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CHAPTER 27 Providing and Obtaining Credit Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Medium: Credit period FI Answer: b Diff: M The credit period is the amount of time it takes to a credit search on a potential customer a True b False Credit standards FI Answer: b Diff: M Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit a True b False Collection policy FI The collection process, although sometimes inexpensive component of doing business Answer: b difficult, is Diff: M a fairly a True b False Collection policy FI Answer: a Diff: M The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses a True b False © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Cash discounts FI Answer: b Diff: M Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms a True b False Cash discounts FI Answer: a Diff: M When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount a True b False Payments pattern approach FI Answer: a Diff: M The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly a True b False Payments pattern approach FI Answer: b Diff: M DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales a True b False Payments pattern approach FI Answer: a Diff: M If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged a True b False Payments pattern approach FI Answer: b Diff: M © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page 10 The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales a True b False Uncollected balances schedule 11 FI Answer: a Diff: M The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month’s sales a True b False Multiple Choice: Conceptual Medium: Credit policy CI Answer: b Diff: M 12 A firm’s credit policy consists of which of the following items? a Credit period, cash discounts, credit standards, receivables monitoring b Credit period, cash discounts, credit standards, collection policy c Credit period, cash discounts, receivables monitoring, collection policy d Cash discounts, credit standards, receivables monitoring, collection policy e Credit period, receivables monitoring, credit standards, collection policy Collection policy CI 13 Which of the following is not correct? Answer: b Diff: M a Collection policy is how a firm goes about collecting past-due accounts b A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales c Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased d Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account e A lax collection policy will frequently lead to an increase in accounts receivable © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Payments pattern approach CI Answer: c Diff: M 14 Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days? a DSO will vary from month to month b The quarterly uncollected balances schedule will be the same in each quarter c The level of accounts receivable will be constant from month to month d The ratio of accounts receivable to sales will vary from month to month e The level of accounts receivable at the end of each quarter will be the same Credit policy and seasonal dating CI 15 Which of the following statements is most correct? Answer: b Diff: M a If credit sales as a percentage of a firm's total sales increases, and the volume of credit sales also increases, then the firm's accounts receivable will automatically increase b It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially "weak" firms A major disadvantage of such a policy is that it is likely to increase uncollectible accounts c A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity d Firms use seasonal dating primarily to decrease their DSO e Seasonal dating with terms 2/15, net 30 days, with April dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st Choosing a bank CI Answer: e Diff: M 16 Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a b c d e Convenience of location Competitive cost of services provided Size of the bank's deposits Experience of personnel Loyalty and willingness to assume lending risks © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Multiple Choice: Problems Easy: Multiple part: (The following information applies to the next two problems.) You have just taken out a loan for $75,000 The stated (simple) interest rate on this loan is 10 percent, and the bank requires you to maintain a compensating balance equal to 15 percent of the initial face amount of the loan You currently have $20,000 in your checking account, and you plan to maintain this balance The loan is an add-on installment loan which you will repay in 12 equal monthly installments, beginning at the end of the first month Loan payments CI 17 How large are your monthly payments? Answer: e Diff: E Add-on installment loan CI Answer: d 18 What is the nominal annual add-on interest rate on this loan? Diff: E a b c d e a b c d e $6,250 $7,000 $7,500 $5,250 $6,875 10.00% 16.47% 18.83% 20.00% 24.00% EAR discount/compensating balance loan CI 19 Suppose you borrow $2,000 from a bank for interest rate of 14 percent, with interest Also, assume that the bank requires you balance