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BEC Corporate Governance, Economics, and Financial Management > Intro to Financial/Capital Structure & Short-Term (Working Capital) Financing > Flashcards

Intro to Financial/Capital Structure & Short-Term (Working Capital) Financing Flashcards

1
Q

What is included in the financial structure of a firm?

A

All liabilities and equities (short & long term) used to finance a firm’s assets. Financial structure = Capital Structure (excludes short term liabilities) + short term liabilities

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2
Q

What accounts on balance sheet are included in financial structure?

A

Equities & liabilities. Everything on right side of balance sheet. Assets on left side. Assets = Liabilities + Owner’s equity

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3
Q

What is the key difference between capital structure and financial structure?

A

Capital structure DOES NOT include current (short-term) liabilities. Only includes long-term liabilities. Financial structure includes both short and long term liabilities.

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4
Q

With regards to capital structure, what are some short term liabilities that are excluded from capital structure?

A
  1. Accounts payable
  2. Wages and Salaries Payable
  3. Short-term notes
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5
Q

Financial structure includes what two important things?

A

All debt and equity

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6
Q

Why would a bonds payable with 10-year maturity be included in both financial and capital structure?

A

All debt is included in financial structure. Only long-term liabilities are included in capital structure (more than one year).

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7
Q

Which capital source would most likely be excluded from WACC formula or weighted average cost of capital? Options: short-term debt, long-term debt, common stock, and preferred stock.

A

Short-term debt. It is not considered a part of capital structure of an entity.

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8
Q

What is the length of time for short term financing?

A

One year or less

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9
Q

Provide three accounts (examples) that can provide short-term financing?

A
  1. Accounts payable
  2. Accounts receivable
  3. Inventory
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10
Q

What is the pledging of accounts receivable?

A

In pledging of accounts receivable, the receivables are used as collateral in a financing agreement with a lender.

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11
Q

What is factoring of accounts receivable?

A

In factoring of accounts receivable, the receivables are sold at a discount for cash to a factor.

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12
Q

Define letter of credit.

A

A conditional commitment to pay a third party in accordance with specified terms.

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13
Q

Define revolving credit agreement.

A

Formal legal commitment, usually by a bank, to extend credit up to some maximum amount to a borrower over a stated period.

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14
Q

Define line of credit.

A

Informal agreement whereby a lender agrees to extend a maximum amount of credit at any one time.

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15
Q

Define trade credit.

A

Short-term (usually 30 to 90 days) deferred payment terms offered by a seller to a buyer as a standard trade practice or to encourage sales; it is the common basis for accounts receivable (seller) and account payable (buyer).

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16
Q

What is commercial paper?

A

Short-term unsecured promissory notes

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17
Q

What form of short-term financing would an importer use to assure a foreign supplier of payment?

A

Letter of credit.

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18
Q

What are some advantages of line of credit, revolving credit, and letter of credit?

A
  1. Commonly available to creditworthy firms
  2. Highly flexible
  3. Unsecured (no assets pledged)
  4. Line of credit/revolving credit provide cash
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19
Q

What are some disadvantages of line of credit, revolving credit, and letter of credit?

A
  1. Poor credit rating results in high interest
  2. Involves fees
  3. Required compensating balance
  4. Not legally obligate financial institution
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20
Q

What are some advantages of commercial paper?

A
  1. Lower interest rates
  2. No compensating balance
  3. Provides broad distribution for borrowing
  4. Larger amount of funds can be obtained
  5. Provides cash for general use
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21
Q

What are some disadvantages of commercial paper?

A
  1. Only creditworthy firms can issue commercial paper
  2. Requires short-term satisfaction
  3. Lacks flexibility of extension
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22
Q

Commercial paper is issued by what entity?

A

Large corporations

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23
Q

Is commercial paper secure of unsecured?

A

Unsecured. No assets are pledged as collateral.

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24
Q

What is the commercial paper short maturity period date range?

