FINAL TERM

Topic 1 – Working Capital Management – Current Liabilities

Trade Credit
[i]
Cash discount Decisions. The credit terms for each of three suppliers are shown below:

Supplier A 2/10 net 55

Supplier B 3/10 net 55
Supplier C 2/15 net 45
Supplier D 2/10 net 30

A. Determine the annual approximate cost of giving up the cash discount from each supplier.

B. Assuming that the firm needs short-term financing, recommend whether it would be better to give up
the cash discount or take the discount and borrow from a bank at 20% annual interest. Evaluate each
supplier separately using your findings in Question A.

C. Assuming that the entity continuously foregoes the cash discount, compute the annual effective cost
of giving up the discount on each supplier.

Nominal answer by using 360 days, and precisive/nominal interest rate:

[1]
.

days X Nominal Effective

Supplier A 2/10 net 55 45 8 16.33% 17.54%

Supplier B 3/10 net 55 45 8 24.74% 27.59%
Supplier C 2/15 net 45 30 12 24.49% 27.43%
Supplier D 2/10 net 30 20 18 36.73% 43.86%

Approximate cost of giving up the cash discount using 365 days

Supplier A = 16.22%
Supplier B = 24.33%
Supplier C = 24.33%
Supplier D = 36.5%

Approximate cost of giving up the cash discount using 360 days

Supplier A = 16.00%
Supplier B = 24.00%
Supplier C = 24.00%
Supplier D = 36.00%

Short-term Loan
[ii]
Divina Mendez, owner of DM Company is negotiating with Island City Bank for a P1M, 1-year loan.
Island City Bank has offered DM Company the following alternatives. Calculate the effective annual
interest rate for each alternative. Which alternative has the lowest effective annual interest rate?

A. A 12.5 percent annual rate on a simple interest loan, with no compensating balance required and
interest due at the end of the year.

B. A 9.25 percent annual rate on a simple interest loan, with a 20 percent compensating balance required
and interest again due at the end of the year.

C. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance.

D. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance and an existing
cash balance of P150,000

E. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance which earns
5% interest income.

F. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance and an existing
cash balance of P150,000. The bank balance earns 5% interest income.
Redo requirement (A) to (F) assuming the loan is for four (4) months.

[1]
.

One-year 4-months

A. 12.5% 12.5%
B. 11.5625%9.25 80 11.5625%
C. 12.28% 8.75 (100 – 8.75 – 20) 11.35%
D. 10.145% 9.5%
E. 10.88% 10.05%
F. 9.86% 9.23%

Short-term Financing Alternatives

[iii]
Lance Hardware can buy equivalent materials from two-distributors. Supplier A offers term 1/10, net
30 whereas Supplier B provides terms of 2/15, net 60.

A. If Lance foregoes the discount, which of the two suppliers should it purchase from if supply prices
are comparable.

B. If Lance can borrow from Lending Bank at a 16%, should it forego the discount?

C. If in (B) above the bank requires a 20% compensating balance for the loan, should the firm forego the
discount?

[1]
. A. Supplier A = 18.18% Supplier B = 16.33%
B. Borrow at 16%, pay supplier within discount period
C. 20% (16/80), Yes, forego the discount.
Tyler Company needs P100,000 to take advantage of a discount based on terms of 3/10, net 60. Barangay
Bank has agreed to lend the money at a 12% rate with a 15% compensating balance requirement.
Townbank will lend at a 13% interest rate on a discounted loan from three months.

A. What is the effective rate of interest charged by each bank?

B. What is the cost of foregoing the discount?

C. How much would Tyler have to borrow from each bank in order to take the discount?

D. Suppose that Tyler normally banks with Barangay Bank and maintains deposit balance of P15,000,
what amount would have to be borrowed and what would the effective interest rate be?

[1]
. A. Barangay Bank = 14.12% (12/85)
Townbank = 13.44% (3.25/96.75) x 4
B. Trade discount = 22.27%
C. Barangay Bank = 117,647 (100,000 0.85)
Townbank = 103,359 (100,000 0.9675)
D. Principal = 100,000, Effective interest rate = 12%

[i]
.

[ii]
.

Dela Merced, owner of DM Company is negotiating with Island City Bank for a P500,000, 1-year loan. Island City
Bank has offered DM Company 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
again due at the end of the year.

