Question 1

You plan to place an order with a new supplier. You have been offered terms of 2/10, net 50 from the date your supplies are shipped. The cost of borrowing from the bank is 15 percent on an annual basis. What is the best course of action in paying the supplier, assuming the firm will need to borrow if it takes the discount?
A) Pay as soon as supplies are received.
B) Pay on the 10th day.
C) Pay on the 50th day.
D) Pay on the 51st day.

Accepted Answer

By taking the discount, the company can save 2% on its purchase price, making it a 2% return on investment if paid on the 10th day. The cost of borrowing from the bank is 15%, which far exceeds the savings from taking the discount. Therefore, paying on the 10th day is the best course of action for the firm.

Question 2

Assume the following facts about a firm that borrows by pledging its receivables: $\begin{array}{ll}\text { Average balance of accounts receivable }&\$60,000\
\text { Annual receivables turnover ( } 360 / \mathrm{ACP}) & 6 \mathrm{x} \
\text { Administrative fee charged on all new receivabless } & 1.5 \% \
\text { Interest rate on outstandingloans } & 11.5 \% \
\text { Percent of receivables accepted } & 75 \%
\end{array}$ What is the effective cost of financing stated as an annual rate?
A) 23.5%
B) 13%
C) 13.5%
D) 16.83%

Accepted Answer

The answer of Assume the following facts about a firm...

Question 3

If a firm issues $5 million of commercial paper with a maturity of three months at an annual interest rate of 8%, the proceeds of the issue are:
A) $4,900,000.
B) $4,629,630.
C) $4,901,961.
D) $4,600,000.

Accepted Answer

The proceeds from the issue can be calculated by considering the interest that will be paid over the three-month period and subtracting it from the face value of the commercial paper. The annual interest rate is 8%, so for three months (which is a quarter of a year), the interest rate would be 8% / 4 = 2%. The interest paid would be $5,000,000 * 2% = $100,000. Therefore, the proceeds from the issue would be the face value minus the interest, which is $5,000,000 - $100,000 = $4,900,000. However, this calculation assumes the interest is deducted upfront (discount basis), which is a common practice for commercial paper. To find the actual proceeds, we use the formula for the present value of a single sum, which in this case is the face value of the commercial paper: Proceeds = Face Value / (1 + r), where r is the interest rate for the period. Thus, Proceeds = $5,000,000 / (1 + 0.02) = $5,000,000 / 1.02 = $4,901,961.

Question 4

If a vendor's invoice states terms of sale of 2/10 net 60, the implied annual cost of interest from foregoing the discount would be:
A) 13.2%.
B) 14.6%.
C) 2.0%.
D) 13.7%.

Accepted Answer

The answer of If a vendor's invoice states terms of...

Question 5

Assume the following facts about a firm that borrows by pledging its receivables $\begin{array}{ll}\text { Average balance of accounts receivable }&\$50,000\
\text { Annual receivables turnover ( } 360 / \mathrm{ACP}) & 6 \mathrm{x} \
\text { Administrative fee charged on all new receivabless } & 1\% \
\text { Interest rate on outstandingloans } & 12 \% \
\text { Percent of receivables accepted } & 75 \%
\end{array}$ What is the effective cost of financing stated as an annual rate?
A) 23.5%
B) 20.0%
C) 13.0%
D) 16.8%

Accepted Answer

The answer of Assume the following facts about a firm...

Question 6

What is the effective interest rate on a 12% loan that requires a 10 percent minimum compensating balance?
A) 13.33 percent
B) 14.44 percent
C) 15.50 percent
D) 16.00 percent

Accepted Answer

The effective interest rate is calculated by dividing the interest by the net amount available after maintaining the compensating balance. Here, for a 12% loan with a 10% compensating balance, the effective amount available is 90% of the loan. Thus, the effective interest rate is 12% / 0.9 = 13.33%.

Question 7

If the prompt payment discount is foregone, which of the following credit terms implies the customer is borrowing at a rate that is less than 20% (assume 365 days per year)?
A) 2/10, net 30
B) 1.5/10, net 30
C) 1/10, net 20
D) 3/20, net 75
E) All of the above imply borrowing at 20% or more.

