory
purchased sold

inventory conversion average collection


period (45 days) period (25 days)

accounts payable cash conversion cycle (40 days)


deferral period
(30 days)

cash paid for receipt of cash from


inventory accounts receivable

operating cycle (70 days)

A. Thus, Network Solution’s cash conversion cycle is 40 days: the difference between its
operating cycle of 70 days and its accounts payable deferral period of 30 days. The firm is
financing its sales during this period: It has already paid its suppliers, but has not yet been paid
by its customers. It must have sufficient other resources to operate during this period.
B. If the firm were able to delay payment to its suppliers, then it would be able to hold on to its
cash longer, decreasing the period that it must finance its sales—that is, decreasing its cash
conversion cycle. Paying its A/P after 50 days instead of after 30 would decrease its cash
conversion cycle to only 20 days.
C. Network Solutions buys raw materials worth $100,000 per day (2000 routers /day at $50 cost
per router) and uses trade credit for the purchase. If payables were extended an additional 20
days, the a/p deferral period would increase 20 days and the cash conversion cycle would go
down from 40 days to 20 days. Net working capital would decrease by $2,000,000 ($100,000
a/p per day ∗ 20 additional days)
The chart below outlines the two scenarios we have considered:

A B C=A+B D E=C-D
inventory average A/P cash
conversion collection operating deferral conversion
period period cycle period cycle
(a) 45 25 70 30 40
(b) 45 25 70 50 20
higher lower

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448 Titman/Keown/Martin • Financial Management, Eleventh Edition

18-6. Carraway Seeds is financing its inventory for 115 days of its 120-day operating cycle. By not
taking advantage of its suppliers’ offer to finance its inventory—by allowing Carraway to delay
their payment—for an extra 40 days essentially means that Carraway is walking away from an
interest-free, 40-day loan. (It pays the same dollar amount to its suppliers regardless of when it
pays.) Carraway should definitely take full advantage of its suppliers’ terms, increasing its A/P
deferral period to the full 45 days, thereby decreasing its cash conversion cycle to 75 days.
Below is a schematic depicting Carraway’s initial situation (part a). The big horizontal arrow near
the bottom depicts the suppliers’ credit terms—the benefit that Carraway is passing up by paying
after 5 days.

inventory inventory
purchased sold

inventory conversion period (90 days) average


collection
period
(30 days)

accounts cash conversion cycle (115 days)


payable
deferral
period
(5 days)

cash paid for receipt of cash from


inventory accounts receivable

operating cycle (120 days)

The following chart quantifies the change in the firm’s cash conversion cycle from delaying its
payments to suppliers (part b).

A B C=A+B D E=C-D
inventory average A/P cash
conversion collection operating deferral conversion
period period cycle period cycle
(a) 90 30 120 5 115
(b) 90 30 120 45 75
higher lower

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Solutions to End of Chapter Problems—Chapter 18 449

18-7. As in the example from Checkpoint 18.3, we’ll assume that Paymaster Enterprises currently has
no account with this bank, and that it will borrow the amount required for its compensating balance
(increasing its borrowing beyond the $100,000 actually needed for financing its seasonal working
capital). If the firm wants to use $100,00 for its purposes, after leaving 10% of the total loan amount
in the bank, then it must be that the $100,000 desired is only (100% − 10%) = 90% of the total amount
borrowed. Thus it must have borrowed $100,000/(0.90) = $111,111. (Ten percent of $111,111 is
$11,111; leaving this balance at the bank means that Paymaster has use of the remainder, $100,000.)
However, its turns out that Paymaster does not have the full use of the $100,000, because the interest
on this loan is calculated on a discount basis. That is, the company will have to pay all of its interest
up front, from the proceeds of the loan. Using equation 18-7, we can calculate this interest amounts as:
interest = principal ∗ rate ∗ time
= $111,111 ∗ (0.12) ∗ (3/12) = $3,333.33.

