"Chapter 8Discussion Questions8-1. Under what circumstances would it be advisable to borrow money to take acash discount?It is advisable to borrow in order to take a cash discount when the cost ofborrowing is less than the cost of foregoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding analternate source of funds for 8 to 10 percent. 8-2. Discuss the relative use of credit between large and small firms. Which groupis generally in the net creditor position, and why?Larger firms tend to be in a net creditor position because they have thefinancial resources to be suppliers to credit. The smaller firm must look to thelarger manufacturer or wholesaler to help carry the firm’s financingrequirements. 8-3. How have new banking laws influenced competition?New banking laws allowed more competition and gave banks the right toexpand across state lines to create larger, more competitive markets. They also increased bank mergers. 8-4. What is the prime interest rate? How does the average bank customer farein regard to the prime interest rate?The prime rate is the rate that a bank charges its most creditworthy customers.The average customer can expect to pay one or two percent (or more) aboveprime. 8-5. What does LIBOR mean? Is LIBOR normally higher or lower than the U.S. prime interest rate?LIBOR stands for London Interbank Offered Rate. As indicated in Figure 8-1, it is consistently below the prime rate. S8-1 8-6. What advantages do compensating balances have for banks? Are theadvantages to banks necessarily disadvantages to corporations?The use of a compensating balance or minimum required account balanceallows the banker to generate a higher return on a loan because not all fundsare actually made available to the borrower. A $125,000 loan with a $25,000compensating balance requirement means only $100,000 is being providedon a net basis. This benefit to the lender need not be a disadvantage to theborrower. The borrower may, in turn, receive a lower quoted interest rateand certain gratuitous services because of the compensating balancerequirement. 8-7. A borrower is often confronted with a stated interest rate and an effectiveinterest rate. What is the difference, and which one should the financial manager recognize as the true cost of borrowing?The stated interest rate is the percentage rate unadjusted for time or methodof repayment. The effective interest rate is the true rate and considers allthese variables. A 5 percent stated rate for 90 days provides a 20 percenteffective rate. The financial manager should recognize the effective rate asthe true cost of borrowing. The effective rate is also referred to as the APR (Annual Percentage Rate). 8-8. Commercial paper may show up on corporate balance sheets as either a current asset or a current liability. Explain this statement.Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporation’s commercialpaper as a short-term investment, it is a current asset. Conversely, if acorporation issues its own commercial paper, it is a current liability. 8-9. What are the advantages of commercial paper in comparison with bankborrowing at the prime rate? What is a disadvantage?In comparison to bank borrowing, commercial paper can generally be issuedat below the prime rate. Furthermore, there are no compensating balancerequirements, though the firm is required to maintain approved credit lines ata bank. Finally, there is a certain degree of prestige associated with theissuance of commercial paper.The drawback is that commercial paper may be an uncertain source of funds.When money gets tight or confidence in the commercial paper marketdiminishes, funds may not be available. There is no loyalty factor such as thatwhich exists between a bank and its best borrowers. S8-2 8-10. What is the difference between pledging accounts receivable and factoringaccounts receivable?Pledging accounts receivable means receivables are used as collateral for aloan; factoring account receivables means they are sold outright to a financecompany. 8-11. What is an asset-backed public offering?A public offering is backed by an asset (accounts receivable) as collateral.Essentially a firm sells its receivables into the securities markets. 8-12. Briefly discuss three types of lender control used in inventory financing.Three types of lender control used in inventory financing are:a. Blanket inventory – lien-general claim against inventory or collateral. Nospecific items are marked or designated.b. Trust receipt – borrower holds the inventory in trust for the lender. Eachitem is marked and has a serial number. When the inventory is sold, thetrust receipt is canceled and the funds go into the lender’s account.c. Warehousing – the inventory is physically identified, segregated, and storedunder the direction of an independent warehouse company that controls themovement of the goods. If done on the premises of the warehousing firm, it istermed public warehousing. An alternate arrangement is field warehousingwhereby the same procedures are conducted on the borrower’s property. 8-13. What is meant by hedging in the financial futures market to offset interest raterisks?Hedging means to engage in a transaction that partially or fully reduces a priorrisk exposure. In selling a financial futures contract, if interest rates go up, oneis able to buy back the contract at a profit. This will help to offset the higherinterest charges to a corporation or other business entity.S8-3 Chapter 8Problems1. Compute the cost of not taking the following cash discounts. a. 2/10, net 40. b. 2/15, net 30. c. 2/10, net 45. d. 3/10, net 90.8-1. Solution:Cost of not Discount % 360 taking a cash = × 100%-- Disc.% Final due date discount Discount period a.2% 360 Cost of = × = 2.04%×12.00=24.48%lost discount 98% 40 -10 b.2% 360 Cost of= × =2.04%×= 24.00 48.96%lost discount 98% 30 -15 c. 2% 360 Cost of= × = 2.04%×10.29= 20.99%lost discount 98% 45 -10 d. 3% 360 Cost of= × = 3.09%×= 4.50 13.91%lost discount 97% 90 -10 S8-4 2 Delilah’s Haircuts can borrow from its bank at 13 percent to take a cash discount. The terms of the cash discount are 2/15, net 55. Should the firm borrow the funds?8-2. Solution:Delilah’s HaircutsFirst, compute the cost of not taking the cash discount andcompare this figure to the cost of the loan.Cost of not Discount% 360 taking a cash = × 100%-- Disc.% final due date discount period discount2% 360 = × 98% 55 -15 =2.04%×= 9 18.36% The cost of not taking the cash discount is greater than the cost ofthe loan (18.36% vs. 13%). The firm should borrow the moneyand take the cash discount.3. Your bank will lend you $4,000 for 45 days at a cost of $50 interest. What is your effectiverate of interest?8-3. Solution:Interest Days in the year (360) Effective rate = × Principal Days loan is outstanding $50 360 = ×$4,000 45 =1.25%×= 8 10% S8-5 "