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Corporate Finance - Berk DeMarzo- Test Bank Chapter 27

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Corporate Finance, 3e (Berk/DeMarzo)

Chapter 27 Short-Term Financial Planning

27.1 Forecasting Short-Term Financing Needs

1) Occasionally, a company will encounter circumstances in which cash flows are temporarily negative for an unexpected reason. We refer to such a situation as: A) a liquidity shock.

B) a negative cash flow shock. C) a negative liquidity shock. D) a cash crunch. Answer: B Diff: 1

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Conceptual

2) When a company analyzes its short-term financing needs, it typically examines cash flows at A) monthly intervals. B) yearly intervals. C) quarterly intervals. D) weekly intervals. Answer: C Diff: 1

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Conceptual

3) Which of the following firms is likely to have the highest short-term financing needs? A) A pharmaceutical manufacturer B) A grocery store C) An electric utility D) A toy store Answer: D Diff: 1

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Conceptual

4) Which of the following statements is FALSE?

A) If a company anticipates an ongoing surplus of cash, it may choose to increase its dividend payout.

B) Seasonal sales can create large short-term cash flow deficits and surpluses.

C) The first step in short-term financial planning is to forecast the company's future net working capital.

D) Deficits resulting from investments in long-term projects are often financed using long-term sources of capital, such as equity or long-term bonds. Answer: C

Explanation: C) The first step in short-term financial planning is to forecast the company’s future cash flows. Diff: 2

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Conceptual

5) Which of the following statements is FALSE?

A) Firms with seasonal cash flows may find themselves with a surplus of cash during some

months that is sufficient to compensate for a shortfall during other months. However, because of timing differences, such firms often have short-term financing needs.

B) A company forecasts its cash flows to determine whether it will have surplus cash or a cash deficit for each period.

C) Like seasonalities, positive cash flow shocks can create short-term financing needs.

D) When sales are concentrated during a few months, sources and uses of cash are also likely to be seasonal. Answer: C

Explanation: C) Like seasonalities, negative cash flow shocks can create short-term financing needs. Diff: 2

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Conceptual

Use the table for the question(s) below.

The quarterly working capital levels for Hasbeen Toys are presented in the following table (in $ millions): Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 6) In which quarter are Hasbeen's seasonal working capital needs the greatest? A) 4 B) 2 C) 3 D) 1

Answer: C

Explanation: C) Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 Working capital 765 1,000 1,105 990 Working capital = Cash + AR + Inventory - AP. Note quarter 3 has the highest Working capital needs. Diff: 2

Section: 27.1 Forecasting Short-Term Financing Needs Skill: Analytical

27.2 The Matching Principle

1) Which of the following is NOT a specific financing option for temporary working capital? A) Secured financing B) Commercial paper C) Bank loans D) Treasury bills Answer: D Diff: 1

Section: 27.2 The Matching Principle Skill: Conceptual

2) Which of the following statements is FALSE?

A) The matching principle indicates that the firm should finance permanent working capital with short-term sources of funds.

B) Following the matching principle should, in the long run, help minimize a firm's transaction costs.

C) In a perfect capital market, the choice of financing is irrelevant; thus how the firm chooses to finance its short-term cash needs cannot affect value.

D) A portion of a firm's investment in its accounts receivable and inventory is temporary and results from seasonal fluctuations in the firm's business or unanticipated shocks. Answer: A

Explanation: A) The matching principle indicates that the firm should finance permanent working capital with long-term sources of funds. Diff: 1

Section: 27.2 The Matching Principle Skill: Conceptual

3) Which of the following statements is FALSE?

A) Because investment in permanent working capital is required so long as the firm remains in business, it constitutes a long-term investment.

B) Because temporary working capital represents a short-term need, the firm should finance this portion of its investment with short-term financing.

C) Temporary working capital is the difference between the lowest level of investment in short-term assets and the permanent working capital investment.

D) The matching principle states that short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds. Answer: C

Explanation: C) Temporary working capital is the difference between the actual level of investment in short-term assets and the permanent working capital investment. Diff: 2

Section: 27.2 The Matching Principle Skill: Conceptual

4) Which of the following statements is FALSE?

