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Chapter 27 Banking RelationshipsANSWERS TO END-OF-CHAPTER QUESTIONS

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Summary

This chapter discussed granting credit and the conventions for interest rates on bank loans. It is important to monitor the results of credit policy by monitoring accounts receivable. A firm can affect its level of accounts receivable by changing its credit and collections policy, but doing so also affects sales. Therefore, a complete analysis of the effects of changes in credit policy is necessary. The key concepts covered are listed below:

• A firm’s credit policy consists of four elements: (1) credit period,(2) discounts given for early payment, (3) credit standards, and (4) collection policy. The first two, when combined, are called the credit terms.

• Additional factors that influence a firm’s overall credit policy are (1) profit potential and (2) legal considerations.

• The basic objective of the credit manager is to increase profitable sales by extending credit to worthy customers and therefore adding value to the firm.

• Firms can use days sales outstanding (DSO)and aging schedules to help monitor their receivables position, but the best way to monitor aggregate receivables is the payments pattern approach. The primary tool in this approach is the uncollected balances schedule.

• If a firm eases its credit policy by lengthening the credit period, relaxing its credit standards and collection policy, and offering (or raising) its cash dis-count, its sales should increase. However, its costs will also increase. A firm should ease its credit policy only if the costs of doing so will be offset by higher expected revenues. In general, credit policy changes should be evaluated on the basis of incremental profits.

• Changes in credit policy can be analyzed in two ways. First, pro forma income statements can be constructed for both the current and the proposed policies.

Second, equations can be used to estimate the incremental change in profits resulting from a proposed new credit policy.

• With a regular, or simple, interest loan interest is not compounded; that is, interest is not earned on interest.

• In a discount interest loan, the bank deducts the interest in advance. Interest is calculated on the face amount of the loan but it is paid in advance.

• Installment loans are typically add-on interest loans. Interest is calculated and added to the funds received to determine the face amount of the loan.

• The annual percentage rate (APR)is a rate reported by banks and other lenders on loans when the effective periodic rate exceeds the nominal periodic rate of interest.

Questions

(27-1) Define each of the following terms:

a. Cash discounts

b. Seasonal dating

c. Aging schedule; days sales outstanding (DSO)

d. Payments pattern approach, uncollected balances schedule

e. Simple interest; discount interest, add-on interest

(27-2) Suppose that a firm makes a purchase and receives the shipment on February 1.

The terms of trade as stated on the invoice read “2/10, net 40, May 1 dating.” What is the latest date on which payment can be made and the discount still be taken? What is the date on which payment must be made if the discount is not taken?

(27-3) Is it true that if a firm calculates its days sales outstanding, it has no need for an aging schedule?

(27-4) Firm A had no credit losses last year, but 1 percent of Firm B’s accounts receivable proved to be uncollectible and resulted in losses. Should Firm B fire its credit man-ager and hire A’s?

(27-5) Indicate by a (

---

), (

---

), or (0) whether each of the following events would proba-bly cause accounts receivable (A/R), sales, and profits to increase, decrease, or be affected in an indeterminate manner:

A/R        Sales     Profits

The firm tightens its credit standards.                                                                     ______ ______ ______

The terms of trade are changed from 2/10, net 30, to 3/10, net 30.           ______ ______ ______

The terms are changed from 2/10, net 30, to 3/10, net 40.                            ______ ______ ______

The credit manager gets tough with past-due accounts.                                                ______ ______ ______

Problems

(27-1) The Boyd Corporation has annual credit sales of $1.6 million. Current expenses for the collection department are $35,000, bad debt losses are 1.5 percent, and  the days sales outstanding is 30 days. The firm is considering easing its collection efforts such that collection expenses will be reduced to $22,000 per year. The change is expected to increase bad debt losses to 2.5 percent and to increase the days sales outstanding to 45 days. In addition, sales are expected to increase to $1,625,000 per year.

Should the firm relax collection efforts if the opportunity cost of funds is 16 percent, the variable cost ratio is 75 percent, and taxes are 40 percent?

