Personal Finance Problem

P16–10Unsecured sources of short-term loans John Savage has obtained a short-term loan from First Carolina Bank. The loan matures in 180 days and is in the amount of $45,000. John needs the money to cover start-up costs in a new business. He hopes to have sufficient backing from other investors in 6 months. First Carolina Bank offers John two financing options for the $45,000 loan: a fixed-rate loan at 2.5% above prime rate or a variable-rate loan at 1.5% above prime.

LG 3

Currently, the prime rate of interest is 6.5%, and the consensus interest rate forecast of a group of economists is as follows: Sixty days from today the prime rate will rise by 0.5%; 90 days from today the prime rate will rise another 1%; 180 days from today the prime rate will drop by 0.5%.

Using the forecast prime rate changes, answer the following questions.

  • a. Calculate the total interest cost over 180 days for a fixed-rate loan.
  • b. Calculate the total interest cost over 180 days for a variable-rate loan.
  • c. Which is the lower-interest-cost loan for the next 180 days?
P16–11Effective annual rate A financial institution made a $4 million, 1-year discount loan at 6% interest, requiring a compensating balance equal to 5% of the face value of the loan. Determine the effective annual rate associated with this loan. (Note: Assume that the firm currently maintains $0 on deposit in the financial institution.)

LG 3

P16–12Compensating balances and effective annual rates Lincoln Industries has a line of credit at Bank Two that requires it to pay 11% interest on its borrowing and to maintain a compensating balance equal to 15% of the amount borrowed. The firm has borrowed $800,000 during the year under the agreement.

LG 3

  • a. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains no deposit balances at Bank Two.
  • b. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains $70,000 in deposit balances at Bank Two.
  • c. Calculate the effective annual rate on the firm’s borrowing if the firm normally maintains $150,000 in deposit balances at Bank Two.
  • d. Compare, contrast, and discuss your findings in parts a, b, and c.
P16–13Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $150,000 for 6 months. State Bank has offered to lend the funds at a 9% annual rate subject to a 10% compensating balance. (Note: Weathers currently maintains $0 on deposit in State Bank.) Frost Finance Co. has offered to lend the funds at a 9% annual rate with discount-loan terms. The principal of both loans would be payable at maturity as a single sum.

LG 3

  • a. Calculate the effective annual rate of interest on each loan.
  • b. What could Weathers do that would reduce the effective annual rate on the State Bank loan?
P16–14Integrative: Comparison of loan terms Cumberland Furniture wishes to establish a prearranged borrowing agreement with a local commercial bank. The bank’s terms for a line of credit are 3.30% over the prime rate, and each year the borrowing must be reduced to zero for a 30-day period. For an equivalent revolving credit agreement, the rate is 2.80% over prime with a commitment fee of 0.50% on the average unused balance. With both loans, the required compensating balance is equal to 20% of the amount borrowed. (Note: Cumberland currently maintains $0 on deposit at the bank.) The prime rate is currently 8%. Both agreements have $4 million borrowing limits. The firm expects on average to borrow $2 million during the year no matter which loan agreement it decides to use.

LG 3

  • a. What is the effective annual rate under the line of credit?
  • b. What is the effective annual rate under the revolving credit agreement? (Hint: Compute the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of.)
  • c. If the firm does expect to borrow an average of half the amount available, which arrangement would you recommend for the borrower? Explain why.
P16–15Cost of commercial paper Commercial paper is usually sold at a discount. Fan Corporation has just sold an issue of 90-day commercial paper with a face value of $1 million. The firm has received initial proceeds of $978,000. (Note: Assume a 365-day year.)

LG 4

  • a. What effective annual rate will the firm pay for financing with commercial paper, assuming that it is rolled over every 90 days throughout the year?
  • b. If a brokerage fee of $9,612 was paid from the initial proceeds to an investment banker for selling the issue, what effective annual rate will the firm pay, assuming that the paper is rolled over every 90 days throughout the year?
P16–16Accounts receivable as collateral Kansas City Castings (KCC) is attempting to obtain the maximum loan possible using accounts receivable as collateral. The firm extends net-30-day credit. The amounts that are owed KCC by its 12 credit customers, the average age of each account, and the customer’s average payment period are as shown in the following table.

