5.4 Short-Term Financing Flashcards
The prime lending rate of commercial banks is an announced rate and is often understated from the viewpoint of even the most credit-worthy firms. Which one of the following requirements always results in a higher effective interest rate?
A. The imposition of a compensating balance with an absolute minimum that cannot be met by current transaction balances.
B. The absence of a charge for any unused portion in the line of credit.
C. A floating rate for the loan period.
D. A covenant that restricts the issuance of any new unsecured bonds during the existence of the loan.
A. The imposition of a compensating balance with an absolute minimum that cannot be met by current transaction balances.
When a firm borrows money from the bank, it is often required to keep a certain percentage of the funds in the bank at all times. These compensating balances effectively increase the rate of interest on the money borrowed from the bank.
The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.
1. Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.
2. Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
3. Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year in all of your calculations.
The cost of Alternative 2 to Frame Supply Company is
A. 21.0%
B. 12.0%
C. 13.2%
D. 9.0%
C. 13.2%
The effective interest rate on a loan that requires a compensating balance can be calculated as follows:
Effective Rate = Standard Rate ÷ (1.0 – Compensating balance %)
= 12% ÷ (1.0 – 9%)
= 12% ÷ 91%
= 13.19%
If a firm borrows $500,000 at 10% and is required to maintain $50,000 as a minimum compensating balance at the bank, what is the effective interest rate on the loan?
A. 12.2%
B. 9.1%
C. 11.1%
D. 10.0%
C. 11.1%
At 10%, the interest on a $500,000 loan is $50,000 per year. However, the $500,000 loan is effectively reduced to $450,000 of usable funds by the compensating balance requirement. Thus, the borrower pays $50,000 of interest for a $450,000 loan, an effective rate of 11.1% ($50,000 ÷ $450,000).
The following forms of short-term borrowing are available to a firm:
* Floating lien
* Factoring
* Revolving credit
* Chattel mortgages
* Bankers’ acceptances
* Lines of credit
* Commercial paper
The forms of short-term borrowing that are unsecured credit are
A. Floating lien, revolving credit, chattel mortgage, and commercial paper.
B. Factoring, chattel mortgage, bankers’ acceptances, and line of credit.
C. Revolving credit, bankers’ acceptances, line of credit, and commercial paper.
D. Floating lien, chattel mortgage, bankers’ acceptances, and line of credit.
C. Revolving credit, bankers’ acceptances, line of credit, and commercial paper.
An unsecured loan is a loan made by a bank based on credit information about the borrower and the ability of the borrower to repay the obligation. The loan is not secured by collateral but is made on the signature of the borrower. Revolving credit, bankers’ acceptances, lines of credit, and commercial paper are all unsecured means of borrowing.
If a firm’s credit terms require payment within 45 days but allow a discount of 2% if paid within 15 days (using a 360-day year), the approximate cost or benefit of the trade credit terms is
A. 2%
B. 24%
C. 48%
D. 16%
B. 24%
The annualized effective rate on credit terms is derived using this formula:
The effective rate on terms of 2/15, net 45 can thus be calculated as follows:
Effective rate = [2% ÷ (100% – 2%)] × [360 days ÷ (45 days – 15 days)]
= (2% ÷ 98%) × (360 days ÷ 30 days)
= 2.0408% × 12
= 24.49%
A small retail business would most likely finance its merchandise inventory with
A. Terminal warehouse receipt loan.
B. A line of credit.
C. Commercial paper.
D. A chattel mortgage.
B. A line of credit.
A small retail would not have access to major capital markets. In fact, the only options available, outside of owner financing, are bank loans and a line of credit from suppliers. It is this latter alternative that is most often used because it permits the store to finance inventories for 30 to 60 days without incurring interest cost. A line of credit is an arrangement between a bank and a borrower in which the bank commits itself to lend up to a certain maximum amount to the borrower in a given period.
