Chapter 21, Problem 17P

The Raattama Corporation had sales of $3.5 million last year, and it earned a 5% return (after taxes) on sales. Recently, the company has fallen behind in its accounts payable. Although its terms of purchase are net 30 days, its accounts payable represents 60 days’ purchases. The company’s treasurer is seeking to increase bank borrowing in order to become current in meeting its trade obligations (that is, to have 30 days’ payables outstanding). The company’s balance sheet is as follows (in thousands of dollars):

1. a. How much bank financing is needed to eliminate the past-due accounts payable?
2. b. Assume that the bank will lend the firm the amount calculated in part a. The terms of the loan offered are 8%, simple interest, and the bank uses a 360-day year for the interest calculation. What is the interest charge for 1 month? (Assume there are 30 days in a month.)
3. c. Now ignore part b and assume that the bank will lend the firm the amount calculated in part a. The terms of the loan are 7.5%, add-on interest, to be repaid in 12 monthly installments.
   1. (1) What is the total loan amount?
   2. (2) What are the monthly installments?
   3. (3) What is the APR of the loan?
   4. (4) What is the effective rate of the loan?
4. d. Would you, as a bank loan officer, make this loan? Why or why not?

Summary Introduction

To determine: Size of bank loan.

Explanation of Solution

Calculation of size of bank loan:

$\begin{array}{c}\text{Size of bank loan}=\left(\frac{\text{Purchases}}{\text{Days}\text{payables}\text{outstanding}}\right)\left(\text{Days}\text{payables}\text{outstanding}-30\right)\\ =\left(\frac{\$600,000}{60}\right)\left(60-30\right)\\ =\$300,000\end{array}$

Therefore, the size of bank loan is $300,000

Alternatively, one might simply recognize that accounts payable should be cut ½ of its existing result, because 30 days is ½ of 60 days.

Summary Introduction

To determine: Interest charge per month.

Explanation of Solution

Calculation of simple interest per day:

$\begin{array}{c}\text{Simple interest per day}=\frac{\text{Nominal}\text{rate}}{\text{Days}\text{in}\text{a}\text{year}}\\ =\frac{0.08}{360}\\ =0.000222222\end{array}$

Hence, simple interest per day is 0.000222222

Calculation of interest charge per month:

$\begin{array}{c}\text{Interest}\text{charge}\text{per}\text{month}=\text{Rate}\text{per}\text{day}\times \text{Loan}\text{amount}\times \text{Days}\text{in}\text{a}\text{month}\\ =0.000222222\times \$300,000\times 30\\ =\$2,000\end{array}$

Hence, interest charge per month is $2,000

Summary Introduction

To determine: Total loan amount

Explanation of Solution

Calculation of total loan amount:

$\begin{array}{c}\text{Interest}=\$300,000\times 0.075\\ =\$22,500\end{array}$

Hence, interest is $22,500

$\begin{array}{c}\text{Total}\text{loan}\text{amount}=\$300,000+\$22,500\\ =\$322,500\end{array}$

Therefore, total loan amount is $322,500

Summary Introduction

To determine: Monthly instalments.

Explanation of Solution

Calculation of monthly instalments:

$\begin{array}{c}\text{Monthly installments}=\frac{\$322,500}{12}\\ =\$26,875\end{array}$

Hence, monthly instalments is $26,875

Summary Introduction

To determine: APR (Annual percentage rate) of the loan.

Explanation of Solution

Calculation of APR on loan:

Working note:

Monthly rate is 1.13% so,

For 12 months,

$\begin{array}{c}\text{APR}=12\times 1.130552\\ =13.57\%\end{array}$

Hence, APR on loan is 13.57%

Summary Introduction

To determine: Effective rate on loan.

Explanation of Solution

Calculation of effective rate on loan:

$\begin{array}{c}\text{EFF\%}={\left(1.01130552026\right)}^{12}-1\\ =14.44\%\end{array}$

Hence, Effective rate on loan is 14.44%

Summary Introduction

To discuss: Whether person X as a bank officer to make this loan or not.

Explanation of Solution

The decision should be based on rule-of-thumb comparison,

Debt ratio: The debt ratio is 73% as compared to typical debt ratio of 50% so the company appears is to be undercapitalized.

$\begin{array}{c}\text{Debt