equal to 20 percent of the initial annual interest rate are you being charged? a b c d e Answer: d Diff: E one year at a stated annual prepaid (a discounted loan) to maintain a compensating loan value What effective 14.00% 8.57% 16.28% 21.21% 28.00% © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page EAR discount/compensating balance loan CI Answer: b Diff: E 20 Wentworth Greenery harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped However, the firm must plant, irrigate, and harvest on a near continual schedule The firm uses 90-day bank notes to finance its operations The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually What is the effective annual interest rate of these discount loans? a b c d e 11.00% 15.94% 11.46% 13.75% 12.72% Effective annual rate CI Answer: d Diff: E 21 Assume you borrow $12,000 from the bank using a 10.19 percent “add-on”, one-year installment loan, payable in four equal quarterly payments What is the effective annual rate of interest? a b c d e 9.50% 10.19% 15.99% 16.98% 20.38% Effective annual rate CI Answer: c Diff: E 22 XYZ Company needs to borrow $200,000 from its bank The bank has offered the company a 12-month installment loan (monthly payments) with percent add-on interest What is the effective annual rate (EAR) of this loan? a b c d e 16.22% 17.97% 17.48% 18.67% 18.00% © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Effective annual rate CI Answer: e Diff: E 23 First National Bank of Micanopy has offered you the following loan alternatives in response to your request for a $75,000, 1-year loan Alternative 1: percent discount compensating balance interest, with a 10 percent Alternative 2: percent simple interest, with interest paid monthly What is the effective annual rate on the cheaper loan? a b c d e 8.00% 7.23% 7.67% 8.43% 8.30% EAR discounted loan CI Answer: d Diff: E 24 Coverall Carpets Inc is planning to borrow $12,000 from the bank The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in equal quarterly payments What is the effective rate of interest on the 12 percent discounted loan? a b c d e 10.7% 12.0% 12.5% 13.6% 14.1% Discount interest face value CI Answer: c Diff: E 25 Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and harvest its fruit crop Picard borrows on a discount interest basis at a nominal annual rate of 11 percent If Picard must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note? a b c d e $111,000 $100,000 $112,360 $ 89,000 $108,840 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Discount interest face value CI Answer: a Diff: E 26 Viking Farms harvests crops in roughly 90-day cycles based on a 360-day year The firm receives payment from its harvests sometime after shipment Due in part to the firm's rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest If the firm requires $60,000 in proceeds from each note, what must be the face value of each note? a b c d e $61,856 $67,531 $60,000 $68,182 $67,423 Medium: Add-on interest loan CI Answer: d Diff: M 27 Coverall Carpets Inc is planning to borrow $12,000 from the bank The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in equal quarterly payments What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan? a b c d e 5.10% 10.19% 12.00% 20.38% 30.57% (The following information applies to the next three problems.) East Lansing Appliances (ELA) expects to have sales this year of $15 million under its current credit policy The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is percent Since ELA wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days Expected bad debt losses on the remaining sales would fall to percent The variable cost percentage is 60 percent, and the cost of capital is 15 percent Bad debt losses CI Answer: d Diff: E 28 What would be the incremental bad losses if the change were made? a $315,000 b $260,500 c -$260,500 (bad debt losses would decline) d -$315,000 (Bad debt losses would decline) e $ (no change would occur) © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Cost of carrying receivables CI Answer: b Diff: M 29 What would be the incremental cost of carrying receivables if this change were made? a $108,750 b -$116,250 (carrying costs would decline) c $157,900 d -$225,000 (carrying costs would decline) e $260,500 Incremental profits CI Answer: e 30 What are the incremental pre-tax profits from this proposal? a b c d e Diff: M $181,250 $271,750 $256,250 $206,500 $231,250 (The following information applies to the next four problems.) Berkeley Prints expects to have sales this year of $15 million under its current credit policy The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is percent Also, Berkeley’s cost of capital is 15 percent, and its variable costs total 60 percent of sales Since Berkeley wants to improve its profitability, a proposal has been made to offer a percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30 The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to percent Cash discounts CI Answer: c 31 What would be the cost to Berkeley of the discounts taken? Diff: E a $116,750 b -$108,750 