24 hours. Questions A-E

Build a Model

Student

10/30/17

Chapter:

22

Problem:

11

Stewart Manufacturing buys on terms of 2/10, net 30, but it has not been paying on time--it is a "slower payer," and its suppliers are getting upset. Stewart does not take discounts, and it has been paying in 50 rather than the required 30 days. Assume that the accounts payable are recorded at full cost, not net of discounts. Stewart's balance sheet follows:

Cash

$250,000

Accounts payable

$2,500,000

Accounts Receivable

2,250,000

Notes payable

250,000

Inventory

3,750,000

Accruals

250,000

Current Assets

6,250,000

Current liabilities

3,000,000

Fixed assets

3,750,000

Long-term debt

750,000

Common equity

6,250,000

Total assets

$10,000,000

Total liabilities and equity

$10,000,000

Stewart's suppliers are fed up and will not continue selling to Stewart unless Stewart begins making prompt payments (that is, paying in 30 days or less). The firm is going to have to reduce its level 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 16%, discount interest, with a 15% compensating balance required. The cash currently held by Stewart 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 Stewart takes discounts? If it does not take discounts and pays in 30 days?

Input Data

Discount, if taken

1%

Days actually taken to make payment

50

Term of discount (days)

10

Interest rate on bank loan

16%

Payment due (days)

30

Required compensating balance

15%

Accounting days/year

360

Purchases per day =

Old A/P

/

old days until payment

=

/

=

Accounts payables =

Term of discount (days)

x

Purchases per day =

Accounts payables if take discounts =

x

=

Accounts payables if don't take discounts =

x

=

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

Cash needed to reduce current accounts payble to the level based on taking discounts:

Cash needed to reduce current accounts payble to the level based on not taking discounts:

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 - (Interest rate on loan)(Loan) - (Compensating balance)(Loan)

Loan =

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

Loan amount needed if take discounts on credit purchases:

Loan amount needed if not take discounts on credit purchases:

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 Stewart 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)

=

x

Nominal cost =

Cash to be received =

$250

Desired level of accounts payable =

$2,499,750

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

Effective annual cost =

Option #1: Take discount

New A/P =

x

Term of discount

(2) Cost of the bank loan

New A/P =

ERROR:#REF!

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

ERROR:#REF!

Terms of the bank loan are a 16% discount interest rate, and a 15% compensating balance. This terms (and the effective rate on the loan) are the same regardless of how much the firm borrows. Assume an amount equal to the amount needed if Stewart does not take discounts on its purchases. We will set up a one-year timeline to analyze the cash flow relevant to this situation.

Option #2

New A/P =

Old A/P

/

old days until payment

x

Payment due

New A/P =

$2,500,000

/

50

x

30

0

(1 Year)

1

New A/P =

$1,500,000.00

Loan amount

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

$1,000,000.00

Discount interest

Compensating balance

Net cash flows

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

Cost of bank loan =

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 larger loan. Since the cost of the bank loan exceeds the cost of nonfree trade credit, Stewart should take out the smaller bank loan and then use nonfree trade credit.

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

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

d. Assume that Stewart 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 an account called "prepaid interest" under current assets.)

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

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:

Malone Feed and Supply Company Balance Sheet

Cash

Accounts payable

Accounts Receivable

Notes payable

Inventory

Accruals

Prepaid interest

Current liabilities

Current Assets

Long-term debt

Fixed assets

Common equity

Total assets

Total liabilities and equity

e. Using interest rates in the range of 5% to 25% and compensating balances in the range of 0% to 30%, perform 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.

Set up a data table as shown below:

Interest

Required Loan

Rate

Compensating Balance Percentage

$ - 0

0%

10%

20%

30%

5%

10%

15%

20%

&P of &N

Loan Sensitivity

Comp Bal = 0% 0.05 0.1 0.15 0.2 Comp Bal = 10% 0.05 0.1 0.15 0.2 Comp Bal = 20% 0.05 0.1 0.15 0.2 Comp Bal = 30% 0.05 0.1 0.15 0.2

Interests rate

Size of Loan