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Chapter 16

Current Liabilities Management

Instructors Resources
Overview
This chapter introduces the fundamentals and describes the interrelationship of net working capital,
profitability, and risk in managing the firms current liability accounts. The management of current
liabilities requires choosing appropriate levels of financing and involves tradeoffs between risk and
profitability. This chapter also reviews sources of secured and unsecured short-term financing, including
the role of international loans. Spontaneous sources, such as accounts payable and accruals, are differentiated
from negotiated bank sources, such as lines of credit. The cash discount offered on accounts payable and
the cost of forgoing the discount are described. Secured sources include bank and commercial finance
company loans backed by collateral such as inventory or accounts receivable. Whether borrowing funds as
a manager or for their own personal use, effective management of current liabilities is essential, making
Chapter 16 relevant at the professional and personal levels.

Suggested Answer to Opener in Review Question


In the chapter opener you learned that Memorial Sloan-Kettering Cancer Center had created
significant cash flows by using electronic invoicing and taking advantage of discounts on accounts
payable. Do these gains in working capital efficiency affect Sloan-Ketterings operating risk, and if
so how?

Operating efficiency may well be improved through effective use of an online billing system. Use of
electronic invoicing reduces the chance of nonpayment, which reduces Sloan-Ketterings operating risk.
When it comes to accounts payable, a firm has to compare its cost savings with the chance that it will not
be able to take advantage of future cash flows. Most studies of the cost of forgoing the trade credit show
that it is higher than the cost of borrowing from the bank. Firms without sufficient funds to pay within the
discount period are going to the bank at a time when their financial position has been weakened, resulting
in higher interest rates or possibly the absence of access to short-term funds. Compounding Sloan-Ketterings
operating risk is the chance that it will have to borrow money when the economy has slowed down and
other firms are also seeking short-term funds. As is described in the chapter, new issues of commercial
paper virtually dried up in October 2008, resulting in issuers of those securities also seeking assistance
from the bank at the same time.

Answers to Review Questions


1. The two key sources of spontaneous short-term financing (financing that arises from the normal
operating cycle) are accounts payable and accruals. Both of these sources are spontaneous, since their
levels increase and decrease directly with increases or decreases in sales. If sales increase, the firm
will purchase more materials and increase employment, resulting in higher values for these items.

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Chapter 16 Current Liabilities Management 341

2. There is no coststated or unstatedassociated with taking a cash discount; there is a cost of giving
up a cash discount. By giving up a cash discount, the purchaser pays the full price for merchandise
but can make the payment later. The unstated cost of giving up a cash discount is the implied rate of
interest paid to delay payments. This rate can be used to make decisions with respect to whether or
not the discount should be taken. If the cost of giving up the cash discount is greater than the cost of
borrowing short-term funds, the firm should take the discount. Cash discounts can be a source of
additional profitability for a firm. However, some firms, either due to lack of alternative funding
sources or ignorance of the true cost, do not take advantage of these discounts.

3. Stretching accounts payable is the process of delaying the payment of accounts payable for as long as
possible without damaging the firms credit rating. Stretching payments reduces the implicit cost of
giving up a cash discount.

4. The prime rate of interest, which is the lowest rate charged on business loans to the best business
borrowers, is usually used by the lender as a base rate to which a premium is added by the lender,
depending upon the risk of the borrower, in order to determine the rate charged. A floating-rate loan
has its interest tied to the prime rate. The rate of interest is established at an increment above the
prime rate and floats at that increment above prime over the term of the note.

5. The effective interest rate is the actual rate of interest paid for the period. The calculation of this rate
depends on whether interest is paid at maturity or in advance (deducted from the loan so that the
borrower receives less than the requested amount). When interest is paid at maturity, the effective
interest rate is equal to:

Interest
Amount borrowed
The effective interest rate when interest is paid in advancea discount loanis calculated as follows:

Interest
Amount borrowed Interest
Paying interest in advance raises the effective rate above the stated rate, much like annuity due values
exceed ordinary annuity values.

