Question

1. Under what circumstances would it be advisable to borrow money to take a cash discount?

2. Discuss the relative use of credit between large and small firms. Which group is generally in the net creditor position, and why?

3. How have new banking laws influenced competition?

4. What is the prime interest rate? How does the average bank customer fare in regard to the prime interest rate?

5. What does LIBOR mean? Is LIBOR normally higher or lower than the

U.S. prime interest rate?

6. What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporate borrowers?

• Commercial paper may show up on corporate balance sheets as either

a current asset or a current liability. Explain this statement.

7. What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage?

 

8. What is the difference between pledging accounts receivable and factoring accounts receivable?

9. What is an asset-backed public offering?

• Briefly discuss three types of lender control used in inventory financing.

10. What is meant by hedging in the financial futures market to offset interest rate risks?

The treasurer for Pittsburgh Iron Works wishes to use financial futures to hedge her interest rate exposure. She will sell five Treasury futures contracts at $138,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 13.3 percent. If they increase to 14.5 percent, assume the value of the contracts will go down by 5 percent. Also if interest rates do increase by 1.2 percent, assume the firm will have additional interest expense on its business loans and other commitments of $53,000. This expense, of course, will be separate from the futures contracts.

         a.      What will be the profit or loss on the futures contract if interest rates go to 14.5 percent by December when the contract is closed out?

         b.      Explain why a profit or loss took place on the futures contracts.

         c.      After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of $53,000? What percent of this $53,000 cost did the treasurer effectively hedge away?

         d.      Indicate whether there would be a profit or loss on the futures contracts if interest rates dropped.

Answer 1

Answer 1

It is advisable to borrow in order to avail a cash discount when the cost of borrowing funds is less than the cost of foregoing the discount. Suppose the cost of foregoing the discount is 35% then it would be advisable to borrow if funds are available at lower rates of interest, which usually is the case.

Answer 2

The larger firms are usually in the net creditor position due to the availability of resources with such firms. Because of their large size, they enjoy a higher amount of resources and funds. Therefore, such large firms have the capacity to lend to smaller firms looking for credit for their operations.

Answer 3

New banking laws have allowed more freedom to banks and banks now have the right to expand beyond a particular state border. This allows banks to tap new markets. Also the amount of competition has increased among banks which is leading to the creation of larger and more competitive markets. Bank mergers have also increased as a result.

Answer 4

Prime interest rate is the rate of interest at which the bank would lend funds to most credit worthy borrowers. For an average borrower, the rate of interest might be slightly higher (approximately 100 - 200 bps, that is 1% to 2%)

Answer 5

LIBOR means London Interbank Offered Rate. LIBOR is consistently below the U.S. prime interest rate.

Answer 6

A compensating balance allows banks to generate a higher return on loans because the entire amount of loan is actually NOT made available to the borrower. A $25,0000 loan with a $50,000 compensating balance requirement means only $200,000 is being provided to the borrower on a net basis.

Such a benefit to the lender is not necessarily a disadvantage to the borrower. The borrower might be able to geta lower interest rate on the loan and certain gratuitous services because he is required to maintain a minimum balance.

Answer 7

Commercial papers can be issued as well as purchased by corporations.

If a corporation purchases commercial papers from another corporation, it is an investment and appears as a Current Asset.

If a corporation issues commercial paper, it becomes it's Current Liability.