c $155,000 d $225,000 e $260,500 Bad debt losses CI Answer: d Diff: E 32 What would be the incremental bad debt losses if the change were made? a $130,000 b $250,000 c -$250,000 (bad debt losses would decline) d -$130,000 (bad debt losses would decline) e $620,000 © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page Cost of carrying receivables CI Answer: a Diff: M 33 What would be the incremental cost of carrying receivables if the change were made? a -$108,750 (carrying costs would decline) b $116,250 c $157,900 d -$225,000 (carrying costs would decline) e $260,000 Incremental profits CI Answer: a 34 What are the incremental pre-tax profits from this proposal? a b c d e Diff: M $283,750 $250,500 $303,250 $493,750 $288,250 Cost of short-term financing CI Answer: d Diff: M 35 Judy's Fashions, Inc purchases supplies from a single supplier on terms of 1/10, net 20 Currently, Judy takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount Judy needs an additional $50,000 to support an expansion of fixed assets This amount could be raised by making greater use of trade credit or by arranging a bank loan The banker has offered to loan the money at 12 percent discount interest Additionally, the bank requires an average compensating balance of 20 percent of the loan amount Judy already has a commercial checking account at this bank which could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Judy would otherwise keep in the account Which of the following statements is most correct? a The cost of using additional trade credit is approximately 36 percent b Considering only the explicit costs, Judy should finance the expansion with the bank loan c The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan d The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Judy would hold a cash balance of one-half the compensating balance amount even if the loan were not taken e If Judy had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent © 2011 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Chapter 27 - Page 10 15.Credit policy and seasonal dating CI Answer: b Diff: M I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 1 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 16.Choosing a bank I = ? -13,636.36 12 | -2,270.83 CI Answer: e 3,030.30 - 424.24 discount interest - 606.06 comp balance 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 1 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 17 -13,636.36 12 | -2,270.83 Diff: M .Loan payments CI The monthly payments would be: Monthly payment = = $6,875 I = ? Answer: e Diff: E 3,030.30 - 424.24 discount interest - 606.06 comp balance 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 1 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 18 Add-on installment loan Approximate rate = = 20% I = ? -13,636.36 12 | -2,270.83 CI Answer: d 3,030.30 - 424.24 discount interest - 606.06 comp balance 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 1 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 -13,636.36 Diff: E I = ? 12 | | | 25,000 -2,270.83 -2,270.83 19.EAR discount/compensating balance loan CI Answer: d Will receive $2,000 Face amount of loan = $2,000/(1 - 0.14 - 0.20) = $3,030.30 Discount interest = 0.14($3,030.30) = $424.24 Compensating balance = 0.20($3,030.30) = $606.06 Diff: E I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 2,000.00 -3,030.30 + 606.06 -2,424.24 With a financial calculator, enter N = 1, PV = 2,000, PMT = 0, FV = solve for I/YR = 21.21% I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 I = ? -13,636.36 12 | -2,270.83 3,030.30 -3,030.30 - 424.24 discount interest + 606.06 - 606.06 comp balance -2,424.24 2,000.00 20 EAR discount/compensating balance loan CI Answer: b Assume firm needs $10,000 Face amount of loan = $10,000/(1 - 0.11 - 0.20) = $14,492.75 Discount interest = 0.11($14,492.75) = $1,594.20 Compensating balance = 0.20($14,492.75) = $2,898.55 and I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 -14,492.75 + 2,898.55 -11,594.20 Diff: E With a financial calculator, enter N = 1, PV = 10,000, PMT = 0, FV = -11,594.20, and solve for I/YR = 15.94% I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 I = ? -13,636.36 12 | -2,270.83 3,030.30 - 424.24 discount interest - 606.06 comp balance 21 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 -14,492.75 - 1,594.20 discount interest + 2,898.55 - 2,898.55 comp balance -11,594.20 10,000.00 Effective annual rate CI Answer: d Diff: E First, calculate the amount of "add-on" interest Interest = 0.1019($12,000)= $1,222.80 The total amount to be repaid is $1,222.80 + $12,000 = $13,222.80 The quarterly payments are $13,222.80/4 = $3,305.70 Find the periodic rate, where N = 4, PV = 12,000, PMT = -3,305.70, FV = 0, so the quarterly rate = 3.9977% Finally, enter the nominal rate into your calculator, 3.9977% = 15.99% = NOM% Enter P/YR = Now, solve for EFF% = 16.98% I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 I = ? -13,636.36 3,030.30 - 424.24 discount interest - 606.06 comp balance 22 2,000.00 12 | -2,270.83 -3,030.30 + 606.06 -2,424.24 I = ? 