C. Charles Smith recently was hired as president of Dellvoe Office Equipment Inc., a small...

Question

C. 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.

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

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

c. What is trade credit?

d. 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.

(1) What are Dellvoe's net daily purchases from this supplier?

(2) 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?

(3) What is the APR of the costly trade credit? What is its r_EAR?

e. 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 percent simple, or quoted, rate. However, he forgot to ask what the specific terms would be.

(1) 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 percent simple interest loan for six months rather than for a year, would that have affected r_EAR?

(2) What would rEAR be 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?

(3) 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 r_EAR?

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

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

(6) Now assume all the conditions in Part 4—that is, a 20 percent compensating balance and a 9 percent 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) r_EAR
of the loan?

f. 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?

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

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

i. 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 Dellvoes expectations, and now the firm fords itself short on cash. The firm expects that its cash shortage will be temporary, lasting only three 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 percent annual interest on the used portion, a 1 percent commitment fee on the unused portion, and a $125,000 compensating balance at all times.

Expected inventory levels to be financed are as follows:

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.)

David · Accepted Answer

A: Short-term loans are any liability that was originally paid within one year. The four main 
sources of short-term loans are: provisions, liabilities, loans from commercial banks and 
commercial paper.
B: Accruals increase automatically if a company's business expands. They are composed of 
accrued wages and deferred taxes. The provision is "free" in the sense that no explicit interest in 
money is paid, which is made up of provisions. A company can not properly control due to the 
payment deadlines of economic forces and industries is defined as the date of payment of taxes 
are set by law of their limits.
C: Commercial credit is a spontaneous source of finance in the sense that it is the result of 
normal business transactions. Commercial credit is the largest category of short-term debt, 
accounting for about 40 percent of the current liabilities of the average non-financial company. 
This percentage is slightly larger for small enterprises, as they often do not meet the 
requirements for funding from other sources and therefore largely depend on commercial 
lending.
D1: If Dellvoe’s gross purchases are $50,000 annually, then, with a 2 percent discount,  
net purchases are 0.98 ($50,000) = $49,000.  
If we assume a 360-day year, then net daily purchases are $49,000/360 = $136.11.
D2: If the discount is taken, then Dellvoe must pay this supplier on Day 11 for purchases made 
on Day 1, on Day 12 for purchases made on Day 2, and so on. Thus, in a steady state, Dellvoe 
will on average have 10 days’ worth of purchases in payables, so, 
 Payables = 10($136.11) = $1,361.11. 
If the discount is not taken, then Dellvoe will wait 50 days before paying, so 
 Payables = 50($136.11) = $6,805.56. 
Therefore: 
    Trade credit if discounts are not taken: $6,805.56 = total trade credit 
       Trade credit if discounts are taken:   1,361.11 = free trade credit 
                             Difference: $5,444.45 = costly trade credit
Here we see that Dellvoe gets $1,361.11 of free credit—it can wait 10 days and still take the 
discount. If the firm forgoes the discount then it can get $6,805.56 in credit. The difference, 
$6,805.56 ─ $1,361.11 = $5,444.45, is the amount of costly trade credit.
D3: To get $5,444.45 of costly trade credit Dellvoe must give up 0.02 ($50,000) = $1,000 in lost 
discounts annually. Because the forgone discounts pay for $5,444.45 of credit, the APR is 18.37 
percent:
  %4.181837.0
45.444,5$
000,1$
APR 
%37.181837.09020408.0
40
360
98
2
dateDiscount  - date Payment
360
% Discount1
% Discount
discountcash  a
forgoing of Cost





Note that (1) the formula gives the same cost rate as was calculated earlier, (2) the first term is 
the periodic cost of the credit (Dellvoe spends $2 to get the use of $98), and (3) the second term 
is the number of ―savings periods‖ per year (Dellvoe delays payment for 50 ─ 10 = 40 days, and 
there are 360/40 = 9 40-day periods in a year.) 
The effective annual rate is 19.94%: 
19.94%. = 0.1994 = 1 - 
0.98
0.02
 + 1 = 1 
% iscountD - 1
% iscountD
 + 1EAR
9m
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E1:  With a simple interest loan, Dellvoe gets the full use of the $800,000 for a year, and then 
pays 0.09($800,000) = $72,000 in interest at the end of the term, along with the $800,000 
principal repayment.  For a one-year simple interest loan, the simple rate, 9 percent, is also the 
effective annual rate.
Note that if the loan had been for six months at an 8 percent rate, then Dellvoe would have had to 
pay (0.08/2)($800,000) = 0.04($800,000) = $32,000 in interest after six months, plus repay the 
principal.

C. 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...

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