Sources of Short-Term Financing Answer Key 4

96. A cash discount calls for a reduction in price if payment cannot be made within a specified time period. FALSE 97. The annual effective rate of interest on a loan is a measure that includes the compounding effects on the loan. TRUE 98. The lender's primary concern is whether the borrower's capacity to generate receivables is sufficient to liquidate the loan as it comes due. FALSE 99. The sale of asset-backed securities enables the issuing firm to acquire lower-cost funds than it normally would receive from a bank loan or bond offering. TRUE 100. The upward movement of the exchange rate can increase the total cost of a loan by making the principal repayment require more money than the original amount of the loan. TRUE 101. The London Interbank offered rate is used to set a base lending rate for some corporate loans originating in the Euromarkets. TRUE 102. Firms using commercial paper are generally required to maintain bank lines of credit equal to the amount of paper outstanding. TRUE 103. The commercial paper market is available to all publicly traded companies. FALSE 104. One of the disadvantages of commercial paper is that if the company's credit quality declines, the issuance of additional paper may be impossible. TRUE 105. The banks have been significant issuers of asset-backed securities. TRUE 106. Asset-backed securities often have superior credit ratings because of coverage from deposit insurance. FALSE 107. The effective annual rate on a loan will always be higher than the stated rate because the effective annual rate takes into account compounding. TRUE 108. Commercial Paper is generally issued by public companies that are considered to be financial very secure and thus have much lower levels of business risk. TRUE 109. An instalment loan uses a series of equal payments to retire a loan. TRUE 110. A discounted loan features subtraction of the calculated interest payment in advance. TRUE Short Answer Questions 111. What is a compensating balance and what is its purpose? Is it commonly used? Why or why not? In providing loans and other services, banks will often charge setup fees and administration or review fees. Sometimes banks may require that business customers maintain a minimum average account balance in chequing accounts, referred to as a compensating balance, to cover banking costs. The required amount of a compensating balance is usually computed as a percentage of customer loans outstanding or as a percentage of bank commitments toward future loans to a given account. Generally fees for services are charged by the banking industry on a cost plus profit basis as opposed to requiring a compensating balance. Under the Bank Act, borrowers must agree to the compensating balance requirement, and Canadian banks must disclose the full cost of the loan, which is increased by the need for a compensating balance. However, banks seem to be making most of their loans these days without the requirement for the compensating balance, preferring instead to charge interest rates consistent with their cost of funds. The emphasis has turned to doing more intensive analysis of the profitability of each loan. 112. Why is commercial paper an attractive alternative to short-term bank financing? • Generally it is cheaper (funds are raised in the wholesale market). • Compensating balances are not required (although banks offer standby lines of credit). • It is prestigious to float paper in a somewhat exclusive market. • Asset-backed paper can free up a firm's balance sheet. 113. What are the risks in the commercial paper market? • The possibility of default • The potential for a liquidity freeze • A lack of loyalty or ongoing commitment (as opposed to a banking relationship) Default in the commercial paper has included the Atlantic Acceptance Corporation, Olympia and York, the Mercantile Bank, Confederation Life Insurance Company, and Coventree Capital. Many were left holding unsecured IOUs that could not be liquidated as the market froze. Despite investment grade ratings as high as R1 (low) by the Dominion Bond Rating Service at the time of default, these firms could not raise additional capital to meet their commitments because of financial difficulties. Therefore, lines of credit at a bank are important in protecting the firm against adverse turns of events in the money markets. 114. The Magic Pumpkin Limousine Company wants to purchase a car telephone system for one of its automobiles. The telephone vendor has offered to finance the $1,500 purchase over one year in 12 installments, with a total of $140 in interest to be paid on the loan. Magic Pumpkin's bank has offered to finance the purchase with an instalment loan, where $155 in interest will be repaid and payments on the loan must be made quarterly. What are the annual interest rates on these loans? Vendor Plan: Bank Plan: 115. Business Book Publishing needs to borrow $700,000 in order to finance its new inventory. Two banks in town offered different loan terms: Marine Bank offered a 10% loan with a 15% compensatory balance to be paid back in quarterly payments. McLean National Bank offered Business Book Publishing a 12% loan to be paid back semiannually. Which loan terms should Business Book Publishing take? Marine Bank where the compensating balance is subtracted from the principal. McLean National Bank Take McLean's offer. 116. Slipshod Machine Tool Co. owes $40,000 to one of its suppliers. The supplier has offered a trade discount of 2/10 net 30. Slipshod can borrow the funds from either of two banks. First City Bank will loan the funds for 20 days at a cost of $400. Upstart Bank offers a discounted loan for 20 days at a cost of $320. A) What is the cost of failing to take the discount? B) What is the annual interest rate on each of the loans? C) Which alternative should Slipshod follow? A) B) First City: Upstart: C) Take Upstart's loan. The annual interest rate is much lower. 117. Brand Advertising is offered a 3/10 net 40 trade discount by its supplier. In the past Brand has been able to get away with paying for supplies on credit in 60 days. Since it doesn't have money on hand to take advantage of the discount, it tries to negotiate a loan with Second Canadian Bank. The amount of $375,000 with a 15% compensating balance and a $5,500 interest charge has been negotiated for the month of May. Brand already maintains a $16,250 balance at the bank. Compute the annual rate of interest on the loan, and the cost of not taking the discount. Which one should Brand take? Cost of not taking discount Annual rate on loan Additional compensating balance required $375,000 × 0.15 = On deposit Additional Balance required $56.250 16.250 $40,000 118. In order to finance a shipment of badminton sets, Rujisawa Import-Export is seeking a $500,000 one-year bank loan. The Marine Bank requires that Rujisawa maintain a 20% compensating balance and requires four quarterly payments. The Prairie Bank requires only a 10% compensating balance, but requires 12 monthly payments. In addition, the Prairie Bank discounts the loan. Both banks state that their interest rate is 9%. A) Which bank has the lowest annual interest rate? (NOTE: deduct the compensating balances from the principal in determining the annual rate.) B) If Prairie Bank eliminated its compensating-balance requirement, would your answer change? A) MARINE BANK: PRAIRIE BANK: B) Annual rate = No, Prairie Bank is still more expensive.