CHAPTER 18

Working-Capital Management and Short-Term Financing

CHAPTER ORIENTATION

In this chapter we introduce working-capital management in terms of managing the firm's liquidity. Specifically, net working capital is defined as the difference in current assets and current liabilities. The hedging principle is offered as one approach to addressing the firm's liquidity problems. In addition, this chapter deals with the sources of short-term financing that must be repaid within 1 year.

CHAPTER OUTLINE

I. Managing current assets

A. Like fixed assets, the firm's investment in current assets is determined by the marginal benefits derived from investing in them compared with their acquisition cost.

B. However, the mix of current and fixed assets of the firm's investment in total assets is an important determinant of the firm's liquidity. That is, the greater the firm's investment in current assets, other things remaining the same, the greater the firm's liquidity. This is generally true since current assets are usually more easily converted into cash.

C. The firm can invest in marketable securities to increase its liquidity. However, such a policy involves committing the firm's funds to a relatively low-yielding (in comparison to fixed assets) investment.

II. Managing the firm's use of current liabilities

A. The greater the firm's use of current liabilities, other things being the same, the less will be the firm's liquidity.

B. There are a number of advantages associated with the use of current liabilities for financing the firm's asset investments.

1. Flexibility. Current liabilities can be used to match the timing of a firm's short-term financing needs exactly.

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2. Interest cost. Historically, the interest cost on short-term debt has been lower than that on long-term debt.

C. Following are the disadvantages commonly associated with the use of short-term debt:

1. Short-term debt exposes the firm to an increased risk of illiquidity because short-term debt matures sooner and in greater frequency, by definition, than does long-term debt.

2. Since short-term debt agreements must be renegotiated from year-to-year, the interest cost of each year's financing is uncertain.

III. Determining the appropriate level of working capital

A. Pragmatically, it is impossible to derive the "optimal" level of working capital for the firm. Such a derivation would require estimation of the potential costs of illiquidity which, to date, have eluded precise measurement.

B. However, the "hedging principle" provides the basis for the firm's working-capital decisions.

1. The hedging principle, or rule of self-liquidating debt involves the following: Those asset needs of the firm not financed by spontaneous sources (i.e., payables and accruals) should be financed in accordance with the following rule: Permanent asset investments are financed with permanent sources and temporary asset investments are financed with temporary sources of financing.

2. A permanent investment in an asset is one which the firm expects to hold for a period longer than one year. Such an investment may involve current or fixed assets.

3. Temporary asset investments comprise the firm's investment in current assets that will be liquidated and not replaced during the year.

4. Spontaneous sources of financing include all those sources that are available upon demand (e.g., trade credit--Accounts Payable) or that arise naturally as a part of doing business (e.g., wages payable, interest payable, taxes payable, etc.).

5. Temporary sources of financing include all forms of current or short-term financing not categorized as spontaneous. Examples include bank loans, commercial paper, and finance company loans.

6. Permanent sources of financing include all long-term sources such as debt having a maturity longer than one year, preferred stock, and common stock.

C. Although the hedging principle provides a useful guide to the firm's working-capital decisions, no firm will follow its tenets strictly. At times a firm may rely too much on temporary financing for its cash needs or it may have excess cash as a result of excessive use of permanent financing.

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IV. Determining the appropriate level of short-term financing

A. The hedging concept was presented as one basis for determining the firm's use of short-term debt.

B. Hedging involves attempting to match temporary needs for funds with short-term sources of financing and permanent needs with long-term sources.

V. Measuring the effectiveness of managing net working capital

A. The firm’s goal should be to minimize net working capital. This can be accomplished by:

1. faster collection of cash from sales

2. increasing inventory turns

3. slowing down disbursements to suppliers

B. Cash conversion cycle (CCC) measures these three factors

1. CCC = Days of sales outstanding (DSO) + Days of sales in inventory (DSI) – Days of payables outstanding (DPO)

2. Decreasing DSO or DSI or increasing DPO will lead to a shorter cash conversion cycle.

VI. Selecting a source of short-term financing

A. In general, there are three basic factors that should be considered in selecting a source of short-term financing:

1. The effective cost of the credit source

2. The availability of credit

3. The effect of the use of a particular source of credit on the cost and availability of other sources

B. The basic procedure used in estimating the cost of short-term credit utilizes the basic interest equation, i.e., interest = principal x rate x time.