Thus, Paymaster will only receive proceeds of ($100,000 − $3,333.33) = $96,666.67. Now, we can
calculate the APR of this loan using equation 18-8:
APR = (interest/principal) ∗ (1/time)
 $3,333.33   1 
= ∗  = 13.79%.
 $96,666.67   3 /12 
The compensating balance requirement—which makes Paymaster borrow more than its wants—and
the discounting of interest—which forced Paymaster to pay interest on funds it never receives—makes
the cost of the loan much higher than the stated 12% rate.
But there’s still a problem here. Even though Paymaster pays interest on $111,111, it only receives
$96,666.67, which is not enough to finance its working capital. The company needs to take home
$100,000. How can we determine the amount it must borrow for a loan that would allow it to get
all the money it needs? And what would be the APR for that loan?
If Paymaster needs $100,000, then:
$100,000 = total loan amount − compensating balance − interest charge
= loan − (10% ∗ loan) − [loan ∗ 12% ∗ (3/12)]
= loan − (0.10 ∗ loan) − (0.03 ∗ loan)
= loan ∗ (1 − 0.10 − 0.03)
= loan ∗ (0.87),

which implies that the loan amount is ($100,000/0.87) = $114,942.53. Interest on this loan would be
($114,942.53) ∗ (12%) ∗ (3/12) = $3,448.28, and the compensating balance would be (10%) ∗
($114,942.53) = $11,494.25. Paymaster would then be able to take home ($114,942.53 − $11,494.25
− $3,448.28) = $100,000. Its APR for this loan would be:

APR = (interest/principal) ∗ (1/time)


 $3,448.28   1 
= ∗  = 13.79%,
 $100,000   3 /12 
the same as before! This is because we haven’t changed the relative values here—we’ve just
scaled the loan up.

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450 Titman/Keown/Martin • Financial Management, Eleventh Edition

18-8. For this question, we will be using equation 18-9:

 a   day sin year 


annualized opportunity of forgoing the discount =  ∗ ,
1− a   c−b 
where we are considering a trade discount of the form a/b, net c. For example, in part (a), we are
offered terms of 2/10, net 30, which means that we can take a 2% discount (a) if we pay within
10 days (b); otherwise, we have to pay the full amount in 30 days (c). The cost of not taking
advantage of this offer would be:

 0.02   360 
annualized opportunity of forgoing the discount =  * ,
 1 − 0.02   30 − 10 

or 36.73%. This is much higher than just 2%—because the 2% applies to only 10 days. Two percent
over 10 days means a lot more than 2% over a full year! (Note that part a has the same terms as
the example in the text presented just after equation 18-9, but we have gotten a different answer.
That’s because our annualization—the second term—assumes a 360-day year, while the text’s
example assumed 365.)
The rest of the results are presented below. We have also added to extra parts, (e) and (f), for
expositional purposes.

# of days/year = 360

a b c [a /(1-a )]*[360/(c -b )]
net
days for due in opportunity
part discount % discount (days) cost
(a) 2% 10 30 36.73%
(b) 3% 15 30 74.23%
(c) 3% 15 45 37.11%
(d) 2% 15 60 16.33%
(e) 2% 15 30 48.98%
(f) 3% 10 30 55.67%

Note that, all else equal:


• As the net due date (c) increases, the opportunity cost of forgoing the discount falls (compare
parts b and c)
• As the days for discount (b) increases, the opportunity cost rises (compare parts a and e)
• As the discount percentage (a) rises, the opportunity cost rises (compare parts a and f)

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Solutions to End of Chapter Problems—Chapter 18 451

