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CHAPTER 17
I. Questions
2. The prime rate is the rate that a bank charges its most creditworthy
customers. The average customer can expect to pay one or two percent
(or more) above prime.
3. The stated interest rate is the percentage rate unadjusted for time or
method of repayment. The effective interest rate is the true rate and
considers all these variables. A 5 percent stated rate for 90 days
provides a 20 percent effective rate. The financial manager should
recognize the effective rate as the true cost of borrowing. The effective
rate is also referred to as the APR (Annual Percentage Rate).
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Chapter 17 Short-term Credit for Financing Current Assets
Supporting computations:
5. Discount % 360
100 - Discount % Days credit is Discount
17-2 outstanding period
2% 360 2 360
100% - 2% 40 - 10 98 30
Short-term Credit for Financing Current Assets Chapter 17
Approx. cost = x
= x = x
=24.5%
6.
Discount % 360
Approx. cost = x Days credit is Discount
100 - Discount %
outstanding period
2% 360 2 360
= x = x
100% - 2% 70 - 10 98 60
=12.24%
Therefore, the loan cost is 1.13 percentage points less than trade credit.
7.
= =
P10,000 (0.10) P1,000
Effective rate = P10,000 P10,000 (0.10)
11.1% P9,000
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Chapter 17 Short-term Credit for Financing Current Assets
9.
= = 13.3%
10%
Effective rate 1 0.15 0.10
10.
= P13,333,
P10,000
0.15
since1 0.15 0.10 = P2,000 is required for the compensating
(P13,333)
balance, and 0.10 (P13,333) = P1,333 is required for the immediate
interest payment.
21. The effective rate is equal to net interest expense divided by proceeds
received not proceeds borrowed.
= = 12.67%
Interest 120,000 (0.06 x 100,000)
24. Proceeds 1,000,000 100,000
= 8.67%
= = = .0959
III. Problems
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Short-term Credit for Financing Current Assets Chapter 17
RATE = x
Loan proceeds
(forRATE
P500,000
= loan) x
= P11,667
.030043 12 or 18.026%
x 6 = .18026,
P388,333 2
Note that Jan would actually have to borrow more than the needed
P500,000 in order to cover the compensating balance requirement.
However, as we demonstrated earlier, the effective cost of credit will not
be affected by adjusting the loan amount for interest expense changes
accordingly.
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Chapter 17 Short-term Credit for Financing Current Assets
and does not pay for an additional 45 days (60 days less the discount
period of 15 days). Thus, for the July trade credit, Jan’s cost is
.16 x P200,000 1
calculated as follows:
P200,000 .20 x P200,000 1
RATE = (.03 / .97) x (360 / 45) = 24.74%
However, for the August trade credit the firm actually pays at the end of
the credit period (the 30th day), so that the cost of trade credit becomes
c.
= .12 x x P500,000
= P10,000
RATE = x
P10,000 + P3,750 12
PROBLEM 3 (JELO MFG. COMPANY)
P500,000 2
a.
RATE = x
= .18, or 18%
b.
.18 x P200,000 1
RATE = P200,000 1 x
= .20, or 20%
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Short-term Credit for Financing Current Assets Chapter 17
c. P5,500 360
P300,000 60
RATE = x
= x
= x = 2.04% x 8 = 16.32%
The effective cost of the loan, 17.5%, is more than the cost of passing up the
discount, 16.32%. Kiwi Corporation should continue to pay in 55 days and
pass up the discount.
PROBLEM 5 (READY FLASHLIGHTS, INC.)
= 1.83% x 6 = 10.98%
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Chapter 17 Short-term Credit for Financing Current Assets
= 2.04% x 6 = 12.24%
2 x 12 x P9,000
c. Yes, because the cost of borrowing is less than the cost of losing the
discount. (P100,000 P10,000) x (12 + 1)
d. = =
= 13.68%
a. Trust Bank
Northeast Bank
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Short-term Credit for Financing Current Assets Chapter 17
Trust Bank
Northeast Bank
a. 11.73%
b. 12.09%
c. 18%
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Chapter 17 Short-term Credit for Financing Current Assets
= 2.345%
= 2.20%
Effective cost = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.)
= .02345 + 3(.02200) =
= .02345 + .06600
= .08945
= 8.95%
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Short-term Credit for Financing Current Assets Chapter 17
Familia Inc. should choose commercial paper because the cost of bank
financing (10.4 percent) exceeds the cost of commercial paper (8.95
percent) by greater than 1 percent.
a. The expected monthly cost of bank financing is the sum of the interest
cost, processing cost, bad debt expense, and credit department cost. The
calculations are as follows:
b. The expected monthly cost of factoring is the sum of the interest cost
and the factor cost. The calculations are as follows:
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Chapter 17 Short-term Credit for Financing Current Assets
Cost = x
The cost of each supplier must be weighted by the proportion of the total
provided by the supplier.
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Short-term Credit for Financing Current Assets Chapter 17
Annual Weighted
Percentage Cost Weight Average Cost
Supplier (1) (2) (1) x (2)
Fort Co. .367 .30 .110
Jester Co. .242 .25 .061
Jam Co. - .35 -
Smitt & Co. .172 .10 .017
Total 1.00 .188
b. No, the average effective annual interest rate does not indicate whether
they should borrow funds to take advantage of the terms on a specific
account. The borrowing decision should be based on the effective
annual interest rate of each supplier’s credit terms. Money should be
borrowed to pay within the discount period only when the cost of
borrowing is less than the effective annual interest rate of the credit
terms. For instance, Fort Co. has an effective annual interest rate of
36.7% and should be paid on day 10 only if the cost of borrowing is less
than 36.7%.
17-13