6. A single-payment note is an unsecured loan from a commercial bank. It usually has a short
maturity30 to 90 daysand the interest rate is normally tied in some way to the prime rate of
interest. The interest rate on these notes may be fixed or floating. The effective annual interest rate
when the note is rolled over throughout the year on the same terms is calculated on a compound basis
as follows, using Equation 4.24 in the text.
m
r
reff = 1 + 1
m

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7. A line of credit is an agreement between a commercial bank and a business that states the amount of
unsecured short-term borrowing the bank will make available to the firm over a given period of time.
a. In a line of credit agreement, a bank may retain the right to revoke the line if any major changes
occur in the firms financial condition or operations.
b. To ensure that the borrower will be a good customer, frequently a line of credit will require the
borrower to maintain compensating balances in a demand deposit. In some cases, fees in lieu of
balances may be negotiated.
c. To ensure that money lent under the credit agreement is actually being used to finance seasonal
needs, banks require that the borrower have a zero loan balance for a certain number of days per
year. This is called the annual cleanup period.

8. A revolving credit agreement is a guaranteed line of credit. Under a line of credit agreement, a firm
is not guaranteed that the bank will have funds available to lend upon demand, while under the more
formal revolving credit agreement the availability of funds is guaranteed. Since the lender under the
revolving credit agreement guarantees the availability of funds, the borrower must pay a commitment
fee, a fee levied against the average unused portion of the line.

9. Commercial paper (CP), which is a short-term, unsecured promissory note, can be sold by large,
creditworthy firms in order to raise funds. Commercial paper is merely the IOU of a financially
sound firm. The maturity of commercial paper is generally from 3 to 270 days and is normally
issued in multiples of $100,000 or more. The interest rate on commercial paper is usually 1% to 2%
below the prime rate and is a less costly source of short-term funds than bank loans. Commercial
paper is purchased by corporations, life insurance companies, pension funds, banks, and other
financial institutions and investors. Commercial paper may be sold directly by the issuing firm to
a purchaser or may be sold through a middleman known as a commercial paper house, which
charges a fee to the issuer for its marketing efforts.

10. International transactions differ from domestic ones because they involve payments made or received
in a foreign currency. This results in additional foreign costs and also exposes the company to foreign
exchange risk.
A letter of credit is a letter written by a companys bank to a foreign supplier that effectively
guarantees payment of an invoiced amount, assuming that all the specified terms are met.
Netting occurs when a companys subsidiaries or divisions located in different countries have
transactions that result in intracompany receivables and payables. Rather than pay the gross amount
of both the receivables and payables, paying the net amount duewhich is lowerallows the parent
to reduce foreign exchange fees and other transaction costs.

11. Lenders view secured and unsecured short-term loans as having the same degree of risk. The benefit
of the collateral for a secured loan is only beneficial if the firm goes into bankruptcy. The risk
associated with going bankrupt and defaulting on a loan does not change due to being secured or
unsecured. However, the risk of loss is less on a secured loan.

12. The interest rate charged on secured short-term loans is typically higher than the interest rate on
unsecured short-term loans. Typically, companies that require secured loans may not qualify for
unsecured debt, and they are perceived as higher-risk borrowers by lenders. The presence of collateral
does not change the risk of default; it provides a means to reduce losses if the borrower defaults. In
general, lenders require security for less creditworthy, higher-risk borrowers. Since the negotiation
and administration of these loans is more troublesome for the lender, the lender normally requires
certain fees to be paid by the secured borrower. The higher rates on these secured short-term loans are
attributable to the greater risk of default and the increased loan administration costs of these loans
over the unsecured short-term loan.

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Chapter 16 Current Liabilities Management 343

13. a. A pledge of accounts receivable is the use of a firms receivables to secure a short-term loan. The
lender evaluates the quality of the accounts receivable, selects acceptable accounts, and files a
lien on the collateral. After the selection of accounts, the lender determines the percentage
advanced against receivables. Typically ranging from 50% to 90% of the face value of the
acceptable receivables, this amount becomes the principal on the loan. Pledging receivables
usually costs 2% to 5% above the prime rate due to the nature of the borrower and additional
administrative costs. Commercial banks offer this type of financing.
b. Factoring accounts receivable is the outright sale to the factor or other financial institution. The
factor sets the conditions of the sale in a factoring agreement. Normally factoring is done on a
nonrecourse basis (the factor accepts all credit risks), and the customer is usually notified that the
account receivable has been sold. Factoring can typically cost from 3% to 7% above the prime
rate, including commissions and interest. This type of financing is handled by specialized
financial institutions called factors; some commercial banks and commercial finance companies
factor receivables. While the cost is high, the advantages include immediate conversion of
receivables into cash and also the known pattern of cash flows.