C. The problem faced in assessing the cost of a source of short-term financing involves estimating the annual percentage rate (APR) where the interest amount, the principal sum, and the time for which financing will be needed is known. Thus, the basic interest equation is "rearranged" as follows:

APR =

interestprincipal x

1time

D. Compound interest was not considered in the simple APR calculation. To consider compounding, the following relation is used:

APY = (1+ i

m )m

- 1

where APY is the annual percentage yield, i is the nominal rate of interest per year, and m is the number of compounding periods within one year. The

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effect of compounding is thus to raise the effective cost of short-term credit.

VII. Sources of short-term credit

A. The two basic sources of short-term credit are unsecured and secured credit.

1. Unsecured credit consists of all those sources that have as their security only the lender's faith in the ability of the borrower to repay the funds when due.

2. Secured funds include additional security in the form of assets that are pledged as collateral in the event the borrower defaults in payment of principal or interest.

B. There are three major sources of unsecured short-term credit: trade credit, unsecured bank loans, and commercial paper.

1. Trade credit provides one of the most flexible sources of financing available to the firm. To arrange for credit, the firm need only place an order with one of its suppliers. The supplier then checks the firm's credit and if the credit is good, the supplier sends the merchandise.

2. Commercial banks provide unsecured short-term credit in two basic forms: lines of credit and transaction loans (notes payable). Maturities of both types of loans are usually 1 year or less with rates of interest depending on the credit-worthiness of the borrower and the level of interest rates in the economy as a whole.

3. A line of credit is generally an informal agreement or understanding between the borrower and the bank as to the maximum amount of credit that the bank will provide the borrower at any one time. There is no "legal" commitment on the part of the bank to provide the stated credit. There is another variant of this form of financing referred to as a revolving credit agreement whereby such a legal obligation is involved. The line of credit generally covers a period of one year corresponding to the borrower's "fiscal" year.

4. Transaction loans are another form of unsecured short-term bank credit. The transaction loan, in contrast to a line of credit, is made for a specific purpose.

5. Only the largest and most creditworthy companies are able to use commercial paper, which consists of unsecured promissory notes sold in the money market.

a. The maturities of commercial paper are generally six months or less with the interest rate slightly lower than the prime rate on commercial bank loans. The new issues of commercial paper are either directly placed or dealer placed.

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b. There are a number of advantages that accrue to the user of commercial paper: interest rates are generally lower than rates on bank loans and comparable sources of short-term financing; no minimum balance requirements are associated with commercial paper; and commercial paper offers the firm with very large credit needs a single source for all its short-term financing needs. Since it is widely recognized that only the most creditworthy borrowers have access to the commercial paper market, its use signifies a firm's credit status.

c. However, a very important "risk" is involved in using this source of short-term financing; the commercial paper market is highly impersonal and denies even the most credit-worthy borrower any flexibility in terms of repayment.

B. Secured sources of short-term credit have certain assets of the firm, such as accounts receivable or inventories, pledged as collateral to secure a loan. Upon default of the loan agreement, the lender has first claim to the pledged assets.

1. Generally, a firm's receivables are among its most liquid assets. Two secured loan arrangements are generally made with accounts receivable as collateral:

a. Under the arrangement of pledged accounts receivable, the amount of the loan is stated as a percentage of the face value of the receivables pledged.

b. Factoring accounts receivable involves the outright sale of a firm's accounts receivables to a factor.

2. Four secured loan arrangements are generally made with inventory as collateral:

a. Under the floating lien agreement, the borrower gives the lender a lien against all its inventories.

b. The chattel mortgage agreement involves having specific items of inventory identified in the security agreement.

c. The field warehouse financing agreements means that the inventories used as collateral are physically separated from the firm's other inventories and are placed under the control of a third-party field warehousing firm.

d. Terminal warehouse agreements involve transporting the inventories pledged as collateral to a public warehouse that is physically removed from the borrower's premises.

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ANSWERS TOEND-OF-CHAPTER QUESTIONS

18-l. Working capital has traditionally been defined as the firm's investment in current assets. Current assets are comprised of all assets which the firm expects to convert into cash within one year including: cash, marketable securities, accounts receivable, and inventories. Net working capital refers to the difference in the firm's current assets and its current liabilities, i.e., net working capital = current assets - current liabilities.

18-2. The final composition of the firm's current and fixed asset investments is an important determinant of the firm's liquidity since, other things remaining the same, the greater the firm's investment in current assets the greater its liquidity.

The firm may choose to invest additional funds in cash and/or marketable securities as a means of increasing its liquidity. However, this type of action involves a trade-off between the risk of illiquidity and the firm's return on invested funds. By increasing its investment in cash and marketable securities, the firm reduces its risk of illiquidity. However, the firm has increased its investment in assets which earn little or no return. The firm can reduce its risk of illiquidity only by reducing its overall return on invested funds and vice versa.