A

60 to 270 days or 2 to 9 months

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25
Q

What do payment terms of “2/10,n/30” stand for?

A

2/10 - Means you will receive a 2% discount when you pay within 10 days
n/30 - Means you need to pay within 30 days to avoid penalty
If you cannot pay within 10 days to receive discount, then it makes sense to pay 30 days later in order to avoid penalty

26
Q

What forms of short-term financing are restricted as to use of proceeds?

A
  1. Trade accounts payable - it can provide financing only for assets or expenses acquired through trade accounts
  2. Accrued taxes payable - it can provide financing only for expenses related to taxes
  3. Accrued salaries payable - it can provide financing only for benefits derived through salaries.
  4. Unearned revenue
27
Q

Why are short-term notes payable not a restricted form of short term financing as to use of proceeds.

A

short-term notes usually provide cash which often may be used for various asset and expense purposes.

28
Q

What is the formula to calculate effective rate of interest in short term financing?

A 
Cost of loan/Net Proceeds
or
Cost of loan (Principal x Interest rate)
divided by 
Net Proceeds (Principal - (Principal x Compensating Balance)
29
Q

Alpha Company borrowed $20,000 from High Bank, giving a one-year note. The terms of the note provided for 6% interest and required a 10% compensating balance. Which one of the following is the effective rate of interest on the loan?
Explain how you solve this problem in steps.

A

Step 1: Write out variables
Principal = $20,000
Interest = .06
Compensating balance = .10
Step 2: Formula to calculate effective rate of interest.
Cost of loan (Principal x Interest rate)/Net Proceeds (Principal - Principal x Compensating Balance)
Step 3: Enter numbers in formula
Cost of loan = .06 x 20,000 = 1,200
Net Proceeds = 20,000 - 2,000 (20,000 x (20,000 x .10) = 18,000
Equation: 1,200/18,000 = 6.66%

30
Q

If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is?
How to solve this problem

A 
First: Identify variables
Discount rate: 2%
Net days: 40 days
Discount days: 10 days
Second: APR Formula
Discount %/(1-Discount %) x (360/# Net days - # of Discount days)
31
Q

What financial instrument provides the largest source of short-term financing?

A

Trade credit. It occurs automatically with the purchase of goods and services.

32
Q

What loans terms are most favorable for a borrowing firm? What are the least favorable loans terms for a borrowing firm?

A

Most favorable - Simple interest and no compensating balance (These decrease effective interest rates)
Least Favorable - Discount interest and compensating balance (These increase effective interest rates)

33
Q

What is an inventory secure loan and what are the four different types of these?

A

Inventory secured loan - Firm pledges all or part of its inventory as collateral for short-term loan.

  1. Floating lien agreement
  2. Chattel mortgage agreement
  3. Field warehouse agreement
  4. Terminal warehouse agreement
34
Q

Define floating lien agreement.

A

Borrower retains the inventory, which it continuously sells and replaces. Borrower gives a lien against all of its inventory to the lender.

35
Q

Define chattel mortgage agreement.

A

Borrower retains the inventory, but cannot sell it without the lender’s approval. Borrower gives lien against specifically identified inventory.

36
Q

Define field warehouse agreement.

A

The inventory that serves as security for a borrowing remains with the borrower, but is place under the control of an independent third party.

37
Q

Define terminal warehouse agreement.

A

The inventory is moved to a public warehouse and placed under control of independent third party. It is heled as a security.

38
Q

What inventory secured loan is the most flexible and why?

A

Floating lien agreement. The borrower gives the lender a lien against its inventory, but retains control of the inventory and can continuously sell and replace the inventory.

39
Q

What are some advantages of inventory secured loans for short term financing?

A
  1. Commonly available for certain inventories (wheat)
  2. Flexible (available as security)
  3. Compensating balances not required
  4. Provides cash
40
Q

What are some disadvantages of inventory secured loans for short term financing?

