1.)Throughout the course of a year an agribusiness may have temporary periods of excess cash. During...

1.)Throughout the course of a year an agribusiness may have temporary periods of excess cash. During those periods, management of the firm may be tempted to spend some of that excess cash to purchase a fixed asset and pay for the purchase using the excess cash that is available. Explain why a firm usually should not finance a fixed asset such as a new truck with excess cash or even an operating loan. What problems could this cause?

2. A compensating balance is a term for a loan that usually results in a higher effective interest rate than a simple interest rate. Is there ever a situation when requiring a compensating balance does not result in a higher effective interest rate than a simple interest rate for the loan? Explain your answer.

3. Assume you borrow $100,000 to purchase a house and the stated interest rate is 5 percent. The loan will be set up as an installment loan with monthly payments. What is the annual percentage rate? Show all work to be eligible for full credit. Discuss why the annual percentage rate is different than the stated interest rate.

Solutions

Expert Solution

1. excess cash is a part of the current assets, which is generally used to finance short term borrowing or any other financing. Now, invetsment in fixed assets or an operating loan is a long term strategy, which needs regular flows of cash into the business. Excess cash does not reflect true cash flows in the business but mainly used in debt repayment.

When excess cash is generated in business for the temporary period, it indicates uncertainty in the future excess cash which is different from free cash flows. Puchasing a fixed asset means decrease in working capital or current assets with unchanged current liabilities. Therefore, the problem is negative cash flows in business in any time may lead the company to face repayment of loan. Shortage of cash in future may affect true cash flows and may hamper future business profitability and sales.

Hence, a firm should not finance fixed asset purchase or operating loan with temporary excess cash.

Rahul Sunny answered 1 year ago

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