14. a. Floating inventory liens are made by lenders and secured by a claim on general inventory
consisting of a diversified and low-cost group of merchandise. Generally less than 50% of
the book value of the average inventory is advanced. The interest charge on a floating lien is
typically 3% to 5% above the prime rate.
b. Trust receipt inventory loans are often made by manufacturers financing subsidiaries to their
customers. Under this arrangement, merchandise is typically expensive (automotive, industrial
and consumer-durable equipment, for example) and remains in the hands of the borrower. The
lender advances 80% to 100% of the cost of the salable inventory. The borrower is free to sell
the merchandise and is trusted to remit the loan amount plus accrued interest to the lender
immediately. The interest charge is generally 2% or more above the prime rate.
c. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged
collateral. The inventory may be retained by the borrower in the firms warehouse with security
administered by a field warehousing company, or it may be stored in a terminal warehouse located
in the geographic vicinity of the borrower. Generally, less than 75% to 90% of the collaterals
value is advanced to the borrower at an interest rate from 4% to 8% above the prime rate.

Suggested Answer to Focus on Practice Box: The Ebb and Flow of


Commercial Paper
What factors would contribute to an expansion of the commercial paper market? What factors
would cause a contraction in the commercial paper market?

Commercial paper is issued based on the full faith and credit of the company issuing the paper. That is
why only the larger corporations are able to issue commercial paper. In a business downturn, the credit
rating of even the largest corporations may slip, leading to a decrease in the amount of commercial paper
issued. As the chapter reports, in October 2008, as the financial crisis grew worse, the commercial paper
market dried up and the U.S. Federal Reserve created a means to fund short-term needs directly from it.
Also, a decrease in sales can lead to a decrease in the amount of short-term money needed, hence a
decrease in commercial paper. Finally, when interest rates are low, corporations can access the funds they
need from banks, which pushes down the volume of commercial paper. All of these factors work in
reverse to create an increase in commercial paper volume. Improving business cycles, increases in
business sales, and rising interest rates all can contribute to the increased issuance of commercial paper.

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Suggested Answer to Focus on Ethics Box: Accruals Management


Why might financial managers still be tempted to manage earnings when a clawback is legitimate
possibility?

If financial managers are unlikely to get caught and punished, the expected (positive) payoff from their
actions might tempt them to manage earnings. Financial managers also might engage in earnings
management if the superior performance it allows them to report leads to positive career outcomes (e.g.,
promotions, advancement). In such a case, the possibility of a clawback might be viewed as a small price
to pay when the manager leverages their actions into a higher paying, more prestigious position.

Answers to Warm-Up Exercises


E16-1. Cash discount and the simplified formula
Answer: Payment required if taking the cash discount = $25,000 0.97 = $24,250
Cost of giving up the cash discount = 3% (365 15) = 73%

E16-2. Managing accruals


Answer: Savings = 25 60 $12.50 0.10 = $1,875

E16-3. Effective annual interest rate


Answer: Discount loan
Effective annual interest = ($15,000 0.08) [$15,000 ($15,000 0.08)]
= $1,200 $13,800 = 8.70%
Interest paid at maturity
Effective annual interest = ($15,000 0.09) $15,000 = 9.0%
Jasmine Scents should take the discount loan since it has the better interest rate. Note, however,
that if the firm actually needs the use of $15,000, it will need to borrow more than $15,000
under the discount loan option. Specifically, the company will need to borrow $15,000
(1.00 0.08) = $16,304.35 since only 92% of the loan ($15,000) will be received and available
for use.

