Current liabilities management - Exercises

True or False

1. Accounts payable are spontaneous secured sources of short-term financing that arise from the
normal operations of the firm.

2. Notes payable can be either spontaneous secured or spontaneous unsecured financing and result
from the normal operations of the firm.

3. Accounts payable result from transactions in which merchandise is purchased but no formal note is
signed to show the purchaser’s liability to the seller.
4. In credit terms, EOM (End-of-Month) indicates that the accounts payable must be paid by the end
of the month in which the merchandise has been purchased.

5. Accruals are liabilities for services received for which payment has yet to be made.

6. The cost of giving up a cash discount is the implied rate of interest paid in order to delay payment
of an account payable for an additional number of days.

7. In giving up a cash discount, the amount of the discount that is given up is the interest being paid
by the firm to keep its money by delaying payment for a number of days.

8. If a firm anticipates stretching accounts payable, its cost of giving up a cash discount is increased.

9. A firm should take the cash discount if the firm’s cost of borrowing from the bank is greater than
the cost of giving up a cash discount.

10. If a firm anticipates stretching accounts payable, its cost of giving up a cash discount is reduced.
11. Unlike the spontaneous sources of unsecured short-term financing, bank loans are negotiated and
result from deliberate actions taken by the financial manager.

12. Self-liquidating loans are intended merely to carry the firm through seasonal peaks in financing
needs, mainly buildups of accounts receivable and inventory.

13. Self-liquidating loans are mainly invested in productive assets (i.e., fixed assets) which provide the
mechanism through which the loan is repaid.

14. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to
examine the credit worthiness of a customer each time it borrows money.

15. The interest rate on a line of credit is normally stated as a fixed rate—the prime rate plus a percent.

16. A line of credit is an agreement between a commercial bank and a business specifying the amount
of unsecured short-term borrowing the bank will make available to the firm over a given period of
time.

17. A revolving credit agreement is a form of financing consisting of short-term, unsecured promissory
notes issued by firms with a high credit standing.
18. A short-term self-liquidating loan is a secured short-term loan in which the use to which the
borrowed money is put provides the mechanism through which the loan is repaid.

19. The discount rate is the lowest rate of interest charged by the nation’s leading banks on business
loans to their most important and reliable business borrowers.

20. Operating change restrictions are contractual restrictions that a bank may impose on a firm as part
of a line of credit agreement.

21. The effective interest rate on a bank loan depends on whether interest is paid when the loan matures
or in advance.

22. The prime rate of interest fluctuates with changing supply-and-demand relationships for short-term
funds as well as the risk of the bank’s business borrowers.

23. A discount loan is a loan on which interest is paid in advance by deducting it from the loan so that
the borrower actually receives less money than is requested.

24. A single-payment note is a secured fund which can be obtained from a commercial bank when a
borrower needs additional funds for a short period.
25. In a line of credit agreement, a bank may retain the right to revoke the line if any major changes
occur in the firm’s financial condition or operations.

26. Under a line of credit, a bank may require an annual cleanup, which means that the borrower must
pay off all its outstanding debts to all lenders for a certain number of days during the year.

27. Although more expensive than a line of credit, a revolving credit agreement can be less risky from
the borrower’s viewpoint.

28. Generally the increment above the prime rate on a floating-rate loan will be higher than on a fixed-
rate loan of equivalent risk because the lender bears higher risk with a floating-rate loan.

29. Fixed-rate loan is a loan whose rate of interest is established at a fixed increment above the prime
rate and is allowed to vary above prime only when the prime rate varies until maturity.

30. The effective interest rate for a discount loan is greater than the loan’s stated interest rate.

31. Compensating balance, which is a required checking account balance equal to a certain percentage
of the borrower’s short-term unsecured loan, may not only forces the borrower to be a good
customer of the bank but may also raise the interest cost to the borrower, thereby increasing the
bank’s earnings.
32. Commercial paper is a form of financing that consists of short-term, secured promissory notes
issued by firms with a high credit standing.

33. In doing business in foreign countries, financing operations in the local market not only improves
the company’s business ties to the host community but also minimizes exchange rate risk.

34. The interest paid by the issuer of commercial paper is determined by the size of the discount and
the length of time to maturity.

35. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar
will depreciate.
36. Firms are able to raise funds through the sale of commercial paper more cheaply than by borrowing
from a commercial bank.

37. Secured short-term financing has specific assets pledged as collateral and appears on the balance
sheet as current liabilities.