A chief financial officer follows the policy of matching the maturity of assets with the maturity of financing. The implications of this policy include all of the following, except that
A. The seasonal expansion of cash, receivables, and inventory should be financed by short-term debt, such as vendor payables and bank debt.
B. Cash, receivables, and inventory should be financed with long-term debt or equity.
C. The minimum level of cash, receivables, and inventory required to stay in business can be considered permanent and financed with long-term debt or equity.
D. Long-term assets, like plant and equipment, should be financed with long-term debt or equity.
B. Cash, receivables, and inventory should be financed with long-term debt or equity.
Arranging a portfolio so that the maturity of funds will coincide with the need for funds (called maturity matching) will maximize the average return on the portfolio and provide increased flexibility. Supporting short-term assets, such as cash and receivables, with long-term financing is risky and counterproductive.
A bank offered a 1-year loan to a commercial customer. The instrument is a discounted note with a nominal rate of 12%. What is the effective interest rate to the borrower?
A. 10.71%
B. 13.20%
C. 12.00%
D. 13.64%
D. 13.64%
In the absence of a compensating balance provision, the effective annual rate on a loan can be calculated as follows:
Effective rate = stated rate ÷ (1.0 - stated rate)
= 12% ÷ (100% - 12%)
= 12% ÷ 88%
= 13.64%
An entity needs $150,000 of additional funds over the next year in order to satisfy a significant increase in demand. A commercial bank has offered the entity a 1-year loan at a nominal rate of 8%, which requires a 15% compensating balance. How much would the entity have to borrow, assuming it would need to cover the compensating balance with the loan proceeds?
A. $172,500
B. $194,805
C. $130,435
D. $176,471
D. $176,471
The face amount of a loan with a compensating balance can be calculated as follows:
Total amount needed ÷ (1.0 - Compensating balance %)
Borrowings = $150,000 ÷ (100% - 15%)
= $150,000 ÷ 85%
= $176,471
A company needs to borrow $500,000 to meet its working capital requirements for next year. A bank has offered the company a 9.5% simple interest loan that has a 16% compensating balance requirement. Determine the effective interest rate for the loan.
A. 12.75%
B. 19.00%
C. 11.31%
D. 11.02%
C. 11.31%
The effective interest rate is equal to the net interest expense over the usable funds. The company’s net interest expense is equal to $47,500 ($500,000 x 9.5%). Because the bank is requiring a compensating balance of 16%, the company’s usable funds are equal to $420,000 [$500,000 - ($500,000 x 16%)]. Thus, the effective interest rate is 11.31% ($47,500 ÷ $420,000).
A firm is given payment terms of 3/10, net 90 and forgoes the discount and pays on the net due date. Using a 360-day year and ignoring the effects of compounding, what is the effective annual interest rate cost?
A. 13.9%
B. 12.0%
C. 13.5%
D. 12.4%
A. 13.9%
The annualized cost of not taking a discount can be calculated with the following formula:
[Discount % ÷ (100% - Discount %)] x [Days in year ÷ (Total payment period - Discount Period)]
Cost of not taking discount = [3% ÷ (100% - 3%)] x [360 days ÷ (90 days - 10 days)]
= (3% ÷ 97%) x (360 days 80 days)
= 3.09 % x 4.5
= 13.905%
When a company offers credit terms of 3/10, net 30, the annual interest cost based on a 360-day year is
A. 36.7%
B. 37.1%
C. 24.5%
D. 55.6%
D. 55.6%
The annualized cost of not taking a discount is calculated with this formula:
[Discount % ÷ (100% - Discount %)] x [Days in year ÷ (Total payment period - Discount Period)]
Cost of not taking discount = [3% ÷ (100% - 3%)] x [360 days ÷ (30 days - 10 days)]
= (3% ÷ 97%) x (360 days ÷ 20 days)
= 3.0928% x 18
= 55.67%
A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate but the terms of the loans vary. Which of the following combinations of loan terms will be most attractive for the borrowing firm?