A
  1. Pledged inventory may not be available when needed
  2. Cost can be greater than other sources of short term financing
  3. Requires short term payment
  4. Not available for certain inventory
41
Q

What is pledging accounts receivable?

A 
Using accounts receivable as security for short-term borrowings. Level of borrowing depends on two important things. 
#1: Creditworthiness of AR
#2: Level of lender's recourse against borrower
42
Q

What are some advantages of pledging accounts receivable?

A 
#1: Commonly available
#2: Flexible - available for security as new receivables occur
#3: No compensating balances
#4: Provides cash
#5: Lender assumes billing and collection services
43
Q

What are some disadvantages of pledging accounts receivable?

A 
#1: Accounts are committed to lender
#2: Cost greater than other forms of short term financing
#3: Requires short term payment
44
Q

What is factoring accounts receivable? How does this differ from pledging?

A

Factoring accounts receivable differs from pledging in that it is the sale of accounts receivable to a commercial bank or financial institution. Buyer is called a factor.

45
Q

The terms of sale for factoring accounts receivable are categorized into two different categories. Without recourse and with recourse. Explain the difference between these two.

A

Without recourse - Factor (buyer) bears risk associated with collectability
With recourse - Factor (buyer) has recourse against the firm for some or all of the risk associated with uncollectability.

46
Q

What are advantages of factoring accounts receivable?

A
  1. Commonly available
  2. Flexible
  3. No compensating balances required
  4. Provides cash
  5. Buyer assumes billing/collection responsibilities
47
Q

What are disadvantages of factoring accounts receivable?

A
  1. Cost may be greater than other sources of short-term financing
  2. If sold with recourse, firm may have ongoing risk
  3. Sale of their accounts may alienate customers
48
Q

What is trade accounts payable?

A

Firm routinely buys goods or services on credit from its suppliers. Credit derived from trade accounts is not secure. No assets pledged as collateral. Depend on borrower’s ability and willingness to pay obligation when due.

49
Q

What are advantages of trade accounts payable?

A

1 - Ease of use - little legal documentation required
2- Flexible - expands/contracts with needs
3 - Interest not charged normally
4 - Unsecured - no assets pledged as collateral
5 - Discount for early payment

50
Q

What are disadvantages of trade accounts payable?

A

1 - short term payment required
2 - Higher cost if discount not taken
3 - Use-specific - finances only assets acquired through trade accounts

51
Q

What are accrued accounts payable? What are the three different types of accrued accounts payable?

A 
AAP result from benefits or cash rec'd for related unpaid obligation.
Examples
1. Salaries and wages payable
2. Taxes payable
3. Unearned revenue
52
Q

What are advantages of accrued accounts payable?

A

1 - Ease of use
2 - Flexible
3 - Unsecured (no assets pledged)

53
Q

What are disadvantages of accrued accounts payable?

A

1 - Requires short term satisfaction

2 - Certain sources are use specific

54
Q

What are short-term notes payable?

A

These result from borrowing usually from a commercial bank. Repayment is due in one year or less.

55
Q

What are some advantages of short term notes financing?

A
  1. Commonly available for creditworthy firms
  2. Flexible - amounts and periods can be varied with needs
  3. Unsecured - no assets pledged
  4. Provides cash
  5. Short maturity permits refinancing at lower cost
56
Q

What are some disadvantages of short term notes financing?

A
  1. Poor credit rating results in higher interest
  2. Requires short term satisfaction
  3. Required compensating balance increases cost
  4. Refinancing at higher rates may be necessary if interest rates increase
57
Q

What is the formula to solve for the amount factored from accounts receivable?

A

Accounts receivable amount - Value held in reserve for contingencies (% x AR) - Factor fee (% x AR) - Interest (% x Deducted AR amount including factor fee & reserves)

58
Q

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days:

Value of receivables to be held in reserve for contingencies
10%
Following costs are deducted at time accounts are factored:

Interest rate on amounts provided before deducting interest (annual rate)
12%
Factor fee on total receivables factored
2%

If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored?
How do you solve for calculating the amount factored from accounts receivable?

