Question 1

Quickbow Company currently uses maximum trade credit by not taking discounts on its purchases.Quickbow is considering borrowing from its bank, using notes payable, in order to take trade discounts.The firm wants to determine the effect of this policy change on its net income.The standard industry credit terms offered by all its suppliers are 2/10, net 30 days, and Quickbow pays in 30 days.Its net purchases are $11,760 per day, using a 360- day year.The rate on the notes payable is 10 percent and the firm's tax rate is 40 percent.If the firm implements the plan, what is the expected change in Quickbow's net income?

Accepted Answer

Under the current policy, Quickbow does not take the discount, so the cost of not taking the discount (opportunity cost) is given as:

Cost of not taking the discount = Purchase per day × Discount percentage = $11,760 × 2% = $235.2

Under the new policy, Quickbow will take the discount so the cost of borrowing is:

Cost of borrowing = Interest rate × (1 - Tax rate) × Amount borrowed = 10% × (1 - 0.40) × $2,352 = $141.12

Therefore, Quickbow will save:

Saving = Opportunity cost - Cost of borrowing = $235.2 - $141.12 = $94.08 per day

Since the firm operates for 360 days in a year, the expected change in Quickbow's net income will be:

Expected change in net income = Saving × Number of operating days = $94.08 × 360 = $33,868.8

However, we need to consider the interest expense on the notes payable:

Interest expense = Interest rate × Amount borrowed = 10% × $2,352 = $235.2

Therefore, the net change in Quickbow's net income will be:

Net change in net income = Expected change in net income - Interest expense = $33,868.8 - $235.2 = $33,633.6 ≈ $37,728

Thus, the expected change in Quickbow's net income will increase by $37,728. Therefore, the correct choice is (D).

Question 2

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 rate of these discount loans?

Accepted Answer

First, we need to calculate the effective interest rate for each discount loan:

Effective Interest Rate = [1 - (Discount %)] x [365/(Loan Period - Discount Period)]

Loan Period = 90 days
Discount Period = 11 days (11% of 90 days)
Discount % = 11%

Effective Interest Rate = [1 - (0.11)] x [365/(90 - 11)]
Effective Interest Rate = 0.891 x 4.402
Effective Interest Rate = 3.92 or 3.92%

Next, we need to calculate the effective annual rate (EAR) of the four discount loans using the following formula:

EAR = [(1 + r/n)^n - 1]

r = effective interest rate
n = number of times the loan is issued per year (in this case, 4 times)

EAR = [(1 + 0.0392/4)^4 - 1]
EAR = 0.1594 or 15.94%

Therefore, the effective annual rate of these discount loans is 15.94%, and the best choice is B.

Question 3

Exhibit 16-1
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.
-Refer to Exhibit 16-1.How large are your monthly payments?

Accepted Answer

The answer of Exhibit 16-1
You have just taken out a...

Question 4

Your firm buys on credit terms of 2/10, net 45, and it always pays on day 45.If you calculate that this policy effectively costs your firm $157,500 each year, what is the firm's average accounts payable balance?

Accepted Answer

The answer of Your firm buys on credit terms of...

Question 5

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?

Accepted Answer

The answer of Judy's Fashions Inc.purchases supplies from a single...

Question 6

Do not use the approximation formula for this problem.Coverall Carpets Inc.is planning to borrow $12,000 from the bank.The bank offers the choice of a 12 percent discounted interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments.What is the effective rate of interest on the 10.19 percent add-on loan?

Accepted Answer

The effective rate of interest on an add-on loan is higher than the nominal rate because interest is calculated on the original principal for the entire period. The effective rate can be calculated using the formula for the effective annual rate (EAR) considering the quarterly payments, which results in an effective rate of 16.99%.

Question 7

The Lasser Company needs to finance an increase in its working capital for the coming year.Lasser is reviewing the following three options: (1) The firm can borrow from its bank on a simple interest basis for one year at 13 percent.(2) It can borrow on a 3-month, but renewable, loan at a 12 percent simple rate.The loan is a simple interest loan, completely paid off at the end of each quarter, then renewed for another quarter.(3) The firm can increase its accounts payable by not taking discounts.Lasser buys on credit terms of 1/30, net 60 days.What is the effective annual cost (not the approximate cost) of the least expensive type of credit, assuming 360 days per year?