18-3. Advantages of Short-Term Debt:

(1) The interest rate is usually lower (i.e., the term structure of interest rates is generally upward sloping) for short-term debt.

(2) Funds are paid for only when they are used.

Disadvantages:

(1) Short-term debts must be repaid sooner; thus, there is a greater risk of illiquidity.

(2) Interest costs on short-term debts vary from year-to-year, whereas long-term debt agreements "lock in" the cost of funds to the firm.

18-4. The use of current liabilities, or short-term debt as opposed to long-term debt, subjects the firm to a greater risk of illiquidity. That is, short-term debt by its very nature must be repaid or "rolled over" more often than long-term debt. Thus, the possibility that the firm's financial condition might deteriorate to a point where the needed funds might not be available is enhanced where short-term debt is used.

18-5. The hedging principle involves matching the maturities of the sources of financing for the firm's assets with the useful lives of the assets. To implement the hedging principle, the firm must fund all its permanent assets investments not financed by spontaneous sources (payables) with long-term sources of funds, and then, finance all its temporary asset investments not funded by spontaneous sources with short-term sources of funds.

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18-6. Definitions:

(1) A permanent asset investment is one which the firm expects to hold for a period longer than one year.

(2) Temporary asset investments are comprised of the firm's investments in current assets which will be liquidated and not replaced within the current year.

(3) Permanent sources of financing include intermediate and long-term debt, preferred stock, and common equity.

(4) Temporary sources of financing consist of the various sources of short-term debt: including secured and unsecured bank loans, commercial paper, loans secured by accounts receivable, and loans secured by inventories.

(5) Spontaneous sources of financing consist of the trade credit and other accounts payable which arise "spontaneously" in the firm's day-to-day operations. Examples include wages and salaries payable, accrued interest, and accrued taxes.

18-7. The important factors in selecting a source of short-term credit are as follows:

(1) the effective cost of credit.

(2) the availability of credit.

(3) the effect of the use of a particular source of credit on the cost and availability of other sources of credit.

18-8. The procedure used in estimating the cost of short-term credit relies on the use of the basic interest equation:

i = P x R x T

The problem faced in assessing the cost of a source of short-term financing, however, generally involves estimating the annual effective rate for which both the interest amount, the principal sum, and the time for which financing will be needed is known.

To find the effective rate of interest, we simply solve the interest equation for the rate (APR), i.e.:

APR =

iP x T =

iP x

1T

18-9. Compound interest was not considered in the simple APR calculation. To consider the influence of compounding we can use the following relation:

APY = (1 + i/m)m - 1

where i is the nominal rate of interest per year and m is the number of compounding periods within a year. This cost of credit relationship is frequently referred to as the Annual Percentage Yield, or APY.

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18-10. The trade credit term "2/10, net 30" means that a 2 percent discount is offered for payment within 10 days or the full amount is due in 30 days: "4/20, net 60"--4 percent discount within 20 days, full amount due in 60 days; 3/15, net 45--3 percent discount within 15 days, full amount due in 45 days.

18-11. (a) A line of credit is generally an informal agreement or understanding between the borrower and the bank as to the maximum amount of credit which the bank will provide the borrower at any one time.

(b) Commercial paper consists of unsecured promissory notes of firms that are sold in the money market.

(c) Compensating balance is a minimum balance that a borrower must maintain in a bank throughout a loan period.

(d) The prime rate represents the interest rate which a bank charges its most creditworthy borrowers on short-term loans.

18-12. The four advantages of commercial paper are:

(1) Interest rate. Commercial paper rates are generally lower than rates on bank loans and comparable sources of short-term financing.

(2) Compensating balance requirements. No minimum balance requirements are associated with commercial paper.

(3) Amount of credit. Commercial paper offers the firm with very large credit needs a single source for all its short-term financing needs.

(4) Prestige. Since it is widely recognized that only the most creditworthy borrowers have access to the commercial paper market, its use signifies a firm's credit status.

18-13. The "risk" involved with the firm's use of commercial paper as a source of short-term debt relates to the fact that the commercial paper market is highly impersonal and denies even the most credit-worthy borrower any flexibility in terms of repayment.

18-14. There are two basic procedures which can be used in arranging for financing on receivables--pledging and factoring.

Under pledging, the borrower simply offers his accounts receivable as collateral for a loan obtained from either a commercial bank or a finance company. The amount of the loan is stated as a percent of the face value of the receivables pledged.

The primary advantage of pledging as a source of short-term credit relates to the flexibility it provides the borrower. Financing is available on a continuous basis. Furthermore, the lender may provide credit services which eliminate or reduce the need for similar services within the firm.