(27-2) Kim Mitchell, the new credit manager of the Vinson Corporation, was alarmed to find that Vinson sells on credit terms of net 90 days while industrywide credit terms have recently been lowered to net 30 days. On annual credit sales of $2.5 million, Vinson currently averages 95 days of sales in accounts receivable. Mitchell estimates that tightening the credit terms to 30 days would reduce annual sales to $2,375,000, but accounts receivable would drop to 35 days of sales and the sav-ings on investment in them should more than overcome any loss in profit.

Vinson’s variable cost ratio is 85 percent, and taxes are 40 percent. If the interest rate on funds invested in receivables is 18 percent, should the change in credit terms be made?

(27-3) The Russ Fogler Company, a small manufacturer of cordless telephones, began operations on January 1, 2004. Its credit sales for the first 6 months of operations were as follows:

Month                  Credit Sales

January                $ 50,000

February              100,000

March                   120,000

April                       105,000

May                       140,000

June                      160,000

Throughout this entire period, the firm’s credit customers maintained a constant payments pattern: 20 percent paid in the month of sale, 30 percent paid in the month following the sale, and 50 percent paid in the second month following the sale.

a.       What was Fogler’s receivables balance at the end of March and at the end of June?

b.      Assume 90 days per calendar quarter. What were the average daily sales (ADS) and days sales outstanding (DSO) for the first quarter and for the second quarter? What were the cumulative ADS and DSO for the first half-year?

c.       Construct an aging schedule as of June 30. Use account ages of 0–30, 31–60, and 61–90 days.

d.      Construct the uncollected balances schedule for the second quarter as of June 30.

(27-4) On March 1, Minnerly Motors obtained a business loan from a local bank. The loan is a $25,000 interest-only loan with a nominal rate of 11 percent. Interest is calculated on a simple interest basis with a 365-day year. What is Minnerly’s interest charge for the first month (assuming 31 days in the month)?

(27-5) Mary Jones recently obtained an equipment loan from a local bank. The loan is for $15,000 with a nominal interest rate of 11 percent. However, this is an installment loan, so the bank also charges add-on interest. Mary must make monthly payments on the loan, and the loan is to be repaid in 1 year. What is the effective annual rate on the loan (assuming a 365-day year)?

(27-6) Del Hawley, owner of Hawley’s Hardware, is negotiating with First City Bank for a 1-year loan of $50,000. First City has offered Hawley the following alternatives. Calculate the effective annual interest rate for each alternative. Which alternative has the lowest effective annual interest rate?

a. A 12 percent annual rate on a simple interest loan, with no compensating balance required and interest due at the end of the year.

b. A 9 percent annual rate on a simple interest loan, with a 20 percent compensating balance required and interest due at the end of the year.

c. An 8.75 percent annual rate on a discounted loan, with a 15 percent compensating balance.

d. Interest is figured as 8 percent of the $50,000 amount, payable at the end of the year, but the $50,000 is repayable in monthly installments during the year.

(27-7) The D. J. Masson Corporation needs to raise $500,000 for 1 year to supply working capital to a new store. Masson buys from its suppliers on terms of 3/10, net 90, and it currently pays on the 10th day and takes discounts, but it could forgo discounts, pay on the 90th day, and get the needed $500,000 in the form of costly trade credit. Alternatively, Masson could borrow from its bank on a 12 percent discount interest rate basis. What is the effective annual interest rate of the lower cost source?

(27-8) Yonge Corporation must arrange financing for its working capital requirements for the coming year. Yonge can (a) borrow from its bank on a simple interest basis (interest payable at the end of the loan) for 1 year at a 12 percent nominal rate;

(b) borrow on a 3-month, but renewable, loan basis at an 11.5 percent nominal rate; (c) borrow on an installment loan basis at a 6 percent add-on rate with 12 end-of-month payments; or (d) obtain the needed funds by no longer taking dis-counts and thus increasing its accounts payable. Yonge buys on terms of 1/15, net 60. What is the effective annual cost (not the nominal cost) of the least expensive type of credit, assuming 360 days per year?