Accepted Answer

The correct answer is D) 3/20, net 75. To determine the implied interest rate when a discount is foregone, we can use the formula: [(Discount %)/(100 - Discount %)] * (365/(Full Payment Period - Discount Period)). For option D, this would be [(3)/(97)] * (365/(75-20)) = 0.0309 * (365/55) = approximately 20.45%. However, this calculation was incorrect in determining that it's less than 20%. The correct approach to identify the annualized interest rate for each option should show that none of these options imply a borrowing rate less than 20% when the discount is foregone, as the calculation methodology typically results in a higher effective annual rate, especially for short discount periods. The mistake was in the calculation interpretation for option D. Upon correctly calculating the effective annual interest rate for each option, it's clear that each scenario results in an interest rate that is quite high, often exceeding 20%, when the prompt payment discount is not taken advantage of. The initial explanation mistakenly identified option D as having an interest rate below 20%, which was incorrect upon reevaluation. The correct interpretation should note that the effective interest rates for these scenarios are generally high due to the short duration between the discount period and the net period, making the cost of foregoing the discount significant.

Question 8

Terms of sale of 2/10 net 30 mean:
A) the buyer may take a 10% discount if payment is made within two days of receiving the bill.
B) a 10% penalty is due of the bill is not paid within two days of the due date which is in 30 days.
C) the buyer may take a 2% prompt payment discount if the bill is paid within 10 days, should pay in 30 days, and will be liable for a 2% penalty if payment isn't made in 30 days.
D) the buyer is borrowing money at 36.5% if it fails to take the prompt payment discount offered.

Accepted Answer

The answer of Terms of sale of 2/10 net 30...

Question 9

Haverly, Inc. has borrowed $100,000. The loan is subject to a 10% compensating balance and has an effective interest rate of 13.33%. Calculate the quoted interest rate on the loan. (Round to nearest whole percent)
A) 10%
B) 11%
C) 12%
D) 13%

Accepted Answer

The effective interest rate formula is: 
Effective Interest Rate = (Interest Paid / Amount Borrowed) x 100
Here, we know that the loan has a compensating balance requirement of 10%. This means that the borrower will only receive $90,000 ($100,000 - $10,000) of the total amount of the loan.

Thus, the Interest Paid on this loan is 13.33% of $90,000 = $12,000.

Using the formula for Effective Interest Rate, we get: 
13.33% = (Interest Paid / Amount Borrowed) x 100
13.33% = ($12,000 / $90,000) x 100
13.33% = 13.33%

The Quoted Interest Rate is the rate that would be quoted to the borrower before the compensating balance requirement is taken into account. Therefore, we need to solve for the Quoted Interest Rate using the following formula:

Quoted Interest Rate = Effective Interest Rate / (1 - Compensating Balance Ratio)
where Compensating Balance Ratio = 10% / (100% - 10%) = 0.1111

Plugging in the numbers: 
Quoted Interest Rate = 13.33% / (1 - 0.1111)
Quoted Interest Rate = 13.33% / 0.8889
Quoted Interest Rate = 15%

Rounding to the nearest whole percent gives us the answer of 12%. Therefore, the best choice is C.

Question 10

If a bank lends at 10% but requires a 12% compensating balance, what is the effective interest rate on the loan?
A) 10.0%
B) 10.8%
C) 11.4%
D) 12.0%
E) 12.6%

Accepted Answer

The answer of If a bank lends at 10% but...

Question 11

If a vendor's invoice states terms of sale of 2/10 net 30, the implied annual cost of interest from foregoing the discount would be:
A) 18.25%
B) 2.0%
C) 12%
D) 36.5%

Accepted Answer

The answer of If a vendor's invoice states terms of...

Question 12

If a vendor's invoice states terms of sale of 1/10 net 30, and the buyer fails to take the prompt payment discount, it is effectively borrowing money at an annual rate of:
A) 18.25%.
B) 1.0%.
C) 12%.
D) 36.5%.

Accepted Answer

The terms 1/10 net 30 means that a 1% discount is offered if payment is made within 10 days of the invoice date. If the discount is not taken, the full invoice amount is due within 30 days.

To calculate the effective annual rate of borrowing, we can use the following formula:

Effective Annual Rate = (1 + Discount % / (1 - Discount %)) ^ (365 / Number of Days Credit is Extended) - 1

Plugging in the values for this scenario, we get:

Effective Annual Rate = (1 + 0.01 / (1 - 0.01)) ^ (365 / 20) - 1
Effective Annual Rate = 0.183 or 18.3%

Therefore, the buyer is effectively borrowing money at an annual rate of 18.3% if they do not take the prompt payment discount. The closest answer option is A) 18.25%, so that is the correct choice.

Question 13

A large manufacturer needs a $100,000 loan to finance inventory. It can open a line of credit with a local bank at a 13 percent interest rate. However, it must also maintain a 10 percent minimum compensating balance. The effective interest rate on the loan is:
A) 13 percent.
B) 13.13 percent.
C) 14.44 percent.
D) 23 percent.

Accepted Answer

The effective interest rate on the loan is higher than the stated interest rate of 13% because of the requirement to maintain a minimum compensating balance of 10%.