A) With a discount loan, the borrower is required to pay the interest at the end of the loan period. B) Bridge loans are often quoted as discount loans with fixed interest rates.

C) A bridge loan is another type of short-term bank loan that is often used to \"bridge the gap\" until a firm can arrange for long-term financing.

D) After a natural disaster, lenders may provide businesses with short-term loans to serve as bridges until they receive insurance payments or long-term disaster relief. Answer: A

Explanation: A) With a discount loan, the borrower is required to pay the interest at the beginning of the loan period. Diff: 2

Section: 27.2 The Matching Principle Skill: Conceptual

5) Which of the following statements is FALSE?

A) Financing part or all of the permanent working capital with short-term debt is known as an aggressive financing policy.

B) When the yield curve is downward sloping, the interest rate on short-term debt is lower than the rate on long-term debt. In that case, short-term debt may appear cheaper than long-term debt. C) The value of short-term debt is less sensitive to the firm's credit quality than long-term debt; therefore, its value will be less affected by management's actions or information.

D) Permanent working capital is the amount that a firm must keep invested in its short-term assets to support its continuing operations. Answer: B

Explanation: B) When the yield curve is upward sloping, the interest rate on short-term debt is lower than the rate on long-term debt. In that case, short-term debt may appear cheaper than long-term debt. Diff: 3

Section: 27.2 The Matching Principle Skill: Conceptual

6) Which of the following statements is FALSE?

A) On the other hand, by relying on short-term debt the firm exposes itself to funding risk, which is the risk of incurring financial distress costs should the firm not be able to refinance its debt in a timely manner or at a reasonable rate.

B) An ultra-conservative policy would involve financing even some of the plant, property, and equipment with short-term sources of funds.

C) With a conservative financing policy, the firm would use short-term debt very sparingly to meet its peak seasonal needs.

D) Short-term debt can have lower agency and lemons costs than long-term debt, and an aggressive financing policy can benefit shareholders. Answer: B

Explanation: B) An ultra-aggressive policy would involve financing even some of the plant, property, and equipment with short-term sources of funds. Diff: 2

Section: 27.2 The Matching Principle Skill: Conceptual

7) Which of the following statements is FALSE?

A) When following a conservative financing policy, a firm would use long-term sources of funds to finance its fixed assets, permanent working capital, and some of its seasonal needs.

B) An aggressive financing policy also increases the possibility that managers of the firm will use excess cash nonproductively—for example, on perquisites for themselves.

C) A firm could finance its short-term needs with long-term debt, a practice known as a conservative financing policy.

D) To implement a conservative financing policy effectively, there will necessarily be periods when excess cash is available—those periods when the firm requires little or no investment in temporary working capital. Answer: B

Explanation: B) A conservative financing policy also increases the possibility that managers of the firm will use excess cash nonproductively—for example, on perquisites for themselves. Diff: 2

Section: 27.2 The Matching Principle Skill: Conceptual

Use the table for the question(s) below.

The quarterly working capital levels for Hasbeen Toys are presented in the following table (in $ millions): Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 8) The permanent working capital needs for Hasbeen Toys is closest to: A) $1,100 million B) $2,435 million C) $1,275 million D) $770 million Answer: D

Explanation: D) Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 Working capital 765 1,000 1,105 990 Working capital = Cash + AR + inventory - AP

Permanent working capital equals the minimum level of working capital which occurs at quarter 1 in the amount of $765 million. Diff: 2

Section: 27.2 The Matching Principle Skill: Analytical

9) The temporary working capital needs for Hasbeen Toys in quarter 1 is closest to: A) $0 million B) $340 million C) $770 million D) $845 million Answer: A

Explanation: A) Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 Working capital 765 1,000 1,105 990 Working capital = Cash + AR + inventory - AP

Permanent working capital equals the minimum level of working capital which occurs at quarter 1 in the amount of $765 million.

Temporary working capital = working capital - permanent working capital = $765 - $765 = $0 million Diff: 2

Section: 27.2 The Matching Principle Skill: Analytical

10) The temporary working capital needs for Hasbeen Toys in quarter 3 is closest to: A) $845 million B) $0 million C) $770 million D) $ 340 million Answer: D

Permanent working capital equals the minimum level of working capital which occurs at quarter 1 in the amount of $765 million.