18-9. First, let’s consider Alternative A. Morin has sufficient balances in the bank to allow us to ignore
the loan’s compensating balance requirement (for the moment—we’ll consider the need for new
balances below). If the firm simply borrows $100,000 it will pay ($100,000) ∗ (14%) ∗ (12/12) =
$14,000 in interest immediately (since the loan requires discount interest), leaving the firm with
just $86,000. The cost of this loan is found as follows:
APR = (interest/principal) ∗ (1/time)
 $14,000   1 
= ∗  = 16.28%.
 $86,000   12 /12 
If they want to take home $100,000, then they must borrow more than this to start; they would
need to solve for the loan amount such that [loan amount ∗ (1 − 0.14)] = $100,000  $116,279.07.
(They would still have adequate compensating balances.) For this scenario, the APR is:
APR = (interest/principal) ∗ (1/time)
 $16,279.07   1 
= ∗  = 16.28%,
 $100,000   12 /12 
as before (because we are simply scaling the same loan).
Now, let’s compare this to Alternative B. In this case, the firm borrows $100,000, then repays
$116,300 after 1 year. The total interest charge is therefore ($116,300 − $100,000) = $16,300, and
the APR is:
APR = (interest/principal) ∗ (1/time)
 $16,300   1 
= ∗  = 16.3%.
 $100,000   12 /12 
This is essentially the same deal that Morin is getting from its bank. If we want to play the
rounding error, then Morin should go with its bank. (Although Morin might evaluate why it’s
keeping such a large amount of money at its bank. Perhaps it should simply borrow from its
equipment dealer, then invest the $25,000 from its checking account; the proceeds on the
investment—no matter how small—would mean that this strategy would dominate both
Alternatives A and B. [Of course, this assumes that Morin could maintain sufficient liquidity with
such a strategy, and that there would be no negative consequences from the bank.])
If Morin did not keep sufficient compensating balances on hand as a matter of course, then the cost
of Alternative A would be much higher. In this case, Morin would have to borrow enough to pay
interest, establish the compensating balance, and fund its equipment purchase. If we assume that it
can accept less than the full $100,000 for the latter purpose, then it will borrow only enough more
than the desired $100,000 to establish the compensating balance. It will therefore consider $100,000
to be (100% − 15%) = 85% of the loan amount, so that it must borrow $100,000/(0.85) = $117,647.06.
Fifteen percent of this, or $17,647.06, will establish the compensating balance. Then,
interest = principal ∗ rate ∗ time
= $117,647.06 ∗ (0.14) ∗ (12/12) = $16,470.59.

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452 Titman/Keown/Martin • Financial Management, Eleventh Edition

Thus Morin will only receive proceeds of ($100,000 − $16,470.59) = $83,529.41. Now we can
calculate the APR of this loan using equation 18-8:
APR = (interest/principal) ∗ (1/time)
 $16,470.59   1 
= ∗  = 19.72%,
 $83,529.41   12 /12 
making the equipment dealer a better source of funds.
If Morin wanted to ensure that it received the full $100,000 after establishing the compensating
balance and paying interest, it would need to borrow $140,845.07, of which 15%, or $21,126.76,
would establish the balance. Total interest charges would be 14% of the total $140,845.07 borrowed,
or $19,718.31, leaving Morin with ($140,845.07 − $21,126.76 − $19,718.31) = $100,000. As
explained in Problem 18-7 above, the APR would not change; it would remain at 19.72%.

18-10. A. Southwest keeps at least 20% of $100,000 (its desired line of credit maximum) in the bank at
all times, so the firm won’t need to worry about the compensating balance requirement.
Assuming that the firm borrows the full $100,000 at (12% + 1%) = 13% for 12 months, then:
interest = principal ∗ rate ∗ time
= $100,000 ∗ (0.13) ∗ (12/12) = $13,000,
and
APR = (interest/principal) ∗ (1/time)
 $13,000   1 
= ∗  = 13%.
 $100,000   12 /12 
We have assumed that interest is paid one time, all at the end of the period (as opposed to the
discount interest we’ve considered in earlier problems).
B. What if the compensating balance requirement were binding? Since Southwest cannot borrow
more than $100,000, it will not be able to boost the loan amount enough to allow it to borrow
both the compensating balance and the full $100,000 for other corporate purposes. It will
therefore have to accept less than $100,000 for its proceeds. Using the same analysis as in
problem 18-7, but assuming that interest is not discounted, we have:
amount borrowed = $100,000
compensating balance required = (20%) ∗ ($100,000) = $20,000
proceeds to Southwest = $100,000 − $20,000 = $80,000
interest charge = $100,000 ∗ (13%) = $13,000
 $13,000   1 
APR =  ∗  = 16.25%.
 $80,000   12 /12 
By reducing the funds available for Southwest’s use, while not reducing the interest charge,
the compensating balance requirement has significantly increased the cost of this funding.

