Chapter 15 of Foundations of Finance. Write approximately 900 words for all of the answers combined.
15-5:Define the hedging principle. How can this principle be used in the management of working
15-6:Define the following terms:
a. Permanent asset investments
b. Temporary asset investments
c. Permanent sources of financing
d. Temporary sources of financing
e. Spontaneous sources of financing
15-13: Define the following:
a. Line of credit
b. Commercial paper
c. Compensating balance
d. Prime rate
15-2: (Estimating the cost of commercial paper) On February 3, 2010, the Burlington Western Company
plans a commercial paper issue of $20 million. The firm has never used commercial paper before
but has been assured by the firm placing the issue that it will have no difficulty raising the funds.
The commercial paper will carry a 270-day maturity and require interest based on a rate of 11 percent
per annum. In addition, the firm will have to pay fees totaling $200,000 to bring the issue to
market and place it. What is the effective cost of the commercial paper to Burlington Western?
15-3: (Cost of trade credit) Calculate the effective cost of the following trade credit terms when payment
is made on the net due date.
a. 2/10, net 30
b. 3/15, net 30
c. 3/15, net 45
d. 2/15, net 60
15-5: (Cost of short-term financing) The R. Morin Construction Company needs to borrow $100,000
to help finance the cost of a new $150,000 hydraulic crane used in the firm’s commercial construction
business. The crane will pay for itself in 1 year, and the firm is considering the following alternatives
for financing its purchase:
Alternative A—The firm’s bank has agreed to lend the $100,000 at a rate of 14 percent. Interest
would be discounted, and a 15 percent compensating balance would be required. However,
the compensating-balance requirement would not be binding on R. Morin because the firm
normally maintains a minimum demand deposit (checking account) balance of $25,000 in
Alternative B—The equipment dealer has agreed to finance the equipment with a 1-year loan.
The $100,000 loan would require payment of principal and interest totaling $116,300.
a. Which alternative should R. Morin select?
b. If the bank’s compensating-balance requirement were to necessitate idle demand deposits
equal to 15 percent of the loan, what effect would this have on the cost of the bank loan
15-7: (Cost of commercial paper) Tri-State Enterprises plans to issue commercial paper for the first
time in the firm’s 35-year history. The firm plans to issue $500,000 in 180-day maturity notes. The
paper will carry a 10 1?2 percent rate with discounted interest and will cost Tri-State $12,000 (paid in
advance) to issue.
a. What is the effective cost of credit to Tri-State?
b. What other factors should the company consider in analyzing whether to issue the commercial
15-8: (Cost of accounts receivable) Johnson Enterprises Inc. is involved in the manufacture and sale
of electronic components used in small AM/FM radios. The firm needs $300,000 to finance an
anticipated expansion in receivables due to increased sales. Johnson’s credit terms are net 60,
and its average monthly credit sales are $200,000. In general, the firm’s customers pay within
the credit period; thus, the firm’s average accounts receivable balance is $400,000. Chuck Idol,
Johnson’s comptroller, approached the firm’s bank with a request for a loan for the $300,000 using
the firm’s accounts receivable as collateral. The bank offered to make a loan at a rate of
2 percent over prime plus a 1 percent processing charge on all receivables pledged ($200,000 per
month). Furthermore, the bank agreed to lend up to 75 percent of the face value of the receivables
a. Estimate the cost of the receivables loan to Johnson when the firm borrows the $300,000.
The prime rate is currently 11 percent.
b. Idol also requested a line of credit for $300,000 from the bank. The bank agreed to grant
the necessary line of credit at a rate of 3 percent over prime and required a 15 percent compensating
balance. Johnson currently maintains an average demand deposit of $80,000.
Estimate the cost of the line of credit to Johnson.
c. Which source of credit should Johnson select? Why?
15-9: (Cost of factoring) MDM Inc. is considering factoring its receivables. The firm has credit sales
of $400,000 per month and has an average receivables balance of $800,000 with 60-day credit terms.
The factor has offered to extend credit equal to 90 percent of the receivables factored less interest
on the loan at a rate of 11?2 percent per month. The 10 percent difference in the advance and the face
value of all receivables factored consists of a 1 percent factoring fee plus a 9 percent reserve, which
the factor maintains. In addition, if MDM Inc. decides to factor its receivables, it will sell them all,
so that it can reduce its credit department costs by $1,500 a month.
a. What is the cost of borrowing the maximum amount of credit available to MDM Inc.
through the factoring agreement?
b. What considerations other than cost should be accounted for by MDM Inc. in determining
whether to enter the factoring agreement?
15-11: (Cost of short-term financing) You plan to borrow $20,000 from the bank to pay for inventories
for a gift shop you have just opened. The bank offers to lend you the money at 10 percent annual
interest for the 6 months the funds will be needed.
a. Calculate the effective rate of interest on the loan.
b. In addition, the bank requires you to maintain a 15 percent compensating balance in the
bank. Because you are just opening your business, you do not have a demand deposit account
at the bank that can be used to meet the compensating-balance requirement. This
means that you will have to put up 15 percent of the loan amount from your own personal
money (which you had planned to use to help finance the business) in a checking account.
What is the cost of the loan now?
c. In addition to the compensating-balance requirement in part b, you are told that interest
will be discounted. What is the effective rate of interest on the loan now?
15-12: (Cost of factoring) A factor has agreed to lend the JVC Corporation working capital on the
following terms: JVC’s receivables average $100,000 per month and have a 90-day average collection
period. (Note that JVC’s credit terms call for payment in 90 days, and accounts receivable average
$300,000 because of the 90-day average collection period.) The factor will charge 12 percent
interest on any advance (1 percent per month paid in advance) and a 2 percent processing fee on all
receivables factored and will maintain a 20 percent reserve. If JVC undertakes the loan, it will reduce
its own credit department expenses by $2,000 per month. What is the annual effective rate of
interest to JVC on the factoring arrangement? Assume that the maximum advance is taken.
15-14: (Cash conversion cycle) Sims Electric Corp. has been striving for the last five years to improve
its management of working capital. Historical data for the firm’s sales, accounts receivable, inventories,
and accounts payable follow:
a. Calculate Sims’ days of sales outstanding and days of sales in inventory for each of the five
years. What has Sims accomplished in its attempts to better manage its investments in accounts
receivable and inventory?
b. Calculate Sims’ cash conversion cycle for each of the five years. Evaluate Sims’ overall management
of its working capital.
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