E16-4. Effective annual interest rate


Answer: Effective annual interest rate = ($125,000 0.10) ($125,000 $10,000) = 10.87%

E16-5. Commercial paper interest rate


Answer: Interest = $300,000 $298,000 = $2,000
Effective 120-day rate = $2,000 $298,000 = 0.67%

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Chapter 16 Current Liabilities Management 345

Solutions to Problems
P16-1. Payment dates
LG 1; Basic
a. December 25
b. December 30
c. January 9
d. January 29

P16-2. Cost of giving up cash discount


LG 1; Basic
a. (0.02 0.98) (365 20) = 37.24%
b. (0.01 0.99) (365 20) = 18.43%
c. (0.02 0.98) (365 35) = 21.28%
d. (0.03 0.97) (365 35) = 32.25%
e. (0.01 0.99) (365 50) = 7.37%
f. (0.03 0.97) (365 20) = 56.44%
g. (0.04 0.96) (365 170) = 8.95%

P16-3. Credit terms


LG 1; Basic
a. 1/15 net 45 date of invoice
2/10 net 30 EOM
2/7 net 28 date of invoice
1/10 net 60 EOM
b. 45 days
49 days
28 days
79 days
CD 365
c. Cost of giving up cash discount =
100% CD N
1% 365
Cost of giving up cash discount =
100% 1% 30
Cost of giving up cash discount = 0.0101 12.17 = 0.1229 = 12.29%
2% 365
Cost of giving up cash discount =
98% (49 10)
Cost of giving up cash discount = 0.0204 9.359 = 0.1909 = 19.09%
2% 365
Cost of giving up cash discount =
100% 2% 21
Cost of giving up cash discount = 0.0204 17.38 = 0.3646 = 36.46%
2% 365
Cost of giving up cash discount =
100% 2% 21

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Cost of giving up discount = 20.204 17.38 = 0.3546 = 35.46%


1% 365
Cost of giving up cash discount =
100% 1% (79 10)
Cost of giving up cash discount = 0.0101 5.2899 = 0.0534 = 5.34%
d. For the first three purchases the firm would be better off to borrow the funds and take the
discount. The annual cost of not taking the discount is less than the firms 8% cost of capital
in the last case.

P16-4. Cash discount versus loan


LG 1; Basic
Cost of giving up cash discount = (0.03 0.97) (365 35) = 32.25%
Since the cost of giving up the discount is higher than the cost of borrowing for a short-term loan,
Erica is correct; her boss is incorrect.

P16-5. Personal finance: Borrow or pay cash for an asset


LG 2; Intermediate

a. Calculate the down payment on the loan


Loan principal $ 3,000
Down payment required 10%
Cash down payment on loan $ 300.00

b. Calculate the monthly payment on the loan


Present value (amount borrowed) $2,700.00
Length of loan (months) 24
Monthly interest rate (annual rate 12) 0.333%
Solve for PMT (monthly payment) $ 117.24

c. Cash price of dining room set $ 3,000


Cash rebate $ 200
Cash purchase after rebate $ 2,800
Less: Cash down payment on loan (300)
Net initial cash outlay under cash purchase option $ 2,500
This is the marginal amount of money needed
d. Earnings on savings 5.20%
Years 2
Net initial cash outlay $ 2,500
Opportunity cost under the cash purchase option $ 267
($2,500 x (1.052 1)
2

e. Opportunity cost $ 267


Net initial cash outlay $ 2,500
Cost of cash option $ 2,767

f. Cost of the financing alternative (24 $117.25) $ 2,814


Cost of the cash option $ 2,767

Because it is less expensive, Bob and Carol should pay cash for the furniture. The lower cost of
the cash alternative is largely the result of the $300 cash rebate.

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Chapter 16 Current Liabilities Management 347

P16-6. Cash discount decisions


LG 1, 2; Intermediate
a. Supplier Cost of Forgoing Discount b. Decision
J (0.01 0.99) (365 20) = 18.43% Borrow
K (0.02 0.98) (365 60) = 12.42% Give up
L (0.01 0.99) (365 40) = 9.22% Give up
M (0.03 0.97) (365 45) = 25.09% Borrow

Prairie would have lower financing costs by giving up Ks and Ls discount since the cost of
forgoing the discount is lower than the 16% cost of borrowing.
c. Cost of giving up discount from Supplier M = (0.03 0.97) (365 75) = 15.05% In this
case the firm should give up the discount and pay at the end of the extended period.

