Ch 23-18 Build a Model Solution

3/7/2001

Chapter 23. Solution to Ch 23-18 Build a Model

Malone Feed and Supply Company buys on terms of 1/10, net 30, but it has not been paying on time--it

is a "slower payer," and its suppliers are getting upset. Malone does not take discounts, and it has

been paying in 60 rather than the required 30 days. Assume that the accounts payable are recorded

at full cost, not net of discounts. Malone's balance sheet (in thousands of dollars) follows:

Cash

$50

Accounts payable

$500

Accounts Receivable

450

Notes payable

50

Inventory

750

Accruals

50

Current Assets

1,250

Current liabilities

600

Fixed assets

750

Long-term debt

150

Common equity

1,250

Total assets

$2,000

Total liabilities and equity

$2,000

Now, Malone's suppliers are threatening to stop shipments unless the company begins making

prompt payments (that is, paying in 30 days or less). The firm is going to have to reduce its $500 of

accounts payable, either to an amount that is equal to 30 days purchases (if it does not take discounts)

or to 10 days purchases (if it decides to take discounts). Management has decided to obtain the needed

funds by borrowing on an additional 1-year note payable (call this a current liability) from its bank at

a rate of 15 percent, discount interest, with a 20 percent compensating balance required. The

$50,000 of cash Malone currently has is needed for transactions, so it cannot be used as part of the

compensating balance. So, the issue now facing the company is this: How much trade credit should it

use, and how large a loan should it obtain from its bank?

a. How large would the accounts payable balance be if Malone takes discounts? If it does not take

discounts and pays in 30 days?

Input Data

Discount, if taken

1%

Days Malone has taken to make payment

60

Term of discount (days)

10

Interest rate on bank loan

15%

Payment due (days)

30

Required compensating balance

20%

Accounting days/year

360

Purchases per day =

Old A/P

/

old days until payment

=

500

/

60

=

$8.33

Accounts payables if take discounts:

10

x

$8.33

=

$83.33

Accounts payables if don't take discounts:

30

x

$8.33

=

$250.00

b. How large must the bank loan be if Malone takes discounts? If Malone doesn't take discounts?

The company must go from $500 to either $83.33 or $250, so it will need this amount of cash:

Cash needed if take discounts:

$416.67

Cash needed if don't take discounts:

$250.00

Recall that because of the discount interest and compensating balance, the firm does not actually

receive the full face amount of the loan. Therefore, it must borrow more (face value of the note) than it

actually needs. The formula for finding the necessary loan to sustain a $250,000 cash receipt is:

Amount needed =

Loan - (0.15)(Loan) - (0.2)(Loan)

Loan =

Amount needed/(1- Interest rate - Comp. Balance %)

=

Amount needed/(1 - 0.15 -0.20)

Loan if take discounts:

$641.03

Loan if don't take discounts:

$384.62

c. What are the nominal and effective costs of nonfree trade credit? What is the effective cost of the

bank loan? Based on these costs, what should Malone do?

(1) Cost of nonfree trade credit

Nominal cost =

cost per period

x

Periods per year

Discount/(1- discount)

x

Days per year / (Credit period - this period)

=

1.01%

x

18

Nominal cost =

18.18%

Cash to be received =

$250

Desired level of accounts payable =

$250

Interest charge =

$0.00

Effective annual cost =

(( 1 + cost per period ) ^ periods per year) - 1

Effective interest cost =

0.00%

Effective annual cost =

1

+

1.01%

^

18

-

1

Effective annual cost =

19.83%

Option #1: Take discount

New A/P =

x

Term of discount

(2) Cost of the bank loan

New A/P =

#VALUE!

This means that loan Malone would have to secure from the bank would be:

#VALUE!

Terms of the bank loan are a 15 percent discount interest rate, and a 20 percent compensating

balance. This cost is the same regardless of how much the firm borrows. Assume a $250,000 loan.

Option #2

We will set up a one-year timeline to analyze the cash flow relevant to this situation.

New A/P =

Old A/P

/

old days until payment

x

Payment due

New A/P =

$500

/

60

x

30

0

(1 Year)

1

New A/P =

$250.00

$384.62

Loan amount

($384.62)

This means that loan Malone would have to secure from the bank would be:

$250.00

($57.69)

Discount interest

$57.69

($76.92)

Compensating balance

$76.92

$250.00

Net cash flows

($250.00)

Using the RATE function, we can determine the cost of the bank loan.

Cost of bank loan =

0.00%

Malone has two alternatives under the conditions set forth by its suppliers. It can either choose

This cost rate would be the same for the smaller loan. Since the cost of the bank loan exceeds the cost

to begin paying creditors in the first ten days and receive a discount (Option #1) or it can take

of nonfree trade credit, Malone should take out the smaller bank loan and then use nonfree trade

the full thirty days to make payment (Option #2). The decision here will not directly affect the

credit.

d. Assume that Malone foregoes the discount and borrows the amount needed to become current on its

payables. Construct a pro forma balance sheet based on this decision. (Hint: you will need to include

cost of nonfree trade credit, but will likely come into play later in the problem. For that reason,

an account called "prepaid interest" under current assets.)

we are going to calculate the expected levels of accounts payable under the

The operating assets will remain unchanged, but a new current asset, "Prepaid interest," will be

created. Also, cash will increase by the amount of the compensating balance. On the liability side,

accounts payable will decline, and notes payable will increase. Total assets will increase by the sum of

the compensating balance and the prepaid interest, or:

$134.62

Malone Feed and Supply Company Balance Sheet

Cash

$126.9

Accounts payable

$250.0

Accounts Receivable

$450.0

Notes payable

434.6

Inventory

$750.0

Accruals

$50.0

Prepaid interest

$57.7

Current liabilities

$734.6

Current Assets

1,384.6

Long-term debt

$150.0

Fixed assets

$750.0

Common equity

$1,250.0

Total assets

$2,134.6

Total liabilities and equity

$2,134.6

e. Do a sensitivity analysis that shows how the size of the bank loan would vary with changes in the

interest rate and the compensating balance percentage, using rates in the range of 5% to 25% and

compensating balances in the range of 0% to 30%.

Set up a data table as shown below:

Interest

Required Loan

Rate

Compensating Balance Percentage

$384.62

0%

10%

20%

30%

5%

$263.16

$294.12

$333.33

$384.62

10%

$277.78

$312.50

$357.14

$416.67

15%

$294.12

$333.33

$384.62

$454.55

20%

$312.50

$357.14

$416.67

$500.00