C. An 8.75 percent annual rate on a discount loan, with a 15 percent compensating balance.

D. Interest is figured as 8 percent of the P50,000 amount, payable at the end of the year, but the P50,000 is
repayable in monthly installments during the year.

[iii]
. A. 12% C. 1148% 8.75/(100 – 8.75 – 15)
B. 11.25% 9/80 D. 16% 8/50

Three suppliers of baseball equipment offer different credit terms to City Sports. X Co. offer terms of 1 ½ / 15, net 30.
Y Enterprises offers terms of 1/10, net 30. Z Inc. offers terms of 2/10, net 60. City Sports would have to borrow
from a bank at an annual rate of 10% in order to take any cash discounts. Which one of the following would be
the most attractive for City Sports?
A. Purchase from X and pay in 30 days
B. Purchase from X, pays in 15 days, and borrows any money needed from the bank
C. Purchase from Y and pay in 30 days
D. Purchase from Z and pay in 60 days

Gees Pipeline, Inc., has developed plans for new pump that will allow more economical operation of the company’s
oil pipelines. Management estimates that P2,400,000 will be required to put this new pump into operation. Funds
can be obtained from a bank at 10 percent discount interest, or the company can finance the expansion by
delaying to payment to its suppliers. Presently, Gees purchases under terms of 2/10, net 40, but management
believes payment could be delayed 30 additional days without penalty; that is, payment could be made in 70
days. Which means of financing should Gees use? (Use the approximate cost of trade credit.)
A. Trade credit, since the cost is about 12.24 percent.
B. Trade credit, since the cost is about 3.13 percentage points less than the bank loan
C. Bank loan, since the cost is about 1.13 percent points less than trade credit
D. Bank loan, since the cost is about 3.13 percentage points less than trade credit

Trade Credit
Phranklin Pharms Inc. purchases merchandise from a company that gives sales terms of 2/15, net 40. Phranklin
Pharms has gross purchases of $800,000 per year. What is the maximum amount of costly trade credit
Phranklin could get, assuming they abide by the suppliers credit terms? (Assume a 360-day year.)
A. $32,666.70 C. $54,444.50
B. $52,266.67 D. $87,111.20

On cash discounts, all of the following statements do not apply except

A. The cost of not taking a cash discount is always higher than the cost of a bank loan.
B. The cost of not taking the discount is higher for terms of 2/10, net 60 than for 2/10, net 30.
C. With trade terms of 2/15, net 60, if the discount is taken the buyer receive 45 days of credit.
D. If a firm buys P10,000 of goods on terms of 1/10, net 30 and pays within the discount period, the amount paid
would be P9,000.

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 nominal 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 cost of your firm’s current practice, using a 360-day year?
A. 36.7% C. 106.9%
B. 73.4% D. 43.6%

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?
A. $157,500 C. $750,000
B. $625,000 D. $1,234,000

Bank loans
What is the effective annual interest rate on a 9% annual percentage rate automobile loan that has monthly
payments?
A. 9% C. 9.81%
B. 9.38% D. 10.94%

Corbin, Inc. can issue 3-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs will
be $1,200. The effective annualized percentage cost of the financing, based on a 360-day year, will be
A. 2.00%. C. 8.48%.
B. 8.00%. D. 8.66%.

Short-term financing alternatives

ABC Company finances all of its seasonal inventory needs from the local bank at an effective interest cost of 9%.
The firm’s supplier promises to extend trade credit on terms that will match the 9% bank credit rate. What terms
would the supplier have to offer (approximately)?
A. 2/10, n/60.
B. 2/10, n/90.
C. 2/10, n/100.
D. 3/10, n/60.

A company has accounts payable of $5 million with terms of 2% discount within 15 days, net 30 days (2/15 net 30). It
can borrow funds from a bank at an annual rate of 12%, or it can wait until the 30th day when it will receive
revenues to cover the payment. If it borrows funds on the last day of the discount period in order to obtain the
discount, its total cost will be
A. $24,500 more.
B. $51,000 less.
C. $75,500 less.
D. $100,000 less.

Every 15 days a company receives $10,000 worth of raw materials from its suppliers. The credit terms for these
purchases are 2/10, net 30, and payment is made on the 30th day after each delivery. Thus, the company is
considering a 1-year bank loan for $9,800 (98% of the invoice amount). If the effective annual interest rate on
this loan is 12%, what will be the net dollar savings over the year by borrowing and then taking the discount on
the materials?
A. $1,176
B. $1,224
C. $3,624
D. $4,800