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Solutions to End of Chapter Problems—Chapter 18 453

18-11. A. If there is no compensating balance, and if interest is not discounted, then we note that the
interest charge would be:
interest = principal ∗ rate ∗ time
= $20,000 ∗ (0.10) ∗ (6/12) = $1,000,
and
APR = (interest/principal) ∗ (1/time)
 $1,000   1 
= ∗  = 10%.
 $20,000   6 /12 
Again, we’re assuming that interest is paid all at once, at the very end of the loan.
B. If there were a 15% binding compensating balance requirement, then you’d need to put up
(15%) ∗ ($20,000) = $3,000. You will still borrow the full $20,000 from the bank (since
you’re using “your money” to create the compensating balance), but because you were going
to use your money to invest in your business, you’ve now reduced the amount available to
your business by $3,000. After the whole bank arrangement is considered, you only have
$17,000 new dollars to invest in your business, and you have incurred interest charges of
$1,000. Thus:
 $1,000   1 
APR =  ∗  = 11.76%.
 $17,000   6 /12 
Tying up idle funds has significantly increased the cost of this loan arrangement.
C. If you had not only a compensating balance, but also faced discount interest, then you’d borrow
$20,000, set aside $3,000 as a compensating balance, and pay $1,000 up front, netting you only
$16,000 at the loan’s inception. (It doesn’t matter that the $3,000 is “your” money—after the
whole series of transactions, you only have $16,000 new dollars to invest in your business.
Thus, using “with/without” analysis, we see that the net proceeds from the loan are $16,000.)
Now, your APR is:
 $1,000   1 
APR =  *  = 12.5%.
 $16,000   6 /12 
As the available loan proceeds fall, while total interest charges stay the same, the cost of the
funding rises. Borrowers must be careful to analyze the effects of all of a loan’s terms, not just
the “top-line” stated rate.

18-12. Mr. Hale’s rate is 8% (the 7% prime rate plus the 1% margin). Assuming that he will not borrow
more than $240,000, then his interest charge will be:
interest = principal ∗ rate ∗ time
= $240,000 ∗ (0.08) ∗ (3/12) = $4,800.

If he needs a compensating balance of 20% of the loan amount, then he needs (20%) ∗ ($240,000)
= $48,000; since he already has a $4,000 balance, this means that he’d need to use $44,000 of the
loan proceeds to satisfy this requirement. This would leave him with only ($240,000 − $44,000) =
$196,000. His APR in this case would be:
 $4,800   1 
APR =  ∗  = 9.796%.
 $196,000   3 /12 

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454 Titman/Keown/Martin • Financial Management, Eleventh Edition

If, instead, Mr. Hale wanted to ensure that he received $240,000 in proceeds after meeting the
compensating balance requirement, then he’d have to increase his loan amount. In this case, he’d
have to borrow as follows:

$240,000 = loan − compensating balance increment required


= loan − [(20%) ∗ (loan) − $4,000]
= loan ∗ (1 − 0.20) + $4,000
$236,000 = (0.80) ∗ loan
loan = $295,000.

(To verify: A $295,000 loan would require (20%) ∗ ($295,000) = $59,000 in compensating balances.
Since Mr. Hale already has $4,000, he would need to add $55,000. This would leave him with
($295,000 − $55,000) = $240,000.)

