ANSWERS TO END-OF-CHAPTER QUESTIONS
The two principal reasons for holding cash are for transac¬tions and compensating balances. The target cash balance is not equal to the sum of the holdings for each reason because the same money can often partially satisfy both motives.
The four elements in a firm’s credit policy are (1) credit standards, (2) credit period, (3) discount policy, and (4) collection policy. The firm is not required to accept the credit policies employed by its competition, but the optimal credit policy cannot be determined without considering com¬petitors’ credit policies. A firm’s credit policy has an important influence on its volume of sales, and thus on its profitability.
People or firms borrow on a short-term basis in spite of increased risk for reasons of flexibility. If its need for funds is seasonal or cyclical, a firm may not want to commit itself to long-term debt. Furthermore, short-term interest rates are generally lower than long-term rates.
Larger firms have greater access to the capital markets than smaller firms, because they can sell stocks and bonds. Smaller firms are, therefore, forced to rely on bank loans to a greater extent. In addition, larger firms are typically older and, thus, have had more time to build up retained earnings and other internal sources of funds than new, smaller firms.
The commercial paper market is completely impersonal, while bank loans are negotiated and the parties involved get to know and trust one another. Commercial paper can be sold only by firms whose credit is utterly above question. Suppose a fundamentally sound firm that uses a good deal of short-term credit in the form of commercial paper is suddenly faced with a crippling strike. This may cause commercial paper dealers to refuse to handle its paper, and, as the already outstanding notes begin to mature, the firm may be faced with a financial crisis. On the other hand, if the firm had maintained continuous banking relations, it is far more likely that its bank would have stuck by it and helped it ride out the storm. It is assumed that the firm did not utilize bank credit earlier.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Sales = $10,000,000; S/I = 2.
Inventory = S/2
= = $5,000,000.
If S/I = 5, how much cash is freed up?
Inventory = S/5
= = $2,000,000.
Cash Freed = $5,000,000 - $2,000,000 = $3,000,000.
DSO = 17; Credit Sales/Day = $3,500; A/R = ?
A/R = 17 $3,500 = $59,500.
Nominal cost of trade credit =
= 0.0309 24.33 = 0.7526 = 75.26%.
Effective cost of trade credit = (1.0309)24.33 - 1.0 = 1.0984 = 109.84%.
Effective cost of trade credit = (1 + 1/99)8.11 - 1.0
= 0.0849 = 8.49%.
Net purchase price of inventory = $500,000/day.
Credit terms = 2/15, net 40.
$500,000 15 = $7,500,000.
0.4(10) + 0.6(40) = 28 days.
$912,500/365 = $2,500 sales per day.
$2,500(28) = $70,000 = Average receivables.
0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day.
$2,500(22) = $55,000 = Average receivables.
Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also, some customers may now take discounts further reducing receivables.
Because the firm still takes the discount on Day 20, 20 is used as the discount period in calculating the cost of nonfree trade credit.
Paying after the discount period, but still taking the discount gives the firm more credit than it would receive if it paid within 15 days.
Nominal cost = = (0.03093)(4.5625) = 14.11%.
EAR cost = (1.03093)4.5625 - 1.0 = 14.91%.
= 75 + 38 - 30 = 83 days.
Average sales per day = $3,421,875/365 = $9,375.
Investment in receivables = $9,375 38 = $356,250.
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