Factoring receivables involves the outright sale of a firm's accounts to a factor. The factor, in turn, bears the risk of collection and services the accounts for a fee. In addition, the factor provides advances or loans to the borrower on which interest is charged for the term of the advance.

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SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

18-1A. The financial statements for both firms are found below:

Firm A

Cash 100,000 Accounts Payable 200,000 Accounts Receivable 100,000 Notes Payable 200,000 Inventories 300,000 Bonds 600,000 Net Fixed Assets 1,500,000 Common Equity 1,000,000 Total 2,000,000 Total 2,000,000

Firm B

Cash 150,000 Accounts Payable 400,000Accounts Receivable 50,000 Notes Payable 200,000Inventories 300,000 Current Liabilities 600,000Net Fixed Assets 1,500,000 Bonds 400,000Total 2,000,000 Common Equity 1,000,000

Total 2,000,000

Financial measures of firm liquidity

Firm A Firm BWorking Capital 500,000 500,000 Net Working Capital 100,000 (100,000)Current Ratio 1.25 0.83Acid Test Ratio 0.5 0.33Cash 100,000 150,000

Firm B is obviously the more aggressive of the two firms. Note the fact that it has negative net working capital (current liabilities exceed current assets) and both its current ratio and acid test ratio are lower. Notice that the higher level of cash for Firm B is more than offset by it more aggressive use of current liabilities.

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18-2A. The information contained in the problem provides the basis for the following:

Purchases = $480,000Discount Period = 15 daysCash Discount = 1%Deferred Period = 30 daysMaximum Credit Period = 45 daysPurchases per day = 480,000 ÷ 360 = 1,333.33

a. Purchases/day x 15 day discount period = 20,000.00b. Purchases/day x 45 day maximum credit period = 60,000.00c. The Annual Percentage Rate for forgoing the discount = 12.12%

18-3A.First we calculate the interest expense for the three month loan as follows:

Interest = .12 x $100,000 x 3/12 = $3,000.

Assuming that Paymaster has to leave 10% of the loan idle in a compensating balance the effective cost of credit can be calculated as follows:

APR = [$3,000/($100,000 - 10,000 - 3,000)] x (12/3) = 13.79%

If the company already has sufficient funds in the bank to satisfy the compensating balance requirement then the cost of credit drops to 12.37%.

18-4A.

Interest expense for the commercial paper issue is calculated as follows:

Interest = .11 x $20 million x (270/360) = $1,650,000

The effective rate of interest to Burlington Western (including the issue fee of $200,000) is calculated as follows:

APR = [($1,650,000 + 200,000)/($20 million - 1,650,000 - 200,000)] x (360/270) = 13.59%

Note that both the interest expense and the issue fee are prepaid.

18-5A.

(a)

0 .020 .98 x

120/360 = 0.36734 or 36.73%

(b)

0 .030 .97 x

115/360 = 0.74226 or 74.23%

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(c)

0 .030 .97 x

130/360 = 0.37113 or 37.11%

(d)

0 .020 .98 x

145 /360 = 0.16327 or 16.33%

18-6A.

Instructor’s Note: This problem can be easily solved using the exponent function

(yx) on a hand calculator. Simply let y = (1+r/m) and x = m, then solve for yx. Finally subtract "1" to obtain the effective cost of credit with compounding of interest.

APY = (1 + i/m)m - 1

i = Nominal interest rate

m = # of compounding periods in a year

(a) APY = (1 +

0 .367318 )18 - 1

= 1.4385 - 1

= .4385 or 43.85%

(b) APY = ( 1 +

0 .742324 )24 - 1

= 2.0773 - 1

= 1.0773 or 107.73%

(c) APY = (1 +

0 .371112 )12 - 1

= 1.4412 - 1

= .4412 or 44.12%

(d) APY = (1 +

0 .16338 )8 - 1

= 1.1755 - 1

= .1755 or 17.55%

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18-7A. (a)

Interest = .14 x $100,000

= $14,000

Therefore, the effective rate of interest on the loan is calculated as follows:

APR =

$14 ,000$100 ,000−14 ,000 x

1360/360

= .1628 or 16.28%

Dealer Financing Alternative

APR =

$16 ,300$100 ,000 x

1360/360

= .163 or 16.3%

Analysis. The costs of the two sources of financing are identical for practical purposes. The final choice can now be made based upon other nonquantitative factors. For example, the firm may find that using dealer financing is less time consuming and allows the firm to leave its credit line within the bank unchanged. Since bank credit can be used for a much wider array of financing needs than dealer financing, R. Morin would find that using dealer financing leaves the firm with greater flexibility in raising funds for its future needs.