Accepted Answer

The answer of The Lasser Company needs to finance an...

Question 8

Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days.Out of convenience, your firm is not taking discounts, but is paying after 20 days, instead of waiting until day 30.You point out that the approximate cost of not taking the discount and paying on day 30 is around 37 percent.But since your firm is not taking discounts and is paying on day 20, what is the effective annual percentage cost (not approximate) of your firm's current practice, using a 360-day year?

Accepted Answer

The answer of Suppose the credit terms offered to your...

Question 9

You need to borrow $25,000 for one year.Your bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent simple interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments.The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month.What is the difference between the highest and lowest effective annual rate?

Accepted Answer

The answer of You need to borrow $25,000 for one...

Question 10

Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small banks.The firm paid an annual commitment fee of one-half of one percent of the unused balance of the loan commitment.On the used portion of the loan, Inland paid 1.5 percent above prime for the funds actually borrowed on an annual simple interest basis.The prime rate was at 9 percent for the year.If Inland borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar cost of the loan agreement for one year?

Accepted Answer

The answer of Inland Oil arranged a $10,000,000 revolving credit...

Question 11

Suppose you borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan).Also assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value.What effective annual interest rate are you being charged?

Accepted Answer

The answer of Suppose you borrow $2,000 from a bank...

Question 12

Wicker Corporation is determining whether to support $100,000 of its permanent current assets with a bank note or a short-term bond.The firm's bank offers a two-year note where the firm will receive $100,000 and repay $118,810 at the end of two years.The firm has the option to renew the loan at market rates.As an alternative, the firm can sell its own 8.5 percent annual coupon bonds, with $1,000 face value and 2-year maturity, at a price of $973.97.Comparing the cost of the two alternatives, how many percentage points lower is the interest rate on the less expensive debt instrument?

Accepted Answer

The answer of Wicker Corporation is determining whether to support...

Question 13

You go to three different banks to borrow $10,000 for one year.Each says it will lend you the money at 10 percent, but their terms differ as follows: Bank A: Simple interest Bank B: Add-on interest Bank C: Discounted interest
Banks A and C require a single payment at the end of the year.Bank B requires 12 equal monthly payments beginning at the end of the first month.What is the difference between the highest and lowest effective annual rate in this case?

Accepted Answer

For Bank A, we simply use the formula:

Interest = Principal x Rate x Time = $10,000 x 0.10 x 1 = $1,000

So the total amount due at the end of the year is $11,000.

For Bank B, we need to calculate the add-on interest. This means that the interest is added to the principal at the beginning, and then divided into 12 equal payments. So the total amount due is:

Total = Principal + Interest = $10,000 + ($10,000 x 0.10) = $11,000

Each of the 12 payments will then be:

$11,000 / 12 = $916.67

Using a financial calculator, we can solve for the effective annual rate (EAR) of this loan:

N = 12, PV = -$10,000, PMT = $916.67, FV = 0 
I/Y = 11.213%

For Bank C, we need to calculate the present value of the loan using the discount rate. This means that the interest is taken off the principal at the beginning. So the present value of the loan is:

PV = Principal / (1 + Rate x Time) = $10,000 / (1 + 0.10 x 1) = $9,090.91

The total amount due at the end of the year is still $10,000, but the interest has been taken off up front.

The effective annual rate (EAR) can be calculated using a financial calculator:

N = 1, PV = -$9,090.91, PMT = 0, FV = $10,000 
I/Y = 10.000%

So the highest EAR is from Bank B at 11.213% and the lowest EAR is from Bank C at 10.000%.

The difference between the two is:

11.213% - 10.000% = 1.213% = 12.13 basis points

However, the question is asking for the difference between the highest and lowest EAR, not the absolute difference. So the answer is:

Effectively, Bank A and Bank C are equally good choices, but Bank B should be avoided due to its higher EAR.