38. The outright sale of accounts receivable at a discount in order to obtain funds is called pledging
accounts receivable.

39. One advantage of factoring accounts receivable is the ability it gives the firm to turn accounts
receivable immediately into cash without having to worry about repayment.

40. Fixed assets are the most desirable short-term loan collateral since they normally have a longer life,
or duration, than the term of the loan.

Multiple choice

1. The two major sources of short-term financing are

(a) a line of credit and accounts payable.
b(b) accounts payable and accruals.
(c) a line of credit and accruals.
(d) accounts receivable and notes payable.

2. _________ are the major source of unsecured short-term financing for business firms.
(a) Accounts receivable
(b) Accruals
(c) Notes payable
(d) Accounts payable

3. Accruals and accounts payable are _________ sources of short-term financing.

(a) negotiated, secured
(b) negotiated, unsecured
(c) spontaneous, secured
(d) spontaneous, unsecured
4. Financing that arises from the normal operations of the firm is said to be
(a) expected.
(b) accrued.
(c) spontaneous.
(d) payable.
5. _________ are liabilities for services received for which payment has yet to be made. The most
common accounts are taxes and wages.
(a) Notes payable
(b) Accruals
(c) Accounts payable
(d) Accounts receivable

6. 1/15 net 30 date of invoice translates as

(a) a 1 percent cash discount may be taken if paid in 15 days; if no cash discount is taken, the
balance is due in 30 days after the middle of the month.
(b) a 1 percent cash discount may be taken if paid in 15 days; if no cash discount is taken,
the balance is due 30 days after the invoice date.
(c) a 1 percent cash discount may be taken if paid in 15 days; if no cash discount is taken, the
balance is due 30 days after the end of the month.
(d) a 1 percent discount may be taken on 15 percent of the purchase if the account is paid within 30
days after the end of the month.

7. 3/10 net 45 EOM translates as

(a) a 10 percent cash discount may be taken if paid in three days; if no cash discount is taken,
the balance is due in 45 days.
(b) a 3 percent cash discount may be taken if paid in 10 days; if no cash discount is taken,
the balance is due 45 days after transaction is complete.
(c) a 3 percent cash discount may be taken if paid in 10 days; if no cash discount is taken,
the balance is due 45 days after the end of the month.
(d) a 3 percent discount may be taken on 10 percent of the purchase if the account is paid
within 45 days after the end of the month.

8. One of the most common designations for the beginning of the credit period is
(a) 2/10.
(b) the date of invoice.
(c) the end of the month.
(d) the transaction date.
9. If the firm decides to take the cash discount that is offered on goods purchased on credit, the firm
should
(a) pay as soon as possible.
(b) pay on the last day of the credit period.
(c) take the discount no matter when the firm actually pays.
(d) pay on the last day of the discount period.

10. The cost of giving up a cash discount on a credit purchase is

(a) added on to the price of the goods.
(b) deducted from the price of the goods.
(c) the implied interest rate paid in order to delay payment for an additional number of days.
(d) the true purchase price of the goods.

11. When a firm stretches accounts payable without hurting its credit rating, the cost of foregoing the
cash discount is
(a) reduced.
(b) increased.
(c) unaffected.
(d) immaterial.

12. As part of a union negotiation agreement, the United Clerical Workers Union conceded to be paid
every two weeks instead of every week. A major firm employing hundreds of clerical workers had
a weekly payroll of $1,000,000 and the cost of short-term funds was 12 percent. The effect of this
concession was to delay clearing time by one week. Due to the concession, the firm
(a) realized an annual loss of $120,000.
(b) realized an annual savings of $120,000.
(c) increased its cash cycle.
(d) decreased its cash turnover.
13. A firm purchased goods with a purchase price of $1,000 and credit terms of 1/10 net 30. The firm
paid for these goods on the 5th day after the date of sale. The firm must pay _________ for the
goods.
(a) $990
(b) $900
(c) $1,000
(d) $1,100

14. A firm purchased goods on January 27 with a purchase price of $1,000 and credit terms of 2/10 net
30 EOM. The firm paid for these goods on February 9. The firm must pay _____ for the goods.
(a) $1,000
(b) $980
(c) $800
(d) $900

15. By offering credit to customers, the firm may

(a) increase the price of the good to cover its costs.
(b) decrease its investment in accounts receivable.
(c) decrease its investment in accounts payable.
(d) decrease the cost of goods purchased.