A. Simple interest, no compensating balance.
B. Discount interest, no compensating balance.
C. Discount interest, 20% compensating balance required.
D. Simple interest, 20% compensating balance required.
A. Simple interest, no compensating balance.
The most desirable set of terms are those that result in the lowest cost of borrowing. Discount interest results in a higher effective borrowing cost than simple interest because the bank deducts interest in advance so the borrower receives less than the face value of the loan. A compensating balance results in a higher effective borrowing cost because the compensating balance is an amount of cash that the firm is unable to use. The cheapest terms, given that all options have the same nominal interest rate, will be simple interest with no compensating balance.
A firm is given terms of 2/10, net 45 by its suppliers. If the firm forgoes the cash discount and instead pays the suppliers 5 days after the net due date with no penalty, what is the annual interest rate cost (using a 360 day year)?
A. 21.0%
B. 18.0%
C. 18.4%
D. 24.5%
C. 18.4%
The annualized cost of not taking a discount is calculated with this formula:
[Discount % ÷ (100% - Discount %)] x [Days in year ÷ (Total payment period - Discount Period)]
Cost of not taking discount = [2% ÷ (100% - 2%)] x [360 days ÷ (50 days - 10 days)]
= {2% ÷ 98%) x (360 days 40 days)
= 2.04% x 9
= 18.36%
The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.
1. Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.
2. Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
3. Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year in all of your calculations.
The cost of Alternative 4 to Frame Supply Company is
A. 25.0%
B. 40.0%
C. 50.0%
D. 20.0%
A. 25.0%
The company will receive $100,000 ($125,000 x 80%) at an annual cost of $25,000 ($125,000 - $100,000). The effective interest rate on this loan can thus be calculated as follows:
Effective rate = Interest Expense ÷ Usable Funds
= $25,000 ÷ $100,000
= 25.0%
A company has just borrowed $2 million from a bank. The stated rate of interest is 10%. If the loan is discounted and is repayable in 1 year, the effective rate on the loan is approximately
A. 9.09%
B. 10.00%
C. 11.11%
D. 8.89%
C. 11.11%
The effective interest rate on a discount loan can be calculated as follows:
Effective rate = Stated rate ÷ (1.0 - stated rate)
= 10% ÷ (100% - 10%)
= 10% ÷ 90%
= 11.11%
Note that the amount of the loan is not needed to calculate the effective rate.
A company has a revolving line of credit of $300,000 with a 1-year maturity. The terms call for a 6% interest rate and a 1/2% commitment fee on the unused portion of the line of credit. The average loan balance during the year was $100,000. The annual cost of this financing arrangement is
A. $7,000
B. $6,000
C. $6,500
D. $7,500
A. $7,000
The annual cost of the company’s financing arrangement can be calculated as follows:
Annual cost = Interest expense on average balance + Commitment fee on unused portion
= (Average balance x Stated rate) + [(Credit limit - average balance) x Commitment fee %]
= ($100,000 x 6%) + [($300,000 - $100,000) x 0.5%]
= $6,000 + $1,000
= $7,000
On June 30 of this year, a bank granted a corporation a $20 million 5-year term loan with a floating rate of 200 basis points over Treasury Bill rates, payable quarterly. The loan principal is to be rapid in equal quarterly installment over the term. If Treasury Bills are expected to yield 6% for the rest of the year, how much will the corporation pay to the bank in the last half of this year?
A. $1,800,000
B. $2,800,000
C. $2,780,000
D. $3,170,000
C. $2,780,000
A basis point is one-hundredth of 1%. Thus, the rate on the term loan is 8% [6% treasury bill rate + 200 basis points points (2%)]. The first quarterly payment consists of principal of $1,000,000 and interest of $380,000 [($20,000,000 - $1,000,000) x 8% x (3 / 12 months)], a total of $1,380,000. The total payments in the second half of the year are therefore $2,780,000 ($1,400,000 + $1,380,000).