Temporary working capital = working capital - permanent working capital = $1105 - $765 = $340 million Diff: 2

Section: 27.2 The Matching Principle Skill: Analytical

11) Calculate the temporary working capital needs for each of the four quarters for Hasbeen Toys.

Answer: Quarter 1 2 3 4 Cash 605 625 175 1,000 Accounts Receivable 585 745 1,260 760 Inventory 410 540 725 375 Accounts Payable 835 910 1,055 1,145 Working capital 765 1,000 1,105 990 permanent W/C 765 765 765 765 temporary W/C 0 235 340 225 Working capital = Cash + AR + inventory - AP

Permanent working capital equals the minimum level of working capital which occurs at quarter 1 in the amount of $765 million.

Temporary working capital = working capital - permanent working capital Diff: 2

Section: 27.2 The Matching Principle Skill: Analytical

27.3 Short-Term Financing with Bank Loans

Use the following information to answer the question(s) below.

Taggart Transcontinental needs a $100,000 loan for the next 30 days. Taggart has three alternatives available:

Alternative #1: Forgo the discount on its trade credit agreement that offers terms of 2/5 net 35.

Alternative #2: Borrow the money from Bank A, which has offered to lead the firm $100,000 for one month at

an APR of 9%. The bank will require a (no-interest) compensating balance of 10% of the face-value of the loan and will charge a $200 loan origination fee, which means that Taggart must morrow even more than the $100,000 they need.

Alternative #3: Borrow the money from Bank B, which has offered to lend the firm $100,000 for one month at an APR of 12%. The loan has a 1% origination fee.

1) The effective annual rate for Taggart if they choose alternative #1 is closest to: A) 13.9% B) 18.8% C) 27.0% D) 27.9% Answer: D

Explanation: D) The interest rate per period is $2/$98 = .020408. If the firm delays payment until the 35th day, it has use of the funds for 30 days beyond the discount period. There are 365/30 = 12.167 30 day periods in one year. Thus, the effective annual cost is (1 + .020408)12.167 - 1 = .2786 or 27.86% Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

2) The effective annual rate for Taggart if they choose alternative #2 is closest to: A) 13.0% B) 13.9% C) 18.8% D) 27.0% Answer: A

Explanation: A) Taggart must borrow more than the $100,000 they need because of the loan origination fee and compensating balance. The amount that they will need to borrow is equal to (amount needed + fee) × (1 + compensating balance percentage) = ($100,000 + $200)(1.1) = $110,220 ($10,020 is the compensating balance). The amount that will need to be repaid (with interest) is equal to $110,220(1 +

) = $111,046.65. The actual monthly interest rate paid is - 1 = .010267 or 1.0267%. Thus, the effective annual cost is

(1 + .010267)12 - 1 = .1304 or 13.04% Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

3) The effective annual rate for Taggart if they choose alternative #3 is closest to: A) 13.9% B) 18.8% C) 27.0% D) 27.9% Answer: C

Explanation: C) Taggart must borrow more than the $100,000 they need because of the loan origination fee. The amount that they will need to borrow is equal to the amount needed (1 + fee percentage) = $100,000(1.01) = $101,000. The amount that will need to be repaid (with interest) is equal to $101,000(1 +

) = $102,010. The actual monthly interest rate paid is

- 1 = .020100 or 2.01%. Thus, the effective annual cost is (1 + 2.01)12 - 1 = .2697 or 26.97% Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

4) Which alternative should Taggart choose? A) Alternative #1 since it has the lowest EAR B) Alternative #2 since it has the lowest EAR C) Alternative #3 since it has the lowest EAR

D) Alternative #2 since it has the highest actual rate Answer: B

Explanation: B) Alternative #1 -The interest rate per period is $2/$98 = .020408. If the firm delays payment until the 35th day, it has use of the funds for 30 days beyond the discount period. There are 365/30 = 12.167 30 day periods in one year. Thus, the effective annual cost is (1 + .020408)12.167 - 1 = .2786 or 27.86%