LG 5

Customer Account receivable Average age of account Average payment period of customer
A $37,000 40 days 30 days
B  42,000 25 50
C  15,000 40 60
D   8,000 30 35
E  50,000 31 40
F  12,000 28 30
G  24,000 30 70
H  46,000 29 40
I   3,000 30 65
J  22,000 25 35
K  62,000 35 40
L  80,000 60 70
  • a. If the bank will accept all accounts that can be collected in 45 days or less as long as the customer has a history of paying within 45 days, which accounts will be acceptable? What is the total dollar amount of accounts receivable collateral? (Note: Accounts receivable that have an average age greater than the customer’s average payment period are also excluded.)
  • b. In addition to the conditions in part a, the bank recognizes that 5% of credit sales will be lost to returns and allowances. Also, the bank will lend only 80% of the acceptable collateral (after adjusting for returns and allowances). What level of funds would be made available through this lending source?
P16–17Accounts receivable as collateral Springer Products wishes to borrow $80,000 from a local bank using its accounts receivable to secure the loan. The bank’s policy is to accept as collateral any accounts that are normally paid within 30 days of the end of the credit period as long as the average age of the account is not greater than the customer’s average payment period. Springer’s accounts receivable, their average ages, and the average payment period for each customer are shown in the following table. The company extends terms of net 30 days.

LG 5

Customer Account receivable Average age of account Average payment period of customer
A $20,000 10 days 40 days
B   6,000 40 35
C  22,000 62 50
D  11,000 68 65
E   2,000 14 30
F  12,000 38 50
G  27,000 55 60
H  19,000 20 35
  • a. Calculate the dollar amount of acceptable accounts receivable collateral held by Springer Products.
  • b. The bank reduces collateral by 10% for returns and allowances. What is the level of acceptable collateral under this condition?
  • c. The bank will advance 75% against the firm’s acceptable collateral (after adjusting for returns and allowances). What amount can Springer borrow against these accounts?
P16–18Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed the accounts receivable of Scientific Software, Inc. The bank has chosen eight accounts totaling $134,000 that it will accept as collateral. The bank’s terms include a lending rate set at prime plus 3% and a 2% commission charge. The prime rate currently is 8.5%.

LG 3 LG 5

  • a. The bank will adjust the accounts by 10% for returns and allowances. It then will lend up to 85% of the adjusted acceptable collateral. What is the maximum amount that the bank will lend to Scientific Software?
  • b. What is Scientific Software’s effective annual rate of interest if it borrows $100,000 for 12 months? For 6 months? For 3 months? (Note: Assume a 365-day year and a prime rate that remains at 8.5% during the life of the loan.)
P16–19Factoring Blair Finance factors the accounts of the Holder Company. All eight factored accounts are shown in the following table, with the amount factored, the date due, and the status on May 30. Indicate the amounts that Blair should have remitted to Holder as of May 30 and the dates of those remittances. Assume that the factor’s commission of 2% is deducted as part of determining the amount of the remittance.

LG 5

Account Amount Date due Status on May 30
A $200,000 May 30 Collected May 15
B   90,000 May 30 Uncollected
C  110,000 May 30 Uncollected
D   85,000 June 15 Collected May 30
E  120,000 May 30 Collected May 27
F  180,000 June 15 Collected May 30
G   90,000 May 15 Uncollected
H   30,000 June 30 Collected May 30
P16–20Inventory financing Raymond Manufacturing faces a liquidity crisis: It needs a loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firm’s accounts receivable are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Note: Assume a 365-day year.)

LG 1 LG 6

  • (1) City-Wide Bank will make a $100,000 trust receipt loan against the finished goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
  • (2) Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month period at an annual interest rate of 13%.
  • (3) Citizens’ Bank and Trust will lend $100,000 against a warehouse receipt on the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be levied against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.
  • a. Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
  • b. Which plan do you recommend? Why?
  • c. If the firm had made a purchase of $100,000 for which it had been given terms of 2/10 net 30, would it increase the firm’s profitability to give up the discount and not borrow as recommended in part b? Why or why not?
P16–21ETHICS PROBLEM Rancco, Inc., reported total sales of $73 million last year, including $13 million in revenue (labor, sales to tax-exempt entities) exempt from sales tax. The company collects sales tax at a rate of 5%. In reviewing its information as part of its loan application, you notice that Rancco’s sales tax payments show a total of $2 million in payments over the same time period. What are your conclusions regarding the financial statements that you are reviewing? How might you verify any discrepancies?

LG 2

 

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