P16-7. Changing payment cycle


LG 2; Basic
Annual savings = ($10,000,000) (0.13) = $1,300,000

P16-8. Spontaneous sources of funds, accruals


LG 2; Intermediate
Annual savings = $750,000 0.11 = $82,500

P16-9. Cost of bank loan


LG 3; Intermediate
a. Interest = ($10,000 0.15) (90 365) = $369.86
b. 90-day rate = $369.85 $10,000 = 3.70%
c. Effective annual rate = (1 + 0.037)4.06 1 = 15.89%

P16-10. Personal finance: Unsecured sources of short-term loans


LG 3; Challenge
a. Fixed-rate loan
Interest expense = loan amount (prime rate + percent over prime) (loan period 365)
$45,000 (0.065 + 0.025) (180 365) = $1,997.26

b. Variable-rate loan

Time period First 60 days Days 61 to 90 Days 91 to 180


Prime rate 6.5% 7.0% 8.0%
Percent over prime 1.5% 1.5% 1.5%
Applicable rate 8.0% 8.5% 9.5%
Beginning amount owed $45,000 $45,591.78 $45,910.30
Interest expense $ 591.78 $318.52 $1,075.43
Amount owed at end of period $45,591.78 $45,910.30 $46,985.73

The variable rate loan, which has an interest expense of $1,985.73, is less costly.

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P16-11. Effective annual rate of interest


LG 3; Basic
$10,000 0.10
Effective interest = = 14.29%
[$10,000 (1 0.10 0.20)]

P16-12. Compensating balances and effective annual rates


LG 3; Intermediate
a. Compensating balance requirement = $800,000 borrowed 15%
= $120,000
Amount of loan available for use = $800,000 $120,000
= $680,000
Interest paid = $800,000 11 %
= $88,000
$88,000
Effective interest rate = = 12.94%
$680,000
b. Additional balances required = $120,000 $70,000
= $50,000
$88,000
Effective interest rate = = 11.73%
$800,000 $50,000
c. Effective interest rate = 11%
(None of the $800,000 borrowed is required to satisfy the compensating balance
requirement.)
d. The lowest effective interest rate occurs in situation (c), when Lincoln has $150,000
on deposit. In situations (a) and (b), the need to use a portion of the loan proceeds for
compensating balances raises the borrowing cost.

P16-13. Compensating balance versus discount loan


LG 3; Intermediate
$150,000 0.09 $13,500
a. State Bank interest = = = 10.0% This calculation
$150,000 ($150,000 0.10) $135,000
assumes that Weathers does not maintain any normal account balances at State Bank.
$150,000 0.09 6 /12 $6,750
Frost finance interest = = = 4.71%
$150,000 ($150,000 0.09 6 /12) $143,250
Effective annual rate = (1.0471) 1 = 0.0964 = 9.64%
2

b. If Weathers became a regular customer of State Bank and kept its normal deposits at the bank,
then the additional deposit required for the compensating balance would be reduced and the
cost would be lowered.

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Chapter 16 Current Liabilities Management 349

P16-14. Integrativecomparison of loan terms


LG 3; Challenge
a. (0.08 + 0.033) 0.80 = 14.125%
[$2,000,000 (0.08 + 0.028) + (0.005 $2,000,000)]
b. Effective annual interest rate = = 14.125%
($2,000,000 0.80)
c. The revolving credit account seems better, since the cost of the two arrangements is the same;
with a revolving loan arrangement, the loan is committed.

P16-15. Cost of commercial paper


LG 4; Intermediate

$1,000,000 $978,000
a. Effective 90-day rate = = 2.25%
$978,000

Effective annual rate = (1 + 0.0225)365/90 1 = 9.44%


b. Effective 90-day rate with transaction costs:

[$1,000,000 $978,000 $9612] [ $978,000 + $9612]

= $12,388 987,612 = 1.25%


Effective annual rate = (1 + 0.0125) 1 = 5.17%
365/90

P16-16. Accounts receivable as collateral


LG 5; Intermediate
a. Acceptable accounts receivable

Customer Amount
D $ 8,000
E 50,000
F 12,000
H 46,000
J 22,000
K 62,000
Total collateral $200,000

b. Adjustments: 5% returns/allowances, 80% advance percentage.


Level of available funds = [$200,000 (1 0.05)] 0.80 = $152,000

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P16-17. Accounts receivable as collateral


LG 5; Intermediate
a.