(b) If the compensating balance becomes binding, then the effective rate on the bank loan alternative will be

Interest = .14 x $100,000

= $14,000

Compensating Balance = .15 x $100,000

= $15,000

APR =

$14 ,000$100 ,000−14 ,000−15 ,000 x

= .197 or 19.7%

Thus, where the 15 percent compensating balance requirement is binding on R. Morin, the cost of the bank loan rises to 19.7 percent. In this case, dealer financing is clearly less costly.

Note that equipment dealers will frequently price their merchandise so as to compensate them for offering "below market" rates of interest for financing. This may well be the case here such that R. Morin should use the dealer financing unless

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it can negotiate a price concession equal to the value of "bargain financing."

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18-8A. Interest = .13 x 100,000

= $13,000

$1083/month -- interest

Compensating balance = 100,000 x .20

= $20,000

(a) APR =

$13 ,000$100 ,000 x

1360/360 = 0.13 or 13%

(b) APR =

$13 ,000$100 ,000−20 ,000 x

1360/360 = 0.1625 or 16.25%

Interest expense for the loan is $13,000; however, the firm gets the use of only .8 x $100,000 = $80,000.

18-9A. (a) Interest = .1025 x $500,000 x 180/360 = 25,625

APR =

interestprincipal x

1time

APR =

$25 ,625+12 ,000$500 ,000−12 ,000−25 ,625 x

1180/360

= .1627 = 16.27%

(b) The risk involved with the issue of commercial paper should be considered. This risk relates to the fact that the commercial paper market is highly impersonal and denies even the most credit-worthy borrower any flexibility in terms of when repayment is made.

In addition, commercial paper is a viable source of credit to only the most credit-worthy borrowers. Thus, it may simply not be available to the firm.

18-10A.(a) Interest = P x R x T = (400,000 x .75) x .13 x 1 = $39,000

Fee = $200,000 x .01 x 12 = $24,000

APR =

interestprincipal x

1time

APR =

$39 ,000+24 ,000$400 ,000 x .75 x

1360/360 = .21 or 21%

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(b) $300,000 x .15 = $45,000 (compensating balance)

Since Johnson maintains a balance of $80,000 normally with the bank, the compensating balance requirement will not increase the effective cost of credit.

Interest = 300,000 x (.11 + .03) x 1 = $42,000

$ 42 ,000$300 ,000 x

1360/360 = 0.14 or 14%

(c) Choose the line of credit since the effective interest is considerably lower. Note, however, that the pledging arrangement may reduce credit services to Johnson which would reduce Johnson's credit department expense. If this were the case then these savings would reduce the effective cost of that financing arrangement.

18-11A.(a) Maximum Advance

Face Value of Receivables (2 months credit sales) $ 800,000

Less: Factoring Fee (1%) (8,000)

Reserve (9%) (72,000)

Interest (1 1/2% per month for 60 days)* (21,600 )

Loan Advance (less discount interest) $ 698,400

*Interest is calculated on the 90 percent of the factored accounts that can be borrowed, (.90 x $800,000 x .015 x 2 months) = $21,600 or ($800,000 - 8,000 - 72,000) x .015 x 2 months = $21,600.

Thus, the effective cost of credit to MDM is calculated as follows:

APR =

$21 ,600+8 ,000−3 ,000**$698 ,400 x

1(60/360 )

= .2285 or 22.85%

**Credit department savings for 60 days equals 2 x $1500.

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Calculated on an annual basis, the cost of credit would be:

APR =

$129 ,600+48 ,000−18 ,000$ 698 ,400 x

1360/360

= .2285 or 22.85%

where interest = .015 x $720,000 x 12 = $129,600

factoring fee = .01 x $400,000 x 12 = $48,000

credit department savings = 12 x $1500 = $18,000

(b) Of particular concern here is the presence of any "stigma" associated with factoring. In some industries, factoring simply is not used unless the firm's financial condition is critical. This would appear to be the case here, given the relatively high effective rate of interest on borrowing.

18-12A.

(a) Pledged Receivables (A/R):

0.80 A/R = $500,000 loan

A/R = $500,000/.80 = $625,000

Fee = (0.01) ($625,000) = $6,250

Interest Cost = (0.11) ($500,000) x 90/360 = $13,750

Effective Rate =( $ 13 ,750+6 ,250

$500 ,000 ) x ( 190/360 )

= .16 or 16%

(b) Warehousing cost = $2,000 x 3 months = $6,000

Interest cost = 0.09 x $500,000 x 90/360 = $11,250

Effective Rate =( $ 6 ,000+11 ,250

$500 ,000 ) x ( 190/360 )

= .138 or 13.8%

The inventory loan would be preferred since its cost is lower under the conditions presented to S-J.