14,492.75 -14,492.75 - 1,594.20 discount interest + 2,898.55 - 2,898.55 comp balance -11,594.20 10,000.00 Effective annual rate CI Answer: c Diff: E Interest is 9%($200,000) = $18,000 Thus, the face value of the loan is $200,000 + $18,000 = $218,000 Monthly payments are $218,000/12 = $18,166.67 Calculate the periodic rate as follows: N = 12, PV = 200,000, FV = 0, PMT = -18,166.67, I/YR = ? = 1.3514% Convert this to an annual rate: 1.3514% 12 = 16.2168% Applying the EAR formula, solve for EAR = (1 + 0.162168/12)12 - = 17.48% I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 I = ? -13,636.36 12 | -2,270.83 3,030.30 - 424.24 discount interest - 606.06 comp balance 23 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 -14,492.75 - 1,594.20 discount interest + 2,898.55 - 2,898.55 comp balance -11,594.20 10,000.00 Effective annual rate CI Answer: e Diff: E Alternative 1: Face amount of loan = $75,000/(1 - 0.07 - 0.10) = $90,361.45 $90,361 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 -90,361 + 9,036 -81,325 To solve for the loan’s effective rate enter N = 1, PV = 75,000, PMT = 0, FV = -81,325, and solve for I/YR = 8.43% Alternative 2: EAR = (1 + 0.08/12)12 - = 8.30% I = ? 13,636.36 - 1,636.36 discount interest 12,000.00 I = ? | | 25,000 -2,270.83 I = ? -13,636.36 12 | -2,270.83 3,030.30 - 424.24 discount interest - 606.06 comp balance 24 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 -90,361 - 6,325 discount interest + 9,036 - 9,036 comp balance -81,325 75,000 EAR discounted loan CI Answer: d Will receive $12,000 Face amount of loan = $12,000/(1 - 0.12) = $13,636.36 Discount interest = 0.12($13,636.36) = $1,636.36 Diff: E I = ? 13,636.36 - 1,636.36 discount interest 12,000.00 -13,636.36 With a financial calculator, enter N = 1, PV = 12,000, PMT = 0, FV = , and solve for I/YR = 13.64% 13.6% I = ? | | 25,000 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 25 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 12 | -2,270.83 -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 interest face value CI Face value = = = = $112,359.55 $112,360 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? -13,636.36 3,030.30 - 424.24 discount interest - 606.06 comp balance 26 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? Discount Answer: c Diff: E -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Discount interest face value CI Answer: a Diff: E Convert the annual rate to a periodic rate (quarterly) in the denominator of the face value formula: Face value = = = = $61,855.67 $61,856 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 27 2,000.00 -3,030.30 + 606.06 -2,424.24 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Add-on interest loan CI Answer: d Total to be repaid = $12,000(1.1019) = $13,222.80 Interest = $13,222.80 - $12,000 = $1,222.80 Approximate rateAdd-on = = 0.2038 = 20.38% I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 28 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? Diff: M -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Bad debt losses CI Answer: d Diff: E Bad debt losses old: (.05)($15,000,000) = $750,000 Bad debt losses new: (.03)($14,500,000) = $435,000 Change in bad debt losses = $435,000 - $750,000 = -$315,000 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 29 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 Cost of carrying receivables DSO0 = 60 days; DSON = 30 days -13,636.36 CI No discounts Answer: b Diff: M Calculate cost of carrying receivables at current and new sales levels: = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000 Sales at $14,500,000: 30($14,500,000/360)(0.6)(0.15) = $108,750 Change = $108,750 - $225,000 = -$116,250 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 30 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 I = ? 13,636.36 - 1,636.36 discount interest 12,000.00 Incremental profits Analysis of policy change: Net sales Production costs Profit before credit costs Cost of carrying receivables Bad debt losses Pre-tax profits -13,636.36 CI Answer: e Current Projections $15,000,000 9,000,000 Effect of Credit Policy Change -$500,000 + 300,000 New Projections $14,500,000 8,700,000 $ 6,000,000 -$200,000 $ 5,800,000 225,000 750,000 $ 5,025,000 + 116,250 + 315,000 +$231,250 108,750 435,000 $ 5,256,250 Diff: M Change in incremental pre-tax profits = $231,250 I = ? | | 25,000 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 31 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? 