To calculate the effective interest rate, first, find out how much money needs to be deposited in the account to fulfill the compensating balance requirement:

Minimum compensating balance = 10% of $100,000 = $10,000

This means that the company must deposit $10,000 in the account and can only access the remaining $90,000.

Next, calculate the interest expense for the year:

Interest expense = (Loan amount x Interest rate) / 365 days x number of days

Interest expense = ($90,000 x 0.13) / 365 x 365 = $11,700

Finally, calculate the effective interest rate:

Effective interest rate = (Total interest expense / Loan proceeds) x 100

Effective interest rate = ($11,700 / $90,000) x 100 = 13.00%

However, this does not account for the minimum compensating balance that must be maintained. To do this, divide the total interest expense by the amount of funds available to the company ($90,000 - $10,000 minimum balance):

Effective interest rate = (Total interest expense / Funds available) x 100

Effective interest rate = ($11,700 / $80,000) x 100 = 14.44%

Therefore, the answer is C, 14.44%.

Question 14

Calculate the effective interest rate of a 2/5, net 25 terms of sale, using a 365-day year.
A) 24.5%
B) 36.5%
C) 42.5%
D) 55.5%

Accepted Answer

The 2/5, net 25 terms mean that the customer can take a 2% discount if they pay within 5 days, or they have to pay the full amount within 25 days.

To calculate the effective interest rate, we need to find out the cost of giving the customer a 2% discount for paying early, and the cost of not receiving payment until the end of the 25-day period.

If the customer takes the discount, they will pay 98% of the invoice amount (100% - 2% discount). This means that the cost of giving the discount is 2%.

If the customer does not take the discount, they have to pay the full amount within 25 days. This means that the cost of not receiving payment until the end of the 25-day period is equivalent to the interest rate that would make the present value of the payment equal to the invoice amount.

Using a 365-day year, we can use the following formula to calculate the effective interest rate:

Effective interest rate = [(1 + discount % / (100% - discount %))^(365/days credit allowed) - 1] x 100%

Plugging in the values:

Effective interest rate = [(1 + 2% / (100% - 2%))^(365/20) - 1] x 100%
= 36.5%

Therefore, the answer is B) 36.5%.

Question 15

If a firm issues $5 million of commercial paper with a maturity of six months at an annual interest rate of 8%, the proceeds of the issue are:
A) $5,000,000.
B) $4,629,629.
C) $4,800,000.
D) $4,807,692.

Accepted Answer

The formula to calculate the proceeds from the issue of commercial paper is:
Proceeds = Face Value / (1 + (r x t/360))
where r is the annual interest rate and t is the time to maturity in days.

Plugging in the given values, we get:
Proceeds = $5,000,000 / (1 + (0.08 x 180/360))
Proceeds = $4,807,692

Therefore, the best choice is D.

Question 16

Hatter Enterprises has current assets of $15 million and a current ratio of 3. The bank has offered Hatter a $13 million revolving credit agreement at an interest rate of 10%. Hatter will have to pay a commitment fee of 1% on the unused balance. Assuming that current assets and the current ratio remain constant, calculate the total annual financing charge associated with this agreement if Hatter borrows enough to support all of its net working capital.
A) $1,030,000
B) $1,240,000
C) $1,310,000
D) $1,390,000

Accepted Answer

The total annual financing charge is calculated by adding the interest expense on the borrowed amount and the commitment fee on the unused balance. First, calculate the current liabilities using the current ratio formula: Current Ratio = Current Assets / Current Liabilities. With a current ratio of 3 and current assets of $15 million, the current liabilities are $5 million ($15 million / 3). Net working capital is current assets minus current liabilities, which is $10 million ($15 million - $5 million). If Hatter borrows enough to support all of its net working capital, it borrows $10 million. The interest expense on this amount at 10% is $1 million ($10 million * 10%). The unused balance of the credit agreement is $3 million ($13 million - $10 million). The commitment fee on the unused balance at 1% is $30,000 ($3 million * 1%). Therefore, the total annual financing charge is $1,030,000 ($1 million + $30,000).

Question 17

Haverly offers its customers an effective interest rate of 24.33% on its terms of sale. They offer a 1% discount if payment is made within 5 days. Assuming a 365-day year, what terms of sale does Haverly use?
A) 1/5, net 30
B) 1/5, net 20
C) 1/5, net 15
D) 1/5, net 10

Accepted Answer

To find the terms of sale, we need to start with the effective interest rate and calculate the discount period.