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18-13A.

(a) Interest = $20,000 x .10 x 180/360

= $1,000

APR =

$ 1,000$20 ,000 x

1(180/360 )

= .10 or 10%

(b) The net proceeds from the loan are now $20,000 - (.15 x $20,000) or $17,000. Thus, the effective cost of credit is

APR =

$ 1,000$17 ,000 x

1180/360

= .1176 or 11.76%

We would have gotten the same answer by assuming that you borrow the necessary compensating balance. In that case the amount borrowed (B) is found as follows:

B - .15B = $20,000.85B = $20,000

B = $20,000/.85= $23,529.41

Interest = .10 x 180/360 x $23,529.41

= $1,176.47

APR =

$1 ,176 .47$20 ,000 x

1180/360

= .1176 or 11.76%

(c) In this case we assess the impact of discounted interest and the 15 percent compensating balance. As in part (b) the discounted interest serves to reduce the loan proceeds:

APR =

$1 ,000$20 ,000−3 ,000−1 ,000 x

1(180/360 )

= .125 or 12.5%

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If you borrowed enough to cover both the compensating balance requirement and discounted interest, then you would borrow (B) such that

B - .15B - (.10 x 6/12)B = $20,000.8B = $20,000B = $25,000

Interest = .10 x 6/12 x $25,000

= $1,250

Compensating Balance = .15 x $25,000

= $3,750

Thus,

APR =

$1 ,250$25 ,000−1 ,250−3 ,750 x

1180/360

= .125 or 12.5%

The cost of the bank loan rises once again in part (c) due to the reduction in funds available to you from the loan as a result (this time) of discounted interest.

18-14A.

Calculation of the Maximum AdvanceFace Amount of Receivables Factored $300,000Less: Fee (.02 x $300,000) (6,000)

Reserve (.20 x $300,000) (60,000)Interest (.01 x $234,000 x 3 months) (7,020)

Maximum Advance $226,980

Calculation of the cost of credit

APR =$7 ,020+6 ,000−6 ,

000∗¿$226 ,980

¿ x

123

= .0309 x 4 = .1237 or 12.37%

* Credit department expenses reduced by $2,000 per month for 3 months.

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18-15A.

(a) Days of Sales Outstanding (DSO) =

Accounts ReceivableSales/365

Days of Sales in Inventory (DSI) =

InventoriesSales/365

1999 2000 2001 2002 2003DSO 52.2 56.5 50.0 42.5 44DSI 28.0 30.8 29.6 11.8 6.9

(b) Days of Payables Outstanding (DPO) =

Accounts PayableSales/365

Cash Conversion Cycle (CCC) = DSO + DSI - DPO

1999 2000 2001 2002 2003DPO 35.9 47.0 32.1 48.9 48.7CCC 44.22 40.3 47.5 5.4 2.2

Generally, DSO and DSI are decreasing and DPO is increasing. This signifies that Mega PC is collecting receivables faster, turning inventory more rapidly, and paying suppliers slower. Mega PC has achieved significant improvement in its working capital management practices.

Solutions to Problem Set B

18-1B.

Firm A

Cash 200,000 Accounts Payable 400,000 Accounts Receivable 200,000 Notes Payable 400,000 Inventories 600,000 Bonds 1,200,000 Net Fixed Assets 3,000,000 Common Equity 2,000,000 Total 4,000,000 Total 4,000,000

Firm B

Cash 200,000 Accounts Payable 600,000 Accounts Receivable 400,000 Notes Payable 400,000 Inventories 400,000 Bonds 500,000

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Net Fixed Assets 3,000,000 Common Equity 2,500,000 Total 4,000,000 Total 4,000,000 The preceding financial statements provide the information needed to compute the following measures of liquidity for the two firms:

Firm A Firm BWorking Capital 1,000,000 1,000,000Net Working Capital 200,000 0Current Ratio 1.25 1Acid Test Ratio .5 0.6Cash 200,000 200,000

Firm B is the more aggressive of the two firms with respect to the management of its working capital. Firm B has zero net working capital which is reflected in its lower current ratio.

18-2B.

