Current Assets Paper 2

(a) The requirement is to identify the advantage of using long-term debt as a source of financing current assets. Answer (a) is correct because financing with long-term as opposed to short-term debt reduces the risk of the firm. Long-term debt does not have to be repaid as soon as short-term debt. Answer (b) is incorrect because long-term debt is generally more costly than short-term debt. Answer (c) is incorrect because the debt covenants are usually more restrictive in long-term debt agreements. Answer (d) is incorrect because early payment of long-term debt can result in prepayment penalties.

(c) The requirement is to identify the item that is not an implication of the policy of matching maturity assets with the maturity of financing. Answer (c) is correct because under this policy current assets are financed with current liabilities. Answers (a), (b), and (d) are incorrect because they are all appropriate implications of the policy.

(d) The requirement is to identify the term used to describe asset-backed public offerings. Answer (d) is correct because securitization of assets is the offering of debt collateralized by a firm’s accounts receivable. Answer (a) is incorrect because a trust receipt is an instrument that acknowledges that the borrower holds a collateralized inventory and that proceeds from the sale will be put in trust for the lender. Answer (b) is incorrect because warehousing is the storage of inventory in a public warehouse that can only be removed with the lender’s permission. Answer (c) is incorrect because a blanket inventory lien is a document that establishes the inventory as collateral for the loan.

(d) The requirement is to calculate the effective cost of a loan with a compensating balance requirement. Answer (d) is correct because the effective interest rate is equal to the interest paid, $7,000 ($100,000 × 7%) divided by the funds that are available, $80,000 (80% × $100,000). Therefore, the effective interest rate is equal to 8.75% ($7,000 ÷ $80,000). Answer (a) is not reasonable because the amount is less than the stated interest rate. Answer (b) is incorrect because it is the stated rate. Answer (c) is incorrect because it is computed by adding 20% of the stated rate to the stated rate.

(d) The requirement is to identify the term used to describe asset-backed public offerings. Answer (d) is correct because securitization of assets is the offering of debt collateralized by a firm’s accounts receivable. Answer (a) is incorrect because a trust receipt is an instrument that acknowledges that the borrower holds a collateralized inventory and that proceeds from the sale will be put in trust for the lender. Answer (b) is incorrect because warehousing is the storage of inventory in a public warehouse that can only be removed with the lender’s permission. Answer (c) is incorrect because a blanket inventory lien is a document that establishes the inventory as collateral for the loan.

(b) The requirement is to calculate the weightedaverage annual interest rate for trade credit. If the company does not pay Web Master within the discount period, it will incur interest costs of $500 ($25,000 × 2%). This results in an annualized interest rate of 36.7347% [($500 ÷ $24,500) × 360 days ÷ (30 – 10 days)]. If the company does not pay the Softidee account during the discount period, it will incur interest cost of $2,500 ($50,000 × 5%). This results in an annualized interest rate of 23.6842% [($2,500 ÷ $47,500) × 360 days ÷ (90 – 10 days)]. To determine the weighted-average interest rate, we must first determine the average amount borrowed. For Web Master, this is equal to $24,500 × (20 days ÷ 360 days) = $1,361.11, and for Softidee, it is equal to $47,500 × (80 days ÷ 360 days) = $10,555.56. Therefore, the weighted-average interest rate is equal to 25.2% {[(36.7347% × $1,361.11) + (23.6842% × $10,555.56)] ÷ ($1,361.11 + $10,555.56)}. Answer (a) is incorrect because it uses weights of $25,000 and $50,000. Answer (c) is incorrect because it is based on weights of $24,500 and $47,500. Answer (d) is incorrect because it is the unweighted-average of the two rates.

(d) The requirement is to identify the statement that determines whether Cyber Age should continue to use the trade credit. Answer (d) is correct because the company should continue to use the trade credit as long as the alternative cost of other forms of financing is higher. Answer (a) is incorrect because if alternative sources are less, the alternative should be used. Answer (b) is incorrect because in considering short-term financing alternatives, it is the marginal cost of capital that is important, not the weighted-average cost of capital. Answer (c) is incorrect because if the cost of long-term financing is greater, the trade credit should be used.

(a) The requirement is to calculate the effective interest on the loan. Answer (a) is correct because the effective interest is 6.44%. The effective interest rate is determined by calculating the net interest expense, which is $15,000 ($250,000 × 6%) minus the interest income from the compensating balance $500 ($25,000 × 2%) equals $14,500. Then, this amount is divided by the amount of money that the firm has available, $250,000 – $25,000 compensating balance. Thus, the effective interest rate is 6.44% ($14,500/$225,000).

(b) The requirement is to identify the statement that is most likely true about commercial paper. Answer (b) is correct because commercial paper is normally issued with a short maturity period, usually 2 to 9 months. Answer (a) is incorrect because commercial paper is issued by the corporation. Answer (c) is incorrect because commercial paper is unsecured. Answer (d) is incorrect because commercial paper is typically issued by large corporations.

(a) The requirement is to identify the loan with the most favorable terms. Answer (a) is correct because simple interest with no compensating balance is the most favorable terms from an effective interest basis. Answers (b), (c), and (d) are incorrect because discount interest and/or a compensating balance increase the effective interest rate on the loan.