Alternative #2 - Taggart must borrow more than the $100,000 they need because of the loan origination fee and compensating balance. The amount that they will need to borrow is equal to (amount needed + fee) × (1 + compensating balance percentage) = ($100,000 + $200)(1.1) = $110,220 ($10,020 is the compensating balance). The amount that will need to be repaid (with interest) is equal to $110,220(1 +

) = $111,046.65. The actual monthly interest rate paid is - 1 = .010267 or 1.0267%. Thus, the effective annual cost is

(1 + .010267)12 - 1 = .1304 or 13.04%

Alternative #3 - Taggart must borrow more than the $100,000 they need because of the loan origination fee. The amount that they will need to borrow is equal to the amount needed (1 + fee percentage) = $100,000(1.01) = $101,000. The amount that will need to be repaid (with interest) is equal to $101,000(1 +

= $102,010. The actual monthly interest rate paid is

- 1 = .020100 or 2.01%. Thus, the effective annual cost is (1 + 2.01)12 - 1 = .2697 or 26.97%

Choose alternative #2 since it has the lowest EAR. Diff: 3

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

5) A loan agreement requires that the firm pay interest on the loan and pay back the principal in one lump sum at the end of the loan is called: A) a short-term mortgage loan.

B) a single, end-of-period-payment loan. C) a bridge loan. D) a line of credit. Answer: B Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Definition

6) A short-term bank loan that is often used until a firm can arrange for long-term financing is called:

A) a committed line of credit. B) a short-term mortgage loan. C) a bridge loan.

D) a single, end-of-period-payment loan. Answer: C Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Definition

7) A a written, legally binding agreement that obligates the bank to lend a firm any amount up to a stated maximum, regardless of the financial condition of the firm (unless the firm is bankrupt) as long as the firm satisfies any restrictions in the agreement is called: A) a bridge loan.

B) a single, end-of-period-payment loan. C) a short-term mortgage loan. D) a committed line of credit. Answer: D Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Definition

8) Which of the following statements is FALSE?

A) Bank loans are typically initiated with a promissory note, which is a written statement that indicates the amount of the loan, the date payment is due, and the interest rate.

B) The most straightforward type of bank loan is a single, end-of-period-payment loan.

C) With a fixed interest rate, the specific rate that the bank will charge is stipulated at the time the loan is made.

D) One of the primary sources of short-term financing, especially for small businesses, is the investment bank. Answer: D

Explanation: D) One of the primary sources of short-term financing, especially for small businesses, is the commercial bank. Diff: 1

Section: 27.3 Short-Term Financing with Bank Loans Skill: Conceptual

9) Which of the following statements is FALSE?

A) The prime rate is the rate banks charge other banks.

B) With a variable interest rate, the terms of the loan may indicate that the rate will vary with some spread relative to a benchmark rate, such as the yield on one-year Treasury securities or the prime rate.

C) With a discount loan, the borrower is required to pay the interest at the beginning of the loan period.

D) A common benchmark rate is the London Inter-Bank Offered Rate, or LIBOR, which is the rate of interest at which banks borrow funds from each other in the London inter bank market. Answer: A

Explanation: A) The prime rate is the rate banks charge their most creditworthy customers. Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Conceptual

10) Which of the following statements regarding lines of credit is FALSE?

A) The line of credit agreement may also stipulate that at some point in time the outstanding balance must be zero. This policy ensures that the firm does not use the short-term financing to finance its long-term obligations.

B) A revolving line of credit is an uncommitted line of credit that involves an informal agreement from the bank for a longer period of time, typically two to three years.

C) The line of credit may be uncommitted, meaning it is an informal agreement that does not legally bind the bank to provide the funds.

D) A revolving line of credit with no fixed maturity is called evergreen credit. Answer: B

Explanation: B) A revolving line of credit is a committed line of credit that involves a solid commitment from the bank for a longer period of time, typically two to three years. Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Conceptual

11) Which of the following statements is FALSE?

A) Regardless of the loan structure, the bank may include a compensating balance requirement in the loan agreement that reduces the usable loan proceeds.

B) Another common type of fee is a loan origination fee, which a bank charges to cover credit checks and legal fees.

C) Firms frequently use lines of credit to finance seasonal needs.