Customer Amount
A $20,000
E 2,000
F 12,000
G 27,000
H 19,000
Total Collateral $80,000

b. $80,000 (1 0.1) = $72,000


c. $72,000 (0.75) = $54,000
P16-18. Accounts receivable as collateral, cost of borrowing
LG 3, 5; Challenge
a. [$134,000 ($134,000 0.10)] 0.85 = $102,510
b. ($100,000 0.02) + ($100,000 0.115) = $2,000 + $11,500 = $13,500
$13,500
Interest cost = = 13.5% for 12 months
$100,000
0.115
($100,000 0.02) + $100,000 = $2,000 + $5,750 = $7,750
2
$7,750
Interest cost = = 7.75% for 6 months
$100,000
Effective annual rate = (1 + 0.0775)2 1 = 16.1%
0.115
($100,000 0.02) + $100,000 = $2,000 + $2,875 = $4,875
4
$4,875
Interest cost = = 4.88% for 3 months
$100,000
Effective annual rate = (1 + 0.0488)4 1 = 21.0%

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Chapter 16 Current Liabilities Management 351

P16-19. Factoring
LG 5; Intermediate
Holder Company
Factored Accounts
May 30
Status on Amount Date of
Accounts Amount Date Due May 30 Remitted Remittance
A $200,000 5/30 C 5/15 $196,000 5/15
B 90,000 5/30 U 88,200 5/30
C 110,000 5/30 U 107,800 5/30
D 85,000 6/15 C 5/30 83,300 5/30
E 120,000 5/30 C 5/27 117,600 5/27
F 180,000 6/15 C 5/30 176,400 5/30
G 90,000 5/15 U 88,200 5/15
H 30,000 6/30 C 5/30 29,400 5/30

The factor purchases all acceptable accounts receivable on a nonrecourse basis, so remittance is
made on uncollected as well as collected accounts.
P16-20. Inventory financing
LG 1, 6; Challenge
a. City-Wide Bank: [$75,000 (0.12 12)] +(0.0025 $100,000) = $1,000
Sun State Bank: $100,000 (0.13 12) = $1,083
Citizens Bank and Trust: [$60,000 (0.15 12)] + (0.005 $60,000) = $1,050
b. City-Wide Bank is the best alternative, since it has the lowest cost.
c. Cost of giving up cash discount = (0.02 0.98) (365 20) = 37.24%
The effective cost of taking a loan = ($1,000 $75,000) 12 = 16.00%
Since the cost of giving up the discount (37.24%) is higher than borrowing at Citywide Bank
(16%), the firm should borrow to take the discount.

P16-21. Ethics problem


LG 2; Intermediate
The sales tax can be calculated based on the sales data, as follows:
Sales tax = [($73,000,000 $13,000,000) 1.05] 0.05 = $2,857,143
An alternative method is to determine the taxable sales based on the sales tax reported.
Taxable sales = $2,000,000 0.05 = $40,000,000
These calculations show a discrepancy in the financial statement provided by Rancco. The company
has possibly underreported the amount of taxable income to the state and failed to pay the appropriate
amount of sales tax. The other alternative is that Rancco has deliberately inflated the amount of
revenues for the year in an attempt to improve the chances of getting the loan. You will want to have
the company verify its calculation of sales tax due. Notice that to be able to make a valid comparison
of sales taxes paid and revenues reported you must also determine the correct amount of nontaxable
revenue, which is usually not directly available from the companys financial statements.

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Case
Case studies are available on www.myfinancelab.com.

Selecting Kanton Companys Financing Strategy and Unsecured Short-Term


Borrowing Arrangement
This case asks the student to evaluate the permanent and short-term funding requirements of Kanton
Company, and to choose a financing strategy from among three alternatives: aggressive, conservative,
and trade off. The companys funding requirements vary considerably during the year, showing a seasonal
pattern and peaking mid-year. Then the student must calculate the effective annual interest rates for two
short-term borrowing alternatives and make a recommendation.
a. Strategy IAggressive
1. Amount required: $2,500,000 short term and $1,000,000 long term
2. Cost: (10% $2,500,000) + (14% $1,000,000) = $390,000
Strategy 2Conservative
1. Amount required: $7,000,000 long term and $0 short term
2. Cost: (14% $7,000,000) = $980,000
Strategy 3Tradeoff
1. Calculation of short-term requirements
(1) (2)
Total Funds Permanent Seasonal
Month Requirements Requirements Requirements
January $1,000,000 $3,000,000 $0
February 1,000,000 3,000,000 0
March 2,000,000 3,000,000 0
April 3,000,000 3,000,000 0
May 5,000,000 3,000,000 2,000,000
June 7,000,000 3,000,000 4,000,000
July 6,000,000 3,000,000 3,000,000
August 5,000,000 3,000,000 2,000,000
September 5,000,000 3,000,000 2,000,000
October 4,000,000 3,000,000 1,000,000
November 2,000,000 3,000,000 0
December 1,000,000 3,000,000 0