This loan will require ($295,000) ∗ (0.08) ∗ (3/12) = $5,900 in interest. Mr. Hale’s APR in this
case would be:

 $5,900   1 
APR =  *  = 9.833%.
 $240,000   3 /12 

Unlike in earlier problems (e.g., 18-9), our “scaling up” of the loan did not leave the APR
unchanged. This is because we are not really scaling up the loan. Mr. Hale’s $4,000 introduces a
wedge that precludes our simply scaling all of the loan terms up or down by a single factor. In
particular, since his $4,000 balance is a smaller proportion of the larger loan, it satisfies less of the
compensating balance requirement, making the requirement more onerous (that is, more costly).
The APR therefore rises in the larger-scale case. (If Mr. Hale had no initial balance, then his APR
in both cases would be 10%. We can see that the APRs above are approaching this limit.)
What if the bank changed the terms, lowering the rate by 100 bp to prime, but requiring discount
interest? Now, his interest charge is:
interest = principal ∗ rate ∗ time
= $240,000 ∗ (0.07) ∗ (3/12) = $4,200,

which is less than before (by 12.5%). However, now his proceeds will be (assuming a total loan
amount of $240,000) only ($240,000 − $44,000 − $4,200) = $191,800 (2.14% less than in our
initial scenario above), for an APR of:

 $4,200   1 
APR =  *  = 8.76%.
 $191,800   3 /12 

The decrease in the interest rate had more effect on the numerator of our first term (the total
interest charges) than the initial discounting had on the denominator (the proceeds). Mr. Hale
would therefore be better off with these second terms than with the initial prime +100bp loan.
(The new loan terms are still better under the following changes, taken one at a time:
• Increase of the loan term to 12 months (new loan’s relative benefit declines, but still better than original)
• Decrease of Mr. Hale’s initial balance to $0.
• Decrease in required compensating balance proportion.

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Solutions to End of Chapter Problems—Chapter 18 455

However, decreasing the spread on the initial loan to approximately 15 bp or less would make the
original terms more attractive to Mr. Hale.)

18-13. For this question, we will be using equation 18-9:

 a   days in year 
annualized opportunity of forgoing the discount =  ∗ ,
1− a   c−b 
where we are considering a trade discount of the form a/b, net c. The cost of not taking advantage
of our offer would be:

 0.02   360 
annualized opportunity of forgoing the discount =  ∗ ,
 1 − 0.02   50 − 10 
or 18.37%. This is much higher than just 2%—because the 2% applies to only 10 days.

18-14. Again using equation 18-9:

 a   days in year 
annualized opportunity of forgoing the discount =  ∗ ,
1− a   c−b 
we find:

# of days/year = 360

a b c [a /(1-a )]*[360/(c -b )]
net
days for due in opportunity
part discount % discount (days) cost
(a) 1% 10 20 36.36%
(b) 2% 10 30 36.73%
(c) 3% 10 30 55.67%
(d) 3% 10 60 22.27%
(e) 3% 10 90 13.92%
(f) 5% 10 60 37.89%

©2011 Pearson Education, Inc. Publishing as Prentice Hall


456 Titman/Keown/Martin • Financial Management, Eleventh Edition

We can use these results to observe the following:

opportunity cost: discount terms 3/10


59.00%

54.00%

49.00%

44.00%

39.00%

34.00%

29.00%

24.00%

19.00%

14.00%

9.00%
30 60 90
net days

• As the number of days until the net payment is required increase, the opportunity cost falls.

opportunity cost: 10 days/net 30


105.00%

95.00%

85.00%

75.00%

65.00%

55.00%

45.00%

35.00%

25.00%
2% 3% 5%
discount %

• As the discount % increases, the opportunity cost rises.

©2011 Pearson Education, Inc. Publishing as Prentice Hall