12 | -2,270.83 -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Cash discounts CI Answer: c Diff: E No discounts with old policy; 2% discount with new policy (2/10, net 30) Discount = $15,500,000(0.5)(0.02) = $155,000 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 32 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Bad debt losses Answer: d Bad debt losses old: (0.05)($15,000,000) = $750,000 Bad debt losses new: (0.04)($15,500,000) = $620,000 Changes in bad debt losses = $620,000 - $750,000 = -$130,000 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 33 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? Diff: E -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 Cost of carrying receivables CI Answer: a DSO0 = 60 days; DSON = 30 days = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Diff: M Sales at $15,000,000: 60($15,000,000/360)(0.6)(0.15) = $225,000 Sales at $15,500,000: 30($15,500,000/360)(0.6)(0.15) = $116,250 Change = $116,250 - $225,000 = -$108,750 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 34 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 Incremental profits Analysis of policy change: -13,636.36 Sales Discounts Net sales Production costs Profit before credit costs Cost of carrying receivables Bad debt losses Pre-tax profits CI Answer: a Current Projections $15,000,000 $15,000,000 9,000,000 Effect of Credit Policy Change +$500,000 - 155,000 +$345,000 - 300,000 New Projections $15,500,000 155,000 $15,345,000 9,300,000 $ 6,000,000 +$ 45,000 $ 6,045,000 225,000 750,000 $ 5,025,000 + 108,750 + 130,000 +$283,750 116,250 620,000 $ 5,308,750 Change in incremental pre-tax profits = +$283,750 I = ? | | 25,000 -2,270.83 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 35 2,000.00 12 | -2,270.83 -3,030.30 + 606.06 -2,424.24 Diff: M I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 short-term financing -13,636.36 Cost of Answer: d Diff: M CI Bank loan: With account: 12%/(1 - 0.12 - 0.10) = 15.38% Without account: 12%/(1 - 0.12 - 0.20) = 17.65% Trade credit: Approximately: (1%/99%)[360/(40 - 10)] = 12.12% Effective rate: (1.0101)12 - 1.0 = 12.82% I = ? | | 25,000 -2,270.83 I = ? 12 | -2,270.83 3,030.30 - 424.24 discount interest - 606.06 comp balance 36 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 - 1,636.36 discount interest 12,000.00 short-term financing -13,636.36 CI Cost of Answer: c Diff: M Simple interest: EAR = 15% Nominal interest, daily compounding: EAR = = 13.88% 9% add-on, 12 mos payments: a Total amount to be repaid is $25,000 principal, plus 0.09($25,000) = $2,250 of interest, or $27,250 b The monthly payment = $27,250/12 = $2,270.83 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 c d With a financial calculator, enter N = 12; PV = 25,000; PMT = -2,270.83; and FV = to solve for I = 1.3514% However, this is a monthly rate EARAdd-on = (1.013514)12 - = 17.48% The difference between the highest and lowest EAR is 17.48% - 13.88% = 3.60% I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 37 2,000.00 I = ? -3,030.30 + 606.06 -2,424.24 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? -14,492.75 + 2,898.55 -11,594.20 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 Change in credit CI Answer: e Diff: T DSO0 = 30 days; DSON = 50 days; no discounts policy Calculate cost of carrying receivables at current and new sales levels: = DSO(Sales/Day)(Variable cost ratio)(Cost of funds) Sales at $1,000,000: Sales at $1,200,000: 30($1,000,000/360)(0.8)(0.15) = $10,000 50($1,200,000/360)(0.8)(0.15) = $20,000 Analysis of policy changes: Current Effect of Credit Projections Policy Change New Projections Net sales Production costs Profit before credit costs Cost of carrying receivables Bad debt losses* Pre-tax profits $1,000,000 800,000 +$200,000 - 160,000 $1,200,000 960,000 $ 200,000 +$ 40,000 $ 240,000 $ 10,000 20,000 710,000 - 10,000 - 10,000 +$ 20,000 $ 20,000 30,000 190,000 *Bad debt losses old: Bad debt losses new: $1,000,000(0.02) = $20,000 $1,000,000(0.02) + $200,000(0.05) = $30,000 The annual incremental pre tax profit with the change in policy is $20,000 I = ? 3,030.30 - 424.24 discount interest - 606.06 comp balance 38 2,000.00 I = ? 14,492.75 - 1,594.20 discount interest - 2,898.55 comp balance 10,000.00 I = ? 90,361 - 6,325 discount interest - 9,036 comp balance 75,000 I = ? -3,030.30 + 606.06 -2,424.24 -14,492.75 + 2,898.55 -11,594.20 -90,361 + 9,036 -81,325 13,636.36 -13,636.36 - 1,636.36 discount interest 12,000.00 I = ? 12 | | | 25,000 -2,270.83 -2,270.83 Effective interest rate CI Answer: d Calculate total to be repaid and quarterly payments Total to be repaid = $12,000(1.1019) = $13,222.80 Quarterly payment = $13,222.80/4 = $3,305.70 Diff: T Tabular solution: PV = $12,000 = $3,305.70(PVIFAi,4) (PVIFAi,4) = 3.6301 i 4.0% EAR = 1.0(FVIF4%,4) - 1.0 = 1.1699 - 1.0 = 0.1699 = 16.99% Financial calculator solution: Calculate the nominal interest rate per period Inputs: N = 4; PV = -12,000; PMT = 3,305.71; FV = Output: I = 4.0% Calculate EAR using periodic rate and interest rate conversion feature Nominal annual rate = NOM% = 4.0% = 16.0% Inputs: NOM% = 16; P/YR = Output: EFF% = 16.99% ... amount by April 1st Choosing a bank CI Answer: e Diff: M 16 Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a b c d e Convenience of location... additional $50,000 to support an expansion of fixed assets This amount could be raised by making greater use of trade credit or by arranging a bank loan The banker has offered to loan the money at 12 percent... the bank The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in equal quarterly payments What is the effective rate of
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