Monthly average: Permanent = $3,000,000


Seasonal = $1,166,667 (sum of seasonal requirements 12)
Seasonal = $1,166,667 (14,000,000 12)
2. Cost: (10% $1,166,667) + (14% $3,000,000) = $536,667

b. Net working capital = current assets current liabilities


Aggressive = $4,000,000 $2,500,000 = $1,500,000
Conservative = $4,000,000 $0 = $4,000,000
Tradeoff = $4,000,000 $1,166,667 = $2,833,333

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Chapter 16 Current Liabilities Management 353

c. The three strategies differ in terms of profitability and risk. The aggressive strategy is the most
profitableit has the lowest cost, $390,000because it uses the largest amount of the less-expensive
short-term financing. It also pays interest only on needed financing. The aggressive strategy is also
the most risky, relying heavily on short-term financing, which may have more limited availability.
Net working capital is lowest, also increasing risk.
Because the conservative strategy funds the highest amount in any month for the whole year with
more-expensive long-term financing, it is the most expensive ($980,000) and the least profitable. It is
the lowest-risk strategy, however, reserving short-term financing for emergencies. The high level of
working capital also reduces risk.
The tradeoff strategy falls between the two extremes in terms of both profitability and risk. The cost
($536,667) is higher than the aggressive strategy because the permanent funds requirement of
$3,000,000 is financed with more costly long-term funds. In five months (January, February, March,
November, and December), the company pays interest on unneeded funds. The risk is less than with
the aggressive strategy; some short-term borrowing capacity is preserved for emergencies. Because a
portion of short-term requirements is financed with long-term funds, the firms ability to obtain short-
term financing is good.
Mr. Mercado should consider implementing the tradeoff strategy. The wide swings in monthly funds
requirements make the cost of the conservative strategy very high in comparison to the reduced risk.
For the same reason, the aggressive strategy is quite risky, requiring the firm to raise short-term funds
ranging from $1,000,000 to $6,000,000. If it should become difficult to arrange short-term financing,
Kanton Company would be in trouble.
Note: Other recommendations are possible, depending on the students risk preference. Of course, the
student should present sound reasons for his or her choice of strategy.

d. 1. Effective interest, line of credit:


Interest on borrowing: $600,000 (7% + 2.5%) = $57,000
Interest $57,000
Effective interest = = = 11.88%
Amount available for use $600,000 0.80

2. Effective interest, revolving credit agreement:


Cost of borrowing:
Interest: $600,000 (7% + 3.0%) $60,000
Commitment Fee: $400,000 0.5% 2,000
Total $62,000
Interest and commitment fee
Effective interest =
Amount available for use
$62,000
= = 12.92%
$600,000 0.80

e. The line of credit arrangement seems better, since its annual cost of 11.88% is less than the 12.92%
cost of the revolving loan arrangement. Kanton will save about 1% in terms of annual interest cost
(11.88% versus 12.92%) by using the line of credit. The only negative is that if Third National lacks
loanable funds, Kanton may not be able to borrow the needed funds. Under the revolving credit
agreement, funds availability would be guaranteed.

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354 Gitman/Zutter Principles of Managerial Finance, Thirteenth Edition

Spreadsheet Exercise
The answer to Chapter 16s comparison of borrowing from First American or First Citizen spreadsheet
problem is located on the Instructors Resource Center at www.pearsonhighered.com/irc under the
Instructors Manual.

Group Exercise
Group exercises are available on www.myfinancelab.com.

Continuing the short-term focus of the previous chapter, the groups are asked to now look at the
management of its current liabilities. Students should make the connection between these short-term
liabilities and sources of short-term financing. Different accounts are developed that should allow the
fictitious firm to maximize and maintain profitability.