D) The commitment fee associated with a committed line of credit is designed to decreases the effective cost of the loan to the firm. Answer: D

Explanation: D) The commitment fee associated with a committed line of credit increases the effective cost of the loan to the firm. Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Conceptual

12) Luther Industries is offered a $1 million dollar loan for four months at an APR of 9%. If this loan has an origination fee of 1%, then the effective annual rate (EAR) for this loan is closest to:

A) 12.0% B) 12.6% C) 4.1% D) 13.8% Answer: B

Explanation: B) The origination fee is charged on the principal of the loan. The amount of the fee is equal to .01 × $1,000,000 = $10,000, so that the actual proceeds from the loan = $1,000,000 - $10,000 = $990,000. The interest on the loan equals $1,000,000 × months = $30,000

The actual four month interest rate is:

- 1 = .040404 or 4.04%

Expressing this rate as an EAR gives 1.040404(12/4) - 1 = .126176 or 12.62% Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

13) Luther Industries is offered a $1 million dollar loan for four months at an APR of 9%. If Luther's bank requires that the firm maintain a compensating balance equal to 10% of the loan amount in a non-interest bearing account, then the effective annual rate EAR for this loan is closest to: A) 50.0% B) 12.6% C) 14.4% D) 71.5% Answer: A

Explanation: A) The origination fee is charged on the principal of the loan. The amount of the compensating balance is equal to .10 × $1,000,000 = $100,000, so that the actual proceeds from the loan = $1,000,000 - $100,000 = $900,000. The interest on the loan equals $1,000,000 ×

× 4 months = $30,000

- 1 = .144444 or 14.44%

× 4

The actual four month interest rate is:

Expressing this rate as an EAR gives 1.14444(12/4) - 1 = .4989 or 49.89% Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

14) Luther Industries is offered a $1 million dollar loan for four months at an APR of 9%. Luther's bank requires that the firm maintain a compensating balance equal to 5% of the loan amount in a non-interest bearing account and the bank charges a 1% origination fee. Calculate the the effective annual rate EAR for this loan.

Answer: The origination fee is charged on the principal of the loan. The amount of the compensating balance is equal to .05 × $1,000,000 = $50,000 and the amount of the origination fee is equal to .01 × $1,000,000 = $10,000, so that the actual proceeds from the loan = $1,000,000 - $50,000 - $10,000 = $940,000. The interest on the loan equals $1,000,000 × × 4 months = $30,000

The actual four month interest rate is:

- 1 = .095745 or 9.57%

Expressing this rate as an EAR gives 1.095745(12/4) - 1 = .3156 or 31.56% Diff: 2

Section: 27.3 Short-Term Financing with Bank Loans Skill: Analytical

27.4 Short-Term Financing with Commercial Paper

1) Rearden Metal wants to raise $5 million using six-month commercial paper. The net proceeds to Rearden will be $4,865,000. The effect annual rate for this financing is closest to: A) 5.6% B) 6.6% C) 7.2% D) 8.4% Answer: A

Explanation: A) The actual six-month return

- 1 = .027749 or 2.7749%, expressing

this as an EAR gives us (1 + .027749)2 - 1 = 0.056268 or 5.6268% Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Analytical

2) Wyatt Oil has an issue of commercial paper with a face value of $10,000,000 and a maturity of three months. Wyatt received $9,800,000 when it sold the paper. The effect annual rate for this financing is closest to: A) 5.6% B) 6.6% C) 7.2% D) 8.4% Answer: D

Explanation: D) The actual three-month return

- 1 = .0020408 or 2.0408%,

expressing this as an EAR gives us (1 + .020408)4 - 1 = 0.084166 or 8.4166% Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Analytical

3) Galt Industries has issued four-month commercial paper with a $8 million face value. The firm netted $7,831,000 on the sale. The effect annual rate for this financing is closest to: A) 5.6% B) 6.6% C) 7.2% D) 8.4% Answer: B

Explanation: B) The actual four-month return

- 1 = .0021581 or 2.1581%,

expressing this as an EAR gives us (1 + .021581)2 - 1 = 0.06615 or 6.615% Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Analytical

4) Which of the following statements is FALSE?