(27-9) Gifts Galore Inc. borrowed $1.5 million from National City Bank. The loan was made at a simple annual interest rate of 9 percent a year for 3 months. A 20 per-cent compensating balance requirement raised the effective interest rate.

a. The nominal annual rate on the loan was 11.25 percent. What is the true effective rate?

b. What would be the effective cost of the loan if the note required discount interest?

c. What would be the nominal annual interest rate on the loan if the bank did not require a compensating balance but required repayment in 3 equal monthly installments?

(27-10) Malone Feed and Supply Company buys on terms of 1/10, net 30, but it has not been taking discounts and has actually been paying in 60 rather than 30 days. Assume that the accounts payable are recorded at full cost, not net of discounts.

Malone’s balance sheet follows (thousands of dollars):

Cash                                      $ 50                                                                        Accounts payable                            $ 500

Accounts receivable       450                                                                         Notes payable                                   50

Inventory                            750                                                                         Accruals                                               50

Current assets                   $1,250                                                                   Current liabilities                              $ 600

Long-term debt                                150

Fixed assets                       750                                                                         Common equity                               1,250

Total assets                        $2,000                                                                   Total liabilities and equity             $2,000

Now, Malone’s suppliers are threatening to stop shipments unless the company begins making prompt payments (that is, paying in 30 days or less). The firm can borrow on a 1-year note (call this a current liability) from its bank at a rate of 15 percent, discount interest, with a 20 percent compensating balance required. (Malone’s $50,000 of cash is needed for transactions; it cannot be used as part of the compensating balance.)

a. How large would the accounts payable balance be if Malone takes discounts? If it does not take discounts and pays in 30 days?

b. How large must the bank loan be if Malone takes discounts? If Malone doesn’t take discounts?

c. What are the nominal and effective costs of non free trade credit? What is the effective cost of the bank loan? Based on these costs, what should Malone do?

d. Assume that Malone forgoes the discount and borrows the amount needed to become current on its payables. Construct a pro forma balance sheet based on this decision. (Hint: You will need to include an account called “prepaid interest” under current assets.)

e. Now assume that the $500,000 shown on the balance sheet is recorded net of discounts. How much would Malone have to pay its suppliers to reduce its accounts payables to $250,000? If Malone’s tax rate is 40 percent, what is the effect on its net income due to the lost discount when it reduces its accounts payable to $250,000? How much would Malone have to borrow? (Hint: Ma-lone will receive a tax deduction due to the lost discount, which will affect the amount it must borrow.) If Malone’s tax rate is 40 percent, what is the effect on its net income due to the lost discount when it reduces its accounts payable to $250,000? Construct a pro forma balance sheet based on this scenario.

(Hint: You will need to include an account called “prepaid interest” under current assets and adjust retained earnings by the after-tax amount of the lost discount.)

(27-11) Sun coast Boats Inc. estimates that because of the seasonal nature of its business, it will require an additional $2 million of cash for the month of July. Sun coast Boats has the following 4 options available for raising the needed funds:

(1) Establish a 1-year line of credit for $2 million with a commercial bank.

The commitment fee will be 0.5 percent per year on the unused portion, and the interest charge on the used funds will be 11 percent per annum.

Assume that the funds are needed only in July and that there are 30 days in July and 360 days in the year.

(2) Forgo the trade discount of 2/10, net 40, on $2 million of purchases during July.

(3) Issue $2 million of 30-day commercial paper at a 9.5 percent per annum interest rate. The total transaction fee, including the cost of a backup credit line, on using commercial paper is 0.5 percent of the amount of the issue.

(4) Issue $2 million of 60-day commercial paper at a 9 percent per annum interest rate, plus a transaction fee of 0.5 percent. Since the funds are required for only 30 days, the excess funds ($2 million) can be invested in 9.4 percent per annum marketable securities for the month of August.

The total transactions cost of purchasing and selling the marketable securities is 0.4 percent of the amount of the issue.

a. What is the dollar cost of each financing arrangement?

b. Is the source with the lowest expected cost necessarily the one to select? Why or why not?