A firm has a zero-balance account with a commercial bank. The bank sweeps any excess cash into a commercial investment account earning interest at the rate of 4% per year, payable monthly. When the firm has a cash deficit, a line of credit is used that has an interest rate of 8% per year, payable monthly based on the amount used. The firm expects to have $2 million cash balance on January 1 of next year. Net cash flows for the first half of the year, excluding the effects of interest received or paid, are forecasted (in millions of dollars) as follows:
Net cash inflows ($)
Jan: +2
Feb: +1
Mar: -5
Apr: -3
May: -2
Jun: +6
Assuming all cash flows occur at the end of each month, approximately how much interest will the firm incur for this period?
A. $16,000 net interest paid.
B. $76,000 net interest paid.
C. $53,000 net interest paid.
D. $195,000 net interest paid.
A. $16,000 net interest paid.
The interest incurred on this financing arrangement can be calculated as follows:
Beginning balance: $2,000,000 x (annual rate 4% / 12 months in year) = $6,667 monthly interest income
January inflows: $2,000,000
–> February balance $4,000,000 x (annual rate 4%/ 12 months in year) = 13,333 monthly interest income
February inflows: $1,000,000
–> March balance: $5,000,000 x (annual rate 4%/ 12 months in year) = 16,667 monthly interest income
March outflows: -$5,000,000
–> April balance $0
April outflows: -$3,000,000
–> May balance -$3,000,000 x (annual rate 8%/ 12 months in year) = -20,000 monthly interest expense
May outflows: -$2,000,000
–> June balance -$5,000,000 x (annual rate 8%/ 12 months in year) = -33,000 monthly interest expense
6,667 + 13,333 + 16,667 - 20,000 - 33,333 = -16,667
The question asks approximately how much interest will be paid. The nearest answer is $16,000.
Which one of the following is not a form of short-term credit?
A. Commercial paper.
B. Bankers’ acceptances.
C. Corporate bonds.
D. Accrued wages.
C. Corporate bonds.
Corporate bonds are not a form of short term credit.
The common stock has a beta coefficient of 1.7. The following information about overall market conditions is available.
Expected return on U.S. Treasury bonds 6%
Expected return on the market portfolio 8.5%
Using the capital asset pricing model (CAPM), what is the risk premium on the market?
A. 1.7%
B. 4.3%
C. 10.3%
D. 2.5%
D. 2.5%
The risk premium on the market is the return on the market portfolio (8.5%) minus the risk-free returns as measured by the return on US. Treasury securities (6%), or 2.5%.
A manufacturer with seasonal sales would be most likely to obtain which one of the following types of loans from a commercial bank to finance the need for a fixed amount of additional capital during the busy season?
A. Installment loan.
B. Insurance company term loan.
C. Unsecured short-term term loan.
D. Transaction loan.
C. Unsecured short-term loan.
An unsecured short-term loan is often used to finance a firm’s need for fluctuating (e.g., seasonal) current assets. This practice is consistent with the maturity-matching (self-liquidating) approach to financing current assets.
A corporation can issue 3-month commercial paper with a face value of $1,500,000 for $1,450,000. Transaction costs will be $1,500. The effective annualized percentage cost of the financing, based on a 360-day year, will be
A. 3.56%
B. 14.22%
C. 3.45%
D. 13.79%
B. 14.22%
The total cost to the company will be $51,500 ($50,000 discount + $1,500 of transaction costs), and the net amount available will be $1,448,500. The annualized amount of the cost is $206,000 ($51,500 x 4). Accordingly, the annual interest cost will be 14.22% ($206,000 / $1,448,500).
Morton Company needs to pay a supplier’s invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating balance.
Assuming Morton Company borrows the money on the last day of the discount period and repays it 30 days later, the effective interest rate on the loan is
A. 12.00%
B. 13.20%
C. 13.48%
D. 13.33%
D. 13.33%
Morton’s effective rate on this loan can be calculated as follows:
Effective rate = stated rate / (1.0 - compensating balance %)
= 12% / (100% - 10%)
= 12% / 90%
= 13.33%