A) Unlike long-term debt, because of its short maturity, commercial paper is not rated by credit rating agencies.

B) The interest on commercial paper is typically paid by selling it at an initial discount.

C) Commercial paper is short-term, unsecured debt used by large corporations that is usually a cheaper source of funds than a short-term bank loan.

D) Extending the maturity of commercial paper beyond 270 days triggers a registration

requirement with the Securities and Exchange Commission (SEC), which increases issue costs and creates a time delay in the sale of the issue. Answer: A

Explanation: A) Like long-term debt, commercial paper is rated by credit rating agencies. Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Conceptual

5) Which of the following statements regarding commercial paper is FALSE?

A) With dealer paper, dealers sell the commercial paper to investors in exchange for a spread (or fee) for their services.

B) With dealer paper, the spread increases the proceeds that the issuing firm receives, thereby decreasing the effective cost of the paper.

C) The minimum face value is $25,000, and most commercial paper has a face value of at least $100,000.

D) With direct paper, the firm sells the security directly to investors. Answer: B

Explanation: B) With dealer paper, the spread decreases the proceeds that the issuing firm receives, thereby increasing the effective cost of the paper. Diff: 2

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Conceptual

6) A firm issued three-month commercial paper with a $2,000,000 face value and received $1,964,000. The effective annual rate that this firm is paying is closest to: A) 8.0% B) 7.5% C) 1.8% D) 7.3% Answer: B Explanation: B)

- 1 = .01833 or 1.833% APR

EAR = 1.01833(12/3) - 1 = .075360 or 7.54% Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Analytical

7) Kinston Industries issued $4,000,000 in commercial paper which matures in six months and received $3,876,000. Calculate the effective annual rate that Kinston is paying. Answer:

- 1 = .031992 or 3.1992% APR

EAR = 1.031992(12/6) - 1 = .065007 = 6.5% Diff: 1

Section: 27.4 Short-Term Financing with Commercial Paper Skill: Analytical

27.5 Short-Term Financing with Secured Financing

1) Rearden Metal has borrowed $4 million for three months at a stated annual rate of 8%, using inventory stored in a field warehouse as collateral. The warehouse charges a $10,000 fee, payable at the end of the month. The effect annual rate on this loan is closest to: A) 9.3% B) 11.3% C) 15.2% D) 17.1% Answer: A

Explanation: A) The quarterly interest rate is 8%/4 = 2%. At the end of the quarter Rearden will owe $4 million × 1.02 = 4,080,000 plus the warehouse fee of $10,000 for a total of $4,090,000. The actual quarterly interest rate paid is

- 1 = 0.0225 or 2.25%, expressing

this as an EAR gives us (1 + .0225)4 - 1 = 0.093083 or 9.30835% Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Analytical

2) Hammond Motors is considering using a public warehouse loan as part of its short-term

financing. The firm will require a loan of $2 million for three months. Interest on the loan will be 12% (APR, compounded quarterly) to be paid at the end of the quarter. The warehouse charges 1% of the face value of the loan, payable at the beginning of the quarter. The effect annual rate on this loan is closest to: A) 9.3% B) 11.3% C) 15.2% D) 17.1% Answer: D

Explanation: D) The quarterly interest rate is 12%/4 = 3%. At the end of the quarter Hammond need to borrow $2,000,000 × 1.01 = $2,020,000 to cover the warehouse fee and they will owe $2,020,000 million × 1.03 = 2,080,600 at the end of the quarter. The actual quarter interest rate paid is

- 1 = 0.0403 or 4.03%, expressing this as an EAR gives us

(1 + .0403)4 - 1 = 0.171209 or 17.121% Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Analytical

3) d'Anconia Copper has borrowed $5 million for six months at a stated annual rate of 10%, using inventory stored in a field warehouse as collateral. The warehouse charges a $25,000 fee, payable at the end of the six months. The effect annual rate on this loan is closest to: A) 9.3% B) 11.3% C) 15.2% D) 17.1% Answer: B

Explanation: B) The semiannual interest rate is 10%/2 = 5%. At the end of the six months d'Anconia Copper will owe $5 million × 1.05 = 5,250,000 plus the warehouse fee of $25,000 for a total of $5,275,000. The actual semiannual interest rate paid is

- 1 = 0.055 or 5.25%,

expressing this as an EAR gives us (1 + .055)2 - 1 = 0.113025 or 11.3025% Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Analytical

4) Inventory can be used as collateral for a loan in all of the following ways EXCEPT: A) a floating lien.