16. If a firm gives up the cash discount on goods purchased on credit, the firm should pay the bill
(a) as late as possible.
(b) as soon as possible.
(c) before the credit period ends.
(d) on the last day of the credit period.
17. A firm is offered credit terms of 2/10 net 45 by most of its suppliers but frequently does not have
the cash available to take the discount. The firm has a credit line available at a local bank at an
interest rate of 12 percent. The firm should
(a) give up the cash discount, financing the purchase with the line of credit.
(b) take the cash discount and pay on the 45th day after the date of sale.
(c) take the cash discount and pay on the first day of the cash discount period.
(d) take the cash discount, financing the purchase with the line of credit, the cheaper source of
funds.

18. A firm is offered credit terms of 1/10 net 45 EOM by a major supplier. The firm has determined
that it can stretch the credit period (net period only) by 25 days without damaging its credit
standing with the supplier. Assuming the firm needs short-term financing and can borrow from the
bank on a line of credit at an interest rate of 14 percent, the firm should
(a) give up the cash discount and finance the purchase with the line of credit.
(b) give up the cash discount and pay on the 70th day after the date of sale.
(c) take the cash discount and pay on the first day of the cash discount period.
(d) take the cash discount and finance the purchase with the line of credit, the cheaper source of
funds.

19. The cost of giving up a cash discount under the terms of sale 1/10 net 60 (assume a 360-day year) is
(a) 7.2 percent.
(b) 6.1 percent.
(c) 14.7 percent.
(d) 12.2 percent.

20. The cost of giving up a cash discount under the terms of sale 5/20 net 120 (assume a 360-day year) is
(a) 15 percent.
(b) 18.9 percent.
(c) 15.8 percent.
(d) 20 percent.
21. The major type of loan made by banks to businesses is the
(a) fixed-asset-based loan.
(b) short-term secured loan.
(c) short-term self-liquidating loan.
(d) capital improvement loan.

22. Short-term loans that businesses obtain from banks and through commercial paper are
(a) negotiated and secured.
(b) negotiated and unsecured.
(c) spontaneous and secured.
(d) spontaneous and unsecured.

23. Short-term self-liquidating loans are intended to

(a) finance capital assets.
(b) cover seasonal peaks in financing caused by inventory and receivable buildups.
(c) finance merger/acquisition activity.
(d) recapitalize the firm.

24. A _________ is a type of loan made to a business by a commercial bank. This type of loan is made
when the borrower needs additional funds for a short period but does not believe the need will
continue or reoccur on a seasonal basis.
(a) revolving credit agreement
(b) line of credit
(c) short-term self-liquidating loan
(d) single payment note
25. The _________ is the lowest rate of interest charged on business loans to the best business
borrowers by the nation’s leading banks.
(a) prime rate
(b) commercial paper rate
(c) federal funds rate
(d) treasury bill rate

26. Short-term self-liquidating loans are intended to

(a) finance capital assets.
(b) cover seasonal peaks in financing caused by inventory and receivables buildup.
(c) finance merger and/or acquisition activity.
(d) recapitalize the firm.

27. Commercial banks lend unsecured short-term funds in the following three basic ways.
(a) Single-payment note, lines of credit, and commercial paper.
(b) Single-payment note, lines of credit, and revolving credit agreements.
(c) Single-payment note, revolving credit agreements, and commercial paper.
(d) Commercial paper, lines of credit, and revolving credit agreements.

28. In a line credit arrangement, the firm pays interest on

(a) the full line of credit.
(b) the unused portion of the line of credit.
(c) only the amount actually borrowed.
(d) only the amount actually borrowed and commitment fees on any unused portion of the loan.
29. Loans on which the interest is paid in advance are often called
(a) premium loans.
(b) reduced-principle loans.
(c) called loans.
(d) discount loans.

30. The prime rate of interest fluctuates with

(a) the changing supply and demand relationship for long-term funds.
(b) the changing supply and demand relationship for short-term funds.
(c) the risk of the firm borrowing the funds.
(d) demand in the bond market.

31. A _________ is an agreement between a commercial bank and a business that states the maximum
amount of unsecured short-term borrowing the bank will make available to the firm over a given
period of time, provided sufficient funds are available.
(a) revolving credit agreement
(b) line of credit
(c) short-term self-liquidating loan
(d) single payment note

32. Seasonal build-ups of inventory and receivables are generally financed with
(a) short-term loans.
(b) long-term loans.
(c) accruals.
(d) stockholders’ equity.
33. The effective interest rate is
(a) higher on a loan if interest is paid at maturity.
(b) lower if the loan is a discount loan.
(c) higher if the loan is a discount loan.
(d) not affected by whether the loan is a discount loan or a loan with interest paid at maturity.

