Calculate the annual percentage rate, Cost Accounting

Amanda Deal, president of XYZ, had recently finished an arduous round of meetings with her financial staff". Those meetings dealt with the details necessary to produce an accurate and reliable forecast of the company's cash needs for the next twelve months. The firm's sales were generally not seasonal, and Deal and her finance staff had used annual pro forma financial statements to determine the amount of external financing needed.

XYZ had been in operation since 1981. Amanda Deal believed that the retail personal computer outlet had successfully weathered the business contractions and other manifestations of a changing economy that occurred throughout the 1980s. The firm's sales, $2.5 million in 1993, had grown at a compound rate of 10 percent since 1985; the profit margin had been less steady. Both the most recent sales growth and the profit margin represented improvements over the first several years of the firm's operations. The need for external financing was a new phenomenon for the company. Previously, the firm's short-term funding needs were satis?ed through reliance on trade-credit (a heavy buildup in accounts payable); or through the use of cash reserves over and above the cash needed for normal business transactions. At present, however, increased sales growth and the desire to avoid over-reliance upon the ?1m's suppliers made short-term financing from external sources necessary. It was this overall situation which placed Amanda Deal and her finance staff in the position of having to assess the various types of short-term loans offered by commercial banks.

In typical fashion, Ms. Deal wanted complete information on the various bank lending options. Many who observed her business practices believed that Amanda Deal's attention to detail and her skill at knowing when to delegate authority and duties largely accounted for the success of her business during less than hospitable economic times. In order to satisfy her need for information concerning the speci?c aspects of bank lending, Deal asked Lynn Kerr, the company's controller, to prepare a brief report illustrating the important aspects of bank lending. Kerr believed this to be a logical assignment given the work recently completed concerning the pro forma financial statements. Exhibit 1 below is Kerr's report.


Cost of Bank Lending Summary

Commercial banks are, in general, the primary suppliers of short-term loans to businesses. Short-term financing, as used in this context, refers to the various sources of external financing which are payable within one year. The need for such financing in the well-run ?rm arises when the spontaneous sources of financing prove insufficient. Firms may borrow from banks by using a line of credit, a revolving credit agreement, or a term loan.

The line of credit is for the purpose of providing short-term financing to those ?rms whose needs are reasonably predictable and recurring. In other words, rather than waiting until the funds are needed, the bank is asked by the ?rm to commit to the credit line. Thus, the bank makes a specific amount of funds available to the firm for a specified period. The time commitment on a line of credit rarely extends beyond one year. The rate on the credit line may be variable relative to the prime rate of interest. For the formal line of credit the bank will charge a commitment fee. Once the line is established, the ?rm can "draw down" any desired portion of the line of credit on very short notice to the bank In most short-term revolving credit  agreements the bank will stipulate that the borrower be "out of the bank" for a period of 30-60 days each year. That is,the loan must be paid up for that period. This allows the bank to clearly determine whether the loan is actually a revolving credit situation. If the borrower cannot pay the loan and avoid borrowing for a 30-60 day period then the loan may be converted to a term loan. A term loan is a commercial loan with a maturity greater than one year. Term loans from commercial banks rarely extend beyond seven years.

In terms of a more permanent line of credit, banks offer what is called a revolving credit arrangement. This is similar to a line of credit; however, the bank makes a commitment to the ?rm for a period of several years. There is a commitment fee attached to the revolving credit arrangement as in the case of the line of credit. In addition to the commitment fee, the borrower has to agree in writing to the credit arrangement. The written agreement contains loan covenants. Such covenants protect the lender and refer to such things as the level of working capital, dividend payments, and additional borrowing.

These limitations on further financing activity protect the borrower as well. They may prevent activities not in keep in with sound financial practices.

A further aspect of bank borrowing has to do with the compensating balance. There are two types of compensating balances. One type is the balance that is a part of the check clearing activities of the bank. The compensating balance in this case provides the bank a means for earning a fee for the check clearing. The compensating balance funds are invested by the bank. The other type of compensating balance is part of the loan arrangement. As an example, in the case of a line of credit, the compensating balance may be expressed as some percentage of the drawn down amount of the line, or as a percent of the total line. Compensating balances also increase the effective cost of borrowing.