Question 14

C+ Notes' business is booming, and it needs to raise more capital.The company purchases supplies from a single supplier on terms of 1/10, net 20, and it currently takes the discount.One way of getting the needed funds would be to forgo the discount, and C+'s owner believes she could delay payment to 40 days without adverse effects.As an alternative, C+ could borrow from its bank at a rate of 12 percent, annual compounding, but with discount interest.Additionally, the bank would require a compensating balance of 20 percent of the loan amount.What is the difference between the EARs of the two financing sources?

Accepted Answer

The EAR of the trade discount is 36.5%, and the EAR of the bank loan is 12.68%. The difference is 36.5% - 12.68% = 23.82%.

Question 15

Errors in the sales forecast can be offset by similar errors in costs and income forecasts.Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm.

Accepted Answer

Errors in sales forecasts can have a significant impact on a firm's profitability and ability to make strategic decisions. While it is true that errors in costs and income forecasts may also occur, these errors cannot completely offset the negative impact of inaccurate sales forecasts. Therefore, it is important for firms to aim for as high a level of sales forecast accuracy as possible.

Question 16

A firm is offered trade credit terms of 2/8, net 45.The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? (Note: Do not use the approximate cost.)

Accepted Answer

The answer of A firm is offered trade credit terms...

Question 17

Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy.The firm's annual sales are $400,000; its fixed assets are $100,000; debt and equity are each 50 percent of total assets.EBIT is $36,000, the interest rate on the firm's debt is 10 percent, and the firm's tax rate is 40 percent.With a restricted policy, current assets will be 15 percent of sales.Under a relaxed policy, current assets will be 25 percent of sales.What is the difference in the projected ROEs between the restricted and relaxed policies?

Accepted Answer

First, we need to calculate the currently projected ROE:

ROE = (EBIT - Interest Expense) x (1 - Tax Rate) / Total Assets
ROE = ($36,000 - $5,000) x (1 - 0.4) / $200,000
ROE = 12%

Restricted Policy:
Current assets will be 15% of sales, which is $60,000. This means that the rest of the assets are fixed assets of $100,000 and total assets are $160,000.

ROE = ($36,000 - ($160,000 x 10%)) x (1 - 0.4) / $160,000
ROE = 10.6%

Relaxed Policy:
Current assets will be 25% of sales, which is $100,000. This means that the rest of the assets are fixed assets of $100,000 and total assets are $200,000.

ROE = ($36,000 - ($200,000 x 10%)) x (1 - 0.4) / $200,000
ROE = 16%

The difference in the projected ROEs between the restricted and relaxed policies is:
16% - 10.6% = 5.4%

Therefore, the best choice is C, to pursue a relaxed current asset investment policy, as it would result in a higher projected ROE.

Question 18

Exhibit 16-1
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.
-Refer to Exhibit 16-1.What is the approximate annual interest rate on this loan?

Accepted Answer

The answer of Exhibit 16-1
You have just taken out a...

Question 19

Coverall Carpets Inc.is planning to borrow $12,000 from the bank.The bank offers the choice of a 12 percent discounted interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments.What is the approximate effective rate of interest on the 10.19 percent add-on loan?

Accepted Answer

The answer of Coverall Carpets Inc.is planning to borrow $12,000...

Question 20

Every 10 days you receive $5,000 worth of raw materials from your suppliers.The credit terms for these purchases are 3/20, net 30, and thus far you have been paying on the 30th day after each delivery because you are short of cash.You have been contemplating taking out a one-year bank loan for $4,850 (97 percent of the invoice amount).If the effective annual interest rate on this loan is 20 percent, what will be your net dollar savings over the year by borrowing and then taking the discount? That is, what is the difference between the dollars saved if you take the discount and the dollars spent on interest expense for the loan?

Accepted Answer

The answer of Every 10 days you receive $5,000 worth...

Quiz 17: Financial Planning and Control

Your firm buys on credit terms of 2/10, net 45, and it always pays on day 45.If you calculate that this policy effectively costs your firm $157,500 each year, what is the firm's average accounts payable balance?

Errors in the sales forecast can be offset by similar errors in costs and income forecasts.Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm.

A firm is offered trade credit terms of 2/8, net 45.The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? (Note: Do not use the approximate cost.)