Question

Charles Smith recently was hired as president of Dellvoe Office Equipment Inc., a small manufacturer of metal office equipment. As his assistant, you have been asked to review the company’s short-term financing policies and to prepare a report for Smith and the board of directors. To help you get started, Smith has prepared some questions that, when answered, will give him a better idea of the company’s short-term financing policies.

What is short-term credit, and what are the four major sources of this credit?

Is there a cost to accruals, and do firms have much control over them?

What is trade credit?

Like most small companies, Dellvoe has two primary sources of short-term debt: trade credit and bank loans. One supplier, which supplies Dellvoe with $50,000 of materials a year, offers Dellvoe terms of 2/10, net 50.

What are Dellvoe’s net daily purchases from this supplier?

What is the average level of Dellvoe’s accounts payable to this supplier if the discount is taken? What is the average level if the discount is not taken? What are the amounts of free credit and costly credit under both discount policies?

What is the APR of the costly trade credit? What is its EAR?

In discussing a possible loan with the firm’s banker, Smith found that the bank is willing to lend Dellvoe up to $800,000 for one year at a 9% simple, or quoted, rate. However, he forgot to ask what the specific terms would be.

Assume the firm will borrow $800,000. What would be the effective interest rate if the loan were based on simple interest? If the loan had been an 8% simple interest loan for six months rather than for a year, would that have affected the EAR?

What would be the EAR if the loan were a discount interest loan? What would be the face amount of a loan large enough to net the firm $800,000 of usable funds?

Assume now that the terms call for an installment (or add-on) loan with equal monthly payments. The add-on loan is for a period of one year. What would be Dellvoe’s monthly payment? What would be the approximate cost of the loan? What would be the EAR?

Now assume that the bank charges simple interest, but it requires the firm to maintain a 20% compensating balance. How much must Dellvoe borrow to obtain its needed $800,000 and to meet the compensating balance requirement? What is the EAR on the loan?

Now assume that the bank charges discount interest of 9% and also requires a compensating balance of 20%. How much must Dellvoe borrow, and what is the EAR under these terms?

Now assume all the conditions in part 4—that is, a 20% compensating balance and a 9% simple interest loan—but assume also that Dellvoe has $100,000 of cash balances that it normally holds for transactions purposes, which can be used as part of the required compensating balance. How does this affect (i) the size of the required loan and (ii) the EAR of the loan?

Dellvoe is considering using secured short-term financing. What is a secured loan? What two types of current assets can be used to secure loans?

What are the differences between pledging receivables and factoring receivables? Is one type generally considered better?

What are the differences among the three forms of inventory financing? Is one type generally considered best?

Dellvoe had expected a really strong market for office equipment for the year just ended, and in anticipation of strong sales, the firm increased its inventory purchases. However, sales for the last quarter of the year did not meet its expectations, and now Dellvoe finds itself short on cash. The firm expects that its cash shortage will be temporary, only lasting 3 months. (The inventory has been paid for and cannot be returned to suppliers.) Dellvoe has decided to use inventory financing to meet its short-term cash needs. It estimates that it will require $800,000 for inventory financing during this three-month period. Dellvoe has negotiated with the bank for a three-month, $1,000,000 line of credit with terms of 10% annual interest on the used portion, a 1% commitment fee on the unused portion, and a $125,000 compensating balance at all times.

                                             Expected inventory levels to be financed are as follows:

Month                                                Amount

January                                            $800,000

February                                            500,000

March                                                300,000

                                             Calculate the cost of funds from this source, including interest charges and commitment fees. (Hint: Each month’s borrowings will be $125,000 greater than the inventory level to be financed because of the compensating balance requirement.)

Answer 1

(a) Short term credit basically refers to the loans or credits offered for short term usually less than a year. These type of credit are generally required in a business to meet the short term obligations like utility bills, advances from short term creditors. They are usually required to finance the working capital requirement and current capital expenditures.

Sources of short term credit are -

- Overdraft Agreement

- Customer Advances

- Accounts Receivables Financing

- Selling Goods on Installment

(b) Trade credit is the credit extended by the suppliers. When a trade credit is available or offered, we can buy the goods and have the option to pay on a later date.

(c) Considering that the Dellvoe pays within 10 days and takes a discount of 2% always then total amount of purchases in a year = 50000 * 0.98 = 49000

Net daily purchases = 49000/365 = 134.24 $

(d) Average level of accounts payable if discount is taken = 134.24 * 10 = 134,24 (0 + 10)/2 = 134.24 * 5 = 671.2 $

(e) Average level of accounts payable if discount is not taken = 50000/365 * (11 + 50)/2 = 4178.08 $