Criteria for Sale of Receivables

Question 1

Red Co. had $3 million in accounts receivable recorded on its books. Red wanted to convert the $3 million in receivables to cash in a more timely manner than waiting the 45 days for payment as indicated on its invoices. Which of the following would alter the timing of Red’s cash flows for the $3 million in receivables already recorded on its books?

A) Change the due date of the invoice.
B) Factor the receivables outstanding.
C) Discount the receivables outstanding.
D) Demand payment from customers before the due 
    date.

Answer 1

Factoring is a sale of receivables. This allows Red Co. to sell the receivables and receive cash immediately upon sale.

Answer = B

Question 2

After being held for 40 days, a 120-day, 12% interest-bearing note receivable was discounted at a bank at 15%. The proceeds received from the bank equal

A) Maturity value less the discount at 12%.
B) Maturity value less the discount at 15%.
C) Face value less the discount at 12%.
D) Face value less the discount at 15%.

Answer 2

The bank charges its discount (its fee) on the maturity value, which is the face value of the note plus 12% interest for 120 days. The bank charges 15% on this amount for the 80 remaining days in the note term. Thus, the proceeds equal the maturity value less its fee.

Answer = B

Question 3

Ace Co. sold King Co. a $20,000, 8%, 5-year note that required five equal annual year-end payments. This note was discounted to yield a 9% rate to King. The present value factors of an ordinary annuity of $1 for five periods are as follows:

                               8%	3.992
                               9%	3.890

What should be the total interest revenue earned by King on this note?

A) $9,000
B) $8,000
C) $5,560
D) $5,050

Answer 3

Total interest over the life of the note equals the total amount paid by Ace over the life of the note less the proceeds to Ace. The proceeds equal the present value of the payments at the 9% yield rate. The annual payment is found using the 8% rate because that rate is contractually set and determines the annual payment.

The annual payment P is found as: $20,000 = P(3.992). P = $5,010

Total interest revenue = total payments by Ace - proceeds to Ace

= 5($5,010) − $5,010(3.89) = $5,560.

Answer = C

Question 4

Roth, Inc. received from a customer a one-year, $500,000 note bearing annual interest of 8%. After holding the note for six months, Roth discounted the note at Regional Bank at an effective interest rate of 10%. What amount of cash did Roth receive from the bank?

A) $540,000
B) $523,810
C) $513,000
D) $495,238

Answer 4

Maturity value of the note: $500,000(1.08) $540,000
Less discount to the bank: $540,000(.10)(6/12) (27,000)
Equals proceeds to Roth $513,000

The bank charges its discount on the maturity amount, for the period it holds the note. In effect, it is charging interest on interest yet to accrue (for the last six months). This procedure is followed because the maturity value is the amount at risk.

Answer = C

Question 5

On July 1, 2005, Lee Co. sold goods in exchange for a $200,000, 8-month, noninterest-bearing note receivable. At the time of the sale, the note’s market rate of interest was 12%.

What amount did Lee receive when it discounted the note at 10% on September 1, 2005?

A) $194,000
B) $193,800
C) $190,000
D) $188,000

Answer 5

Six months remain in the note term at the date of discounting.

Maturity value of note: $200,000
Less discount: $200,000(.10)(6/12) (10,000)
Equals proceeds on note $190,000

Answer = C