A

First step: Formula to calculate accounts receivable factored.
Accounts receivable - Reserve contingency amount - Factor Fee - Interest rate
(Interest rate and factor fees are deducted at time accounts are factored)
Step 2: calculate reserves, fees, and interest amounts
Reserves = 200,000 x .10 = 20,000
Factor fee = 200,000 x .02 = 4,000
Interest = 176,000 x .01(1%) = 1,760
To solve for interest rate, the annual rate is 12% (12 months). So for one month (30 days), the rate should be 1% (1/12)
-You will not multiply interest by accounts receivable amount. You will multiply interest rate by (AR - Factor Fee - Reserves) amount which is 176,000.
Step 3: Solve formula
200,000 (AR) - 20,000 (reserves) - 4,000 (factor fee) - 1,760 (interest) = 174,240

59
Q

When there is an amount of accounts receivable that is going to be factored, sometimes a certain amount of the AR will be reversed. Some cases, return or allowances are granted. When this scenario occurs, how do you calculate the amount that a company will receive after a # day period?

A

When a certain amount of AR is reversed, interest rate and factor fee do not apply to this scenario. Only reserves in contingencies is accounted for.
Formula: Reserve amount (AR x reserve %) - Amount to be reversed = Amount rec’d at end of the period

60
Q

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days:

Value of receivables to be held in reserve for contingencies
10%
Following costs are deducted at time accounts are factored:

Interest rate on amounts provided
12%
Factor fee on total receivables factored
2%

If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period?
How to solve this particular problem.

A

First step: Acknowledge scenario
When factoring AR, a certain amount was reversed due to returns and allowances granted. Amount reversed was $10,000.

Second Step: Formula to solve

  • In this scenario, factor fee and interest are not considered. Since there is a reversal.
  • Only reserve % is required to solve.

Therefore, formula is

Formula: Reserve amount (AR x reserve %) - Amount to be reversed = Amount rec’d at end of the period

20,000 (10% x 200,000) - 10,000 (Reversal amount) = 10,000 amount rec’d in 10 day period

61
Q

What is the formula to calculate effective interest rate?

A

Net cost of factoring/Net Amount Received
Net cost of factoring = AMT paid to factor (annual rate x amount received) + annual fee (Total yearly AR x Charge %) - cost savings
Net Amount received = AR x % amount received

62
Q

A company enters into an agreement with a firm who will factor the company’s accounts receivable. The factor agrees to buy the company’s receivables, which average $100,000 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 an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the cost of engaging in this arrangement?
Explain the steps to go about solving this problem.

A

Step 1: In this problem, determine what you are solving for. You are solving for percent of effective interest.
Step 2: Write down variables
AR = $100,000 per month
% of AR Rec’d = 80%
Annual rate = 10%
Annual charge fee = 2%
Savings = $18,000
Step 3: Write formula for effective interest
Effective interest = Net Cost Factoring/Net Amount Received
Step 4: Solve for numerator and denominator
Net Amount received = $100,000 AR per month x .80 of AR Rec’d = $80,000
Net Cost of Factoring = Annual rate x amount rec’d + Annual fee/charge - savings
Annual rate x AMT rec’d = .10 (Annual rate) x $80,000 AMT rec’d (.80 x $100,000) = $8,000
Annual fee/charge = $24,000 (Total yearly AR x Charge %
Calculation: $100,000 (AR monthly) x 12 months (1 annual year) = $1,200,000 x 0.02 Charge Fee = $24,000
Savings = $18,000 (provided in problem)
Net Costs = $8,000 + $24,000 - $18,000 = $14,000
Step 5: Solve equation
ER = Net Costs/Net AMT Rec’d
ER = $14,000/$80,000 = 17.5%

BEC Corporate Governance, Economics, and Financial Management (19 decks)

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