B) a warehouse arrangement. C) a factoring arrangement. D) a trust receipt. Answer: C Diff: 1

Section: 27.5 Short-Term Financing with Secured Financing Skill: Conceptual

5) Which of the following statements is FALSE?

A) If a factoring arrangement is with recourse, the factor will pay the firm the amount due regardless of whether the factor receives payment from the firm’s customers.

B) In a factoring of accounts receivable arrangement, the firm sells receivables to the lender (i.e., the factor), and the lender agrees to pay the firm the amount due from its customers at the end of the firm's payment period.

C) Businesses can also obtain short-term financing by using secured loans, which are loans collateralized with short-term assets—most typically the firm's accounts receivables or inventory.

D) Both the interest rate and the factor's fee vary depending on such issues as the size of the borrowing firm and the dollar volume of its receivables. Answer: A

Explanation: A) If a factoring arrangement is without recourse, the factor will pay the firm the amount due regardless of whether the factor receives payment from the firm's customers. Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Conceptual

6) Which of the following statements is FALSE?

A) Commercial banks, finance companies, and factors, which are firms that purchase the receivables of other companies, are the most common sources for secured short-term loans.

B) The factoring arrangement may be without recourse, in which case the lender bears the risk of bad-debt losses.

C) In a floating lien, general lien, or blanket lien arrangement, specific inventory is used to secure the loan.

D) If a firm sells its goods on terms of net 30, then the factor will pay the firm the face value of its receivables, less a factor's fee, at the end of 30 days. Answer: C

Explanation: C) In a floating lien, general lien, or blanket lien arrangement, all of the inventory is used to secure the loan. Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Conceptual

7) Which of the following statements is FALSE?

A) In a pledging of accounts receivable agreement, the lender reviews the invoices that represent the credit sales of the borrowing firm and decides which credit accounts it will accept as collateral for the loan, based on its own credit standards.

B) With a trust receipts loan or floor planning, all inventory items are held in a trust as security for the loan.

C) If the factoring agreement is without recourse, the borrowing firm must receive credit approval for a customer from the factor prior to shipping the goods. If the factor gives its

approval, the firm ships the goods and the customer is directed to make payment directly to the lender.

D) In a warehouse arrangement, the inventory that serves as collateral for the loan is stored in a warehouse. Answer: B

Explanation: B) With a trust receipts loan or floor planning, distinguishable inventory items are held in a trust as security for the loan. Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Conceptual

8) Which of the following statements is FALSE?

A) A public warehouse is a business that exists for the sole purpose of storing and tracking the inflow and outflow of the inventory.

B) A warehouse arrangement is the riskiest collateral arrangement from the standpoint of the lender.

C) Because the warehouser is a professional at inventory control, there is likely to be little loss due to damaged goods or theft, which in turn lowers insurance costs.

D) A field warehouse is operated by a third party, but is set up on the borrower's premises in a separate area so that the inventory collateralizing the loan is kept apart from the borrower's main plant.

Answer: B

Explanation: B) A warehouse arrangement is the least risky collateral arrangement from the standpoint of the lender. Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Conceptual

9) The Luther Industries wants to borrow $1 million for two months. Using its inventory as collateral, it can obtain a 10% (APR) loan (compounded monthly). The lender requires that a warehouse arrangement be used. The warehouse fee is $10,000, payable at the end of the two months. Calculate the effective annual rate of this loan for Row Cannery. Answer: The monthly interest rate is

= .83333%, so at the end of two months Luther will

owe

$1 million × (1.0083333)2 = $1,016,736 plus the $10,000 warehouse fee for a total of $1,026,736.

The actual interest paid is

= 1.02674 - 1 = .02674 for two months,

expressing as an EAR (1.02674)(12/2) - 1 = .17153 or 17.15% Diff: 2

Section: 27.5 Short-Term Financing with Secured Financing Skill: Analytical

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