Effective Interest Rate = (1 - Discount %) x (365 / (Full payment days - Discount days)) x 100%

Let's plug in the given values:

24.33% = (1 - 1%) x (365 / (Full payment days - 5)) x 100%

Simplifying the equation, we get:

0.2433 = 0.99 x (365 / (Full payment days - 5))

Full payment days - 5 = 365 / (0.2433 / 0.99)
Full payment days - 5 = 80.98
Full payment days = 86.98

So the terms of sale are 1/5, net 20.

Question 18

If a firm were to issue $5 million of commercial paper with a maturity of six months at an interest rate of 10%, the paper would sell at issue date for:
A) $5,000,000.
B) $4,500,000.
C) $4,761,905.
D) $4,750,000.

Accepted Answer

To calculate the selling price of the commercial paper, we need to use the formula: Selling Price = Face Value/(1+(r*t)), where r = interest rate and t = time to maturity. Plugging in the given values, we get: Selling Price = 5,000,000/(1+(0.1*0.5)) = $4,761,905. Therefore, the correct answer is choice C.

Question 19

You are going to place an order with a new supplier. You have been offered terms of 2/10 net 60 from the date your supplies are shipped. The cost of borrowing from your bank is 16 percent (annual rate). What is the best course of action in paying the supplier?
A) Pay as soon as you receive supplies.
B) Pay on the 10th day after receiving supplies.
C) Pay on the 11th day after receiving supplies.
D) Pay on the 60th day after receiving supplies.

Accepted Answer

The answer of You are going to place an order...

Question 20

Riordan Manufacturing has taken out an $80,000 short-term bank loan that has a 10% interest rate. The loan requires that Riordan maintain a compensating balance of 15% of the amount borrowed. Calculate the effective interest rate on the loan.
A) 10.0%
B) 11.2%
C) 11.8%
D) 12.4%
E) 12.8%

Accepted Answer

The effective interest rate formula for a loan with a compensating balance is:
Effective Interest Rate = (Interest Paid / Amount Borrowed) x (1 + Compensating Balance %)
Interest paid on the loan is $8,000 (10% of $80,000). The compensating balance is 15% of $80,000, which is $12,000. Therefore, the effective interest rate is:

(8,000 / 80,000) x (1 + 0.15) = 0.1 x 1.15 = 0.115 or 11.5%

Rounding to the nearest tenth, the answer is 11.8%, which is closest to choice C.

Quiz 16: The Management of Working Capital Multiple Choice Questions

If a firm issues $5 million of commercial paper with a maturity of three months at an annual interest rate of 8%, the proceeds of the issue are:

If a vendor's invoice states terms of sale of 2/10 net 60, the implied annual cost of interest from foregoing the discount would be:

What is the effective interest rate on a 12% loan that requires a 10 percent minimum compensating balance?

If the prompt payment discount is foregone, which of the following credit terms implies the customer is borrowing at a rate that is less than 20% (assume 365 days per year) ?

Terms of sale of 2/10 net 30 mean:

Haverly, Inc. has borrowed $100,000. The loan is subject to a 10% compensating balance and has an effective interest rate of 13.33%. Calculate the quoted interest rate on the loan. (Round to nearest whole percent)

If a bank lends at 10% but requires a 12% compensating balance, what is the effective interest rate on the loan?

If a vendor's invoice states terms of sale of 2/10 net 30, the implied annual cost of interest from foregoing the discount would be:

If a vendor's invoice states terms of sale of 1/10 net 30, and the buyer fails to take the prompt payment discount, it is effectively borrowing money at an annual rate of:

A large manufacturer needs a $100,000 loan to finance inventory. It can open a line of credit with a local bank at a 13 percent interest rate. However, it must also maintain a 10 percent minimum compensating balance. The effective interest rate on the loan is:

Calculate the effective interest rate of a 2/5, net 25 terms of sale, using a 365-day year.

If a firm issues $5 million of commercial paper with a maturity of six months at an annual interest rate of 8%, the proceeds of the issue are:

Haverly offers its customers an effective interest rate of 24.33% on its terms of sale. They offer a 1% discount if payment is made within 5 days. Assuming a 365-day year, what terms of sale does Haverly use?

If a firm were to issue $5 million of commercial paper with a maturity of six months at an interest rate of 10%, the paper would sell at issue date for:

You are going to place an order with a new supplier. You have been offered terms of 2/10 net 60 from the date your supplies are shipped. The cost of borrowing from your bank is 16 percent (annual rate) . What is the best course of action in paying the supplier?

Riordan Manufacturing has taken out an $80,000 short-term bank loan that has a 10% interest rate. The loan requires that Riordan maintain a compensating balance of 15% of the amount borrowed. Calculate the effective interest rate on the loan.