Interest = (P) x (R) x (N+ 360);

Where: P = Principal (face) amount of the loan;

           R = Annual interest rate; and

           N = Number of days outstanding.

Based upon the foregoing example, if a firm borrows $50,000 for one year at an interest rate of 8 percent, the interest on the loan would be $4,000 (i.e., interest = $50,000 X 0.08 x (360 + 360) = $4,000). If the term of the note were four months, 120 days, the interest would be $1,333.33 (i.e., interest = $50,000 x 0.08 X (120 + 360) = $1,333.33). Interest is generally calculated using a 360- day year.

The annual interest rate charged on a loan is called the nominal annual rate of interest. The effective annual cost of the loan usually differs from the nominal rate. The effective annual cost depends upon the net amount of funds available to the borrower. The net fund to the borrower is affected by a compensating balance requirement, or by the loan being a discounted loan. The interest is paid at the inception of the loan in the case of a discounted loan. The borrower receives the principal amount minus the discounted interest. The effective annual cost of a loan which is discounted and has a compensating balance requirement as a specific provision of the loan would appear as follows:

Periodic annual cost = Annual interest rate + [1 - discount percentage - compensating balance percentage].

It is the foregoing which in?uences the effective annual cost of borrowed funds. Banks discount loans or impose compensating balances  based upon a number of factors. The state of the economy, the ?exibility of the bank's lending policies, and the creditworthiness of the borrower are the primary reasons for a com compensating balance or discounting to be u art of the loans to businesses. Deal read Kerr's memorandum with great interest. She then reflected upon the various factors which might in?uence her company's negotiations with the bank. Deal knew that the company's profit margin was less than outstanding in recent years due to a variety of factors Most notable among those factors were the increases in rental costs for the company's administrative offices and retail location, relatively slow moving inventory, and increased training costs, all necessary in order to survive in a slow economy. She was relieved that very recent economic reports spoke of much better days ahead for the economy in general and for the retail personal computer business. Tables 1 and 2 illustrate certain aspects of the firms operating characteristics. The company needed $150,000 on a short-term basis. The rates prevailing at the time were between 7 and 9 percent. Computerland would most likely be able to borrow at a rate of 8 percent. Deal had also read an article in a business publication which stated that banks had become "very cautious lenders." The article described the investment practices followed by many well-run banks which yielded returns sufficient to allow them the selectivity among borrowers to which the article referred.



Income Statement Data ($000s)


















Less: Cost of goods sold






Gross profit






Less: Total operating costs






Earnings before interest and tax






Less: Interest expense






Profit before tax






Less: Income taxes






Profit after tax






XYZ Plastic Molding Company
Incremental Data for the X2-A Extruder



















Inventory-to sales







Current ratio







Total debt-to-total assets








1. Comment upon the Kerr memo. What are its major points and how might these affect XYZ? Is the memo re?ective of the manner in which banks lend money?

2. As a means of adding to Deal's information in this matter, calculate the APR for each of the following for the company's $150,000 loan:

a.   Simple interest at 8 percent.

i. No compensating balance.

ii. 10 percent compensating balance.

b. Discount interest at 8 percent.

i. No compensating balance.

ii. 10 percent compensating balance.

Which of the APR's might be most appropriate for Deal's? Explain your answer.

3. If banks are investing an increasing amount of funds in the money market versus lending to business borrowers, what will this mean to Deal now and in the future?

4. Why does the bank require a period of no drawdown? Is this reasonable? Should Deal change banks because of this provision?

5. Why is Deal concerned about "over-reliance upon the ?rm's supplies?" Discuss the advantages and disadvantages of bank borrowing, given her attitude about the suppliers.

6. Refer to your answer to Question 2. Is Deal in a position to seek the lowest rate shown? Why or why not?

7. Generally, what causes banks to be "cautious lenders?"

8. What type of information, and in what format, will the bank likely want before it seriously considers a loan to XYZ?

9. Of what importance will trend data be to the bank in this decision? Which trends will offer the most useful information to the bank?

10. Describe, without the use of numbers, the difference between the nominal annual rate of interest and the effective annual cost of the loan.

Posted Date: 3/26/2013 7:36:28 AM | Location : United States

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