Question

Question 6

Alphabet Company (ABC) is an electronic manufacturer in Hong Kong. The firm has grown rapidly in recent years, causing a need for short-term financing. Regarding its sales, a majority are for credit although the rest of them are for cash. The credit sales are financed with short-term borrowings.

As a financial manager of ABC,

(a)





(b)




(c)




You are told that ABC has a $900,000 line of credit with a 10% compensating balance requirement with ICBC Bank. It means that 10% of the amount borrowed must be left in a non-interest-bearing account. The quoted interest rate is 8%. It is reported that ABC needs $270,000 to purchase inventory. What interest rate is ABC effectively paying?

You are also told that ABC had an average of $70,000 in accounts receivable last year. Credit sales were $700,000 per year. ABC factors its receivables by discounting them at 2.5%. Assume 365 days a year. What is the effective interest rate on this source of short-term financing?

Critically discuss two decision criteria for determining short-term financing policy of the firm. (word limit: 150 words)

Answer 1

Ans:- The credit sales are financial with   short term borrowing.

If they are ABC limited borrowing money from ICBC Bank that is Intrest Amount pay in $90000, and equated intrest rate 8$=$72000.

Account Reciviable $70000

Credit sales are $700000

Means Sales amount Recover in $630000

Discount of the Accounts Recivable $1750

Over view the working capital and finincial decisions

Evaluating Interest Rates

Management of working capital requires evaluating factors affecting cash flows — including the evaluation of appropriate interest rates.

The company Intrest rates based on development.

Key Points

• The interest rate most commonly used in working capital management is the cost of capital.
• Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions.
• Working capital decision criteria that focus on interest rates include debtors management and short-term financing.
• The discount rates typically applied to different types of companies show significant differences.

Key Terms

• cost of capital: The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• credit rating: An estimate, based on a company or person’s history of borrowing and repayment and/or available financial resources, that is used by creditors to determine the maximum amount of credit it can extend to a without undue risk.
• cash conversion cycle: how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales.

Evaluating Interest Rates

The management of working capital takes place in the realm of short-term decision-making. These decisions are, therefore, based primarily on profitability, cash flows and their management. Many criteria go into the management of cash flows and subsequently the management of working capital — including the evaluation of appropriate interest rates.

The interest rate most commonly used in working capital management is the cost of capital. The cost of capital, in a financial market equilibrium, will be the same as the market rate of return on the financial asset mixture the firm uses to finance capital investment. In other words, a company’s cost of capital is the cost of obtaining funds for operation through the sale of equity or debt in the marketplace. In market equilibrium, investors will determine what return they expect from providing funds to a company. The return expected on debt depends upon the credit rating of the company, which takes into account a number of factors to determine how risky loaning funds to a company will be. The return expected from equity also involves a number of factors, usually centered around the operation of the company and its prospects for profitability. Some conventional rates of return expected for various types of companies include:

• Startups seeking money: 50% – 100%
• Early startups: 40% – 60%
• Late startups: 30% – 50%
• Mature companies: 10% – 25%

When evaluating short-term profitability, company’s may use measures such as return on capital. ROC is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making.

As mentioned, working capital decisions are made with the short-term in mind. Thus, working capital policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Decision criteria that focus on interest rates include debtors management and short-term financing.

Interest: Interest rates of working capital financing can be largely affected by discount rate, WACC and cost of capital.

Debtors management involves identifying the appropriate credit policy — i.e. credit terms which will attract customers — such that any impact on cash.