The first task is the purchase of a typical type of merchandise. Scenarios for the purchase of this
merchandise are designed. The wage structure of the firm is then described, as is the accruals the firm
encounters. The needs of short-term financing are then discussed, as are the terms for its procurement.
A secondary sourcing alternative is then chosen from the list in the text. Providing students with web sites
of factoring companies (i.e., http://www.1stcommercialcredit.com, http://www.facteon.com) helps the last
portion of this exercise go smoothly.

Integrative Case 7: Casa de Diseo


Integrative Case 7, Casa de Diseo, involves evaluating working capital management of a furniture
manufacturer. Operating cycle, cash conversion cycle, and negotiated financing needed are determined and
compared with industry practices. The student then analyzes the impact of changing the firms credit terms
to evaluate its management of accounts receivable before making a recommendation.

a. Operating cycle (OC) = average age of inventory + average collection period


= 110 days + 75 days
= 185 days
Cash conversion cycle (CCC) = OC average payment period
= 185 days 30 days
= 155 days
Total annual outlays
Resources needed = CCC
365 days
$26,500,000
= 155
365
= $11,253,425

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Chapter 16 Current Liabilities Management 355

b. Industry OC = 83 days + 75 days


= 158 days
Industry CCC = 158 days 39 days
= 119 days
$26,500,000
Industry resources needed = 119
365
= $8,639,726

c. Casa de Diseo
Negotiated financing $11,253,425
Less: Industry resources needed 8,639,726
$2,613,699
Cost of inefficiency: $2,613,699 0.15 = $392,055

d. 1. Offering 3/10 net 60:


Reduction in collection period = 75 days (1 0.4)
= 45 days
OC = 83 days + 45 days
= 128 days
CCC = 128 days 39 days
= 89 days
$26,500,000
Resources needed = 89 days
365
= $6,461,644
Additional savings = $8,639,726 $6,461,644 = $2,178,082
= $2,178,082 0.15 = $326,712
2. Reduction in sales: $40,000,000 0.45 0.03 = $540,000
3. Average investment in accounts receivable assuming cash discount:
New average collection period = 45 days
($40,000,000 0.80) (365 45) = $3,945,205
Average investment in accounts receivable assuming no cash discount:
(40,000,000 0.80) (365 75) = $6,575,342
Reduction in investment in accounts receivable:
$6,575,342 $3,945,205 = $2,630,137
Annual savings:
$2,630,137 0.15 = $ 394,521

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356 Gitman/Zutter Principles of Managerial Finance, Thirteenth Edition

4. Reduction in bad debt expense:


$40,000,000 (0.02 0.015) = $ 200,000
5. Cost of offering cash discount ($ 540,000)
Annual savings from reduction in investment
in accounts receivable 394,521
Annual savings from reduction in bad
debt expense 200,000
Savings due to cash discount $ 54,521

e. Ms. Leal should bring working capital measures in line with the industry and offer the proposed cash
discount.

f. The other sources of financing available include both unsecured and secured sources.
Unsecured Sources:
Short-term self-liquidating bank loansusually used to help with seasonal needs where the loan is
repaid as receivables are collected.
Single-payment bank notesnormally a short-term (30 days to 9 months) loan to be repaid on the
end of the loan period.
Line of credita loan much like a credit card in that the borrower can draw down the money as
needed and make various payments. The loan must often be paid in full at some point within
each year.
Revolving credit agreementa guaranteed amount of funds available to the borrower. The
borrower usually pays a commitment fee to the bank to compensate them for having the funds
available on demand.
Commercial papera 3-day to 270-day loan sold as a security to the lender.
Secured Sources:
Pledging accounts receivablea lender loans money on the basis of the creditworthiness of the
borrowers customers who bought on account. The lender advances the money to the borrower in
an amount discounted from the book value of the receivables. When the borrower collects the
receivables payments, the money is remitted to the lender.
Factoring accounts receivableselling the firms accounts receivable to a lender at a discount
to the book value of the receivables. The factor normally receives the payment directly from
the customer when they make payment.
Floating inventory lienswhen inventory is used as collateral for a loan.
Trust receipt inventory loansa loan against relatively expensive and easily identifiable assets,
such as automobiles. The loan is repaid when the asset is sold.
Warehouse receipt loanswhen assets in a warehouse are pledged against a loan. The lender takes
control of the inventory items that are normally stored in a public warehouse.

2012 Pearson Education, Inc. Publishing as Prentice Hall