34. A bank lends a firm $1,000,000 for one year at 12 percent on a discounted basis and requires
compensating balances of 10 percent of the face value of the loan. The effective annual interest rate
associated with this loan is
(a) 12 percent.
(b) 13.3 percent.
(c) 13.6 percent.
(d) 15.4 percent.

35. _________ effectively raises the interest cost to the borrower on a line of credit.
(a) An operating change restriction
(b) An annual cleanup
(c) A compensating balance
(d) A commitment fee

36. A bank lends a firm $500,000 for one year at 8 percent and requires compensating balances of
10 percent of the face value of the loan. The effective annual interest rate associated with this loan
is
(a) 8.9 percent.
(b) 8 percent.
(c) 7.2 percent.
(d) 7.0 percent. 500000(.08)/500000-50000
37. _________ ensure that money lent under a line of credit agreement is actually being used to finance
seasonal needs.
(a) Operating change restrictions
(b) Annual cleanups
(c) Compensating balances
(d) Commitment fees

38. A _________ guarantees the borrower that a specified amount of funds will be available regardless
of the tightness of money.
(a) revolving credit agreement
(b) line of credit
(c) short-term self-liquidating loan
(d) single payment note

39. Compared to a line of credit, a revolving credit agreement generally will be

(a) a lower cost, higher risk method of short-term borrowing.
(b) a lower cost, lower risk method of short-term borrowing.
(c) a higher cost, higher risk method of short-term borrowing.
(d) a higher cost, lower risk method of short-term borrowing.

40. In a revolving credit agreement, the firm pays interest on

(a) the full line of credit.
(b) the unused portion of the line of credit.
(c) only the amount actually borrowed.
(d) the amount actually borrowed and commitment fees on any unused portion of the loan.

Problems

1. ProntoPak Rapid Delivery Service is analyzing the credit terms of each of three suppliers, A, B,
and C.

Supplier Credit Terms

A 1/15 net 40
B 2/10 net 30
C 2/15 net 35

(a) Determine the approximate cost of giving up the cash discount.

(b) Assuming the firm needs short-term financing, recommend whether or not the firm should give
up the cash discount or borrow from the bank at 10 percent annual interest. Evaluate each
supplier separately.

2. Mime Theatrical Supply is in the process of negotiating a line of credit with two local banks. The
prime rate is currently 8 percent. The terms follow:
 Bank Loan Terms
1st National 1 percent above prime rate on a discounted basis and a 20
percent compensating balance on the face value of the loan.
2nd National 2 percent above prime rate and a 15 percent compensating
balance.

(a) Calculate the effective interest rate of both banks.

(b) Recommend which bank’s line of credit Mime Theatrical Supply should accept.

3. A&A Company purchased a new machine on October 20th, 2003 for $1,000,000 on credit. The
supplier has offered A&A terms of 2/10, net 45. The current interest rate the bank is offering is
16 percent.
(a) Compute the cost of giving up cash discount.
(b) Should the firm take or give up the cash discount?
(c) What is the effective rate of interest if the firm decides to take the cash discount by borrowing
money on a discount basis?

4. General Aviation has just sold an issue of 30-day commercial paper with a face value of
$5,000,000. The firm has just received $4,958,000. What is the effective annual interest rate on the
commercial paper?
5. A&A Apple Company would like to manufacture and market a new packaging. A&A has sold an
issue of commercial paper for $1,500,000 and maturity of 90 days to finance the new project. Compute
the annual interest rate on the issue of commercial paper if the value of the commercial paper at maturity
is $1,650,000.

6. Giant Feeds, Inc. is considering obtaining funding through advances against receivables. Total
annual credit sales are $600,000, terms are net 30 days, and payment is made on the average of
30 days. Western National Bank will advance funds under a pledging arrangement for 13 percent
annual interest. On average, 75 percent of credit sales will be accepted as collateral. Commodity
Finance offers factoring on a nonrecourse basis for a 1 percent factoring commission, charging
1.5 percent per month on advances and requiring a 15 percent factor’s reserve. Under this plan,
the firm would factor all accounts and close its credit and collections department, saving $10,000
per year.
(a) What is the effective interest rate and the average amount of funds available under pledging
and under factoring?
(b) Which plan do you recommend? Why?