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Chapter 15 of Foundations of Finance. Write approximately 900 words for all of the answers combined. ?Review Questions 15-5:Define the hedging principle. How can this principle be used in the management of working capital? 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 ?Study Problems 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 the bank. 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 alternative? 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 paper? 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 pledged. 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. Tutorials for this Question Available for $28.00

Chapter 15 of Foundations of Finance. Write approximately 900 words for all of the answers combined.

?Review Questions

15-5:Define the hedging principle. How can this principle be used in the management of working

capital?

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

?Study Problems

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

the bank.

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

alternative?

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

paper?

 

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

pledged.

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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