The information contained in the problem provides the basis for the following:

Purchases = 600,000Discount Period = 30 daysCash Discount = 2%Deferred Period = 30 daysMaximum Credit Period = 60 daysPurchases per day = 600,000 ÷ 360 = 1,666.67

a. Purchases/day x 30 day discount period = 50,000.00

b. Purchases/day x 60 day maximum credit period = 100,000.00

c. The Annual Percentage Rate = 24.49%

18-3B.

First we calculate the interest expense for the three month loan as follows:

Interest = .14 x $125,000 x 3/12 = $4,375.

Assuming that Dee has to leave 10% of the loan idle in a compensating balance, the effective cost of credit can be calculated as follows:

APR = [$4,375/($125,000 - 12,500 - 4,375)] x (12/3) = 16.18%

If the company already has sufficient funds in the bank to satisfy the compensating balance requirement then the cost of credit drops to 14.5%.

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18-4B.Interest expense for the commercial paper issue is calculated as follows:

Interest = .12 x $15 million x (270/360) = $1,350,000

The effective rate of interest to Duro Auto Parts (including the issue fee of $150,000) is calculated as follows:

APR = [($1,350,000 + 150,000)/($15 million - 1,350,000 - 150,000)] x (360/270) = 14.81%

Note that both the interest expense and the issue fee are prepaid.

18-5B.

(a)

0 .010 .99 x

120/360 = .1818 or 18.18%

(b)

0 .020 .98 x

115/360 = .4898 or 48.98%

(c)

0 .020 .98 x

130/360 = .2449 or 24.49%

(d)

0 .030 .97 x

145 /360 = .2474 or 24.74%

18-6B. Instructor’s Note: This problem can be easily solved using the exponent function

(yx) on a hand calculator. Simply let y = (1+i/m) and x = m, then solve for yx. Finally subtract "1" to obtain the effective cost of credit with compounding of interest.

APY = (1 + i/m)m - 1

i = Nominal interest rate

m = # of compounding periods in a year

(a) APY = (1 +

0 .181818 )18 - 1

= .1983 or 19.83%

(b) APY = ( 1 +

0 .489824 )24 - 1

= .6240 or 62.40%

(c) APY = (1 +

0 .244912 )12 - 1

= .2744 or 27.44%

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(d) APY = (1 +

0 .24748 )8 - 1

= .2759 or 27.59%

18-7B. (a) Interest = .15 x $150,000

= $22,500

Therefore, the effective rate of interest on the loan is calculated as follows:

APR =

$22 ,500$150 ,000−22 ,500 x

1360/360

= .1765 or 17.65%

Dealer Financing Alternative

APR =

$30 ,000$150 ,000 x

1360/360

= .20 or 20%

In this case bank financing is preferred.

(b) If the compensating balance becomes binding, then the cost of bank loan alternative will be

Interest = .15 x $150,000

= $22,500

Compensating Balance = .16 x $150,000

= $24,000

APR =

$22 ,500$150 ,000−22 ,500−24 ,000 x

1360/360

= .2174 or 21.74%

Thus, where the 16 percent compensating balance requirement is binding on Vitra, the cost of the bank loan rises to 21.74 percent, and dealer financing is preferred.

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18-8B. Interest = 100,000 x .14 x 1= $14,000

Compensating balance = 100,000 x .15 = 15,000

(a) APR =

$14 ,000$100 ,000 x

1360/360 = 0.14 or 14%

(b) APR =

$14 ,000$100 ,000 - 15 ,000 x

1360/360 = .1647 or 16.47%

Interest expense for the loan is $14,000; however, the firm gets the use of only .85 x $100,000 = $85,000.

18-9B.

(a) APR =

interestprincipal x

1time

Interest = .11 x $450,000 x 180/360 = $24,750

APR =

$ 24 ,750+13 ,000$ 450 ,000−13 ,000−24 ,750 x

= .1831 or 18.31%

(b) The risk involved with the issue of commercial paper should be considered. This risk relates to the fact that the commercial paper market is highly impersonal and denies even the most credit-worthy borrower any flexibility in terms of when repayment is made.

In addition, commercial paper is a viable source of credit to only the most credit-worthy borrowers. Thus, it may simply not be available to the firm.

18-10B.

Interest = ($500,000 x 0.80) x .13 x 1 = $52,000

Processing fee = (250,000 x .01 x 12) = $30,000

(a) APR =

$52 ,000+30 ,000$5 00 ,000 x . 80 x = .205 or 20.5%

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(b) Interest = $400,000 x .14 = $56,000

Compensating Balance = $400,000 x .15 = $60,000

Since the firm maintains a balance of $100,000 normally with the bank, the compensating balance requirement will not increase the effective cost of credit.

$ 56 ,000$ 400 ,000 x

1360/360 = 0.14 or 14%

(c) Choose the line of credit since the effective interest is considerable lower. Note, however, that the pledging arrangement may reduce credit services to the firm which would reduce its credit department expense. If this were the case then these savings would reduce the effective cost of that financing arrangement.

18-11B.

(a) Maximum Advance

Face Value of Receivables(2 months credit sales) $ 600,000

Less: Factoring Fee (1%) (6,000)Reserve (9%) (54,000)Interest (1 1/2% per monthfor 60 days)* (16,200 )

Loan Advance (less discount interest) $ 523,800

*Interest is calculated on the 90 percent of the factored accounts that can be borrowed, (.90 x $600,000 x .015 x 2 months) = $16,200 or ($600,000 - 6,000 - 54,000) x .015 x 2 months = $16,200.

Thus, the effective cost of credit to Dal Molle is calculated as follows:

APR =

$16 ,200+6 ,000−2 ,800 **$523 ,800 x

= .2222 or 22.22%

**Credit department savings for 60 days equals 2 months x $1,400/month.

(b) Of particular concern here is the presence of any "stigma" associated with factoring. In some industries, factoring simply is not used unless the firm's financial condition is critical. This would appear to be the case here, given the relatively high effective rate of interest on borrowing.

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18-12B.

Pledged Receivables (A/R):

0.80 A/R = $400,000 loan

A/R = $400,000/.80 = $500,000

Fee = (0.01) ($500,000) = $5,000

Interest Cost = (0.11) ($400,000) x 3/12 = $11,000

Effective Rate =( $ 11 ,000+5 ,000

$ 400 ,000 ) x ( 13 /12 )

= .16 or 16%

Inventory Loan:

Warehousing cost = $2,000 x 3 months = $6,000

Interest cost = 0.09 x $400,000 x 3/12 = $9,000

Effective Rate =( $ 6 ,000+9 ,000

$ 400 ,000 ) x ( 13/12 )

= .15 or 15%

The inventory loan would be preferred since its cost is lower under the conditions presented.

18-13B.

(a) Interest = $25,000 x .11 x 180/360

= $1,375

APR =

$ 1,375$25 ,000 x

1(180/360 )

= .11 or 11%

(b) The net proceeds from the loan are now $25,000 - (.15 x $25,000) or $21,250. Thus, the effective cost of credit is

APR =

$1 ,375$21 ,250 x

1180/360

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= .1294 or 12.94%

We would have gotten the same answer by assuming that you borrow the necessary compensating balance. In that case the amount borrowed (B) is found as follows:

B - .15B = $25,000

.85B = $25,000

B = $25,000/.85

= $29,411.76

Interest = .11 x 180/360 x $29,411.76

= $1,617.65

Compensating Balance = .15 x 29,411.76 = 4,411.76

APR =

$1 ,617 . 65$29 , 411.76−4 ,411.76 x

1180/360

= .1294 or 12.94%

(c) In this case we assess the impact of discounted interest and the 15 percent compensating balance. As in part (b) the discounted interest serves to reduce the loan proceeds:

APR =

$1 ,375$25 ,000−3 ,750−1 ,375 x

1(180/360 )

= .1383 or 13.83%18-14B.

Calculation of the Maximum Advance

Face Amount of Receivables Factored $450,000Less: Fee (.02 x $450,000) (9,000)

Reserve (.15 x $450,000) (67,500)Interest ( .13/12 x $373,500 x 3 months) (12,139 )

Maximum Advance $361,361

Calculation of the cost of credit

APR =

$12 ,139+9 ,000−(3 x 2000 )$361 ,361 x

123

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= .1676 or 16.76%

18-15B

(a) Days of Sales Outstanding (DSO) =

Accounts ReceivableSales/365

Days of Sales in Inventory (DSI) =

InventoriesSales/365

1997 1998 1999 2000 2001DSO 59.4 63.7 63.6 62.7 60.5DSI 46.9 24.7 32.8 31.5 26.0

(b) Days of Payables Outstanding (DPO) =

Accounts PayableSales/365

Cash Conversion Cycle (CCC) = DSO + DSI - DPO

1997 1998 1999 2000 2001DPO 26.5 18.9 20.2 19.4 22.6CCC 79.8 79.5 76.2 74.8 63.9

Although there has been some improvement in DSO, DSI, and DPO during the last 5 years, there has been little change during the most recent 2 years. Allergan should focus on collecting receivables faster and increasing inventory turns to reduce the DSO and DSI measures. This will in turn reduce the cash conversion cycle. Allergan should also try to obtain more favorable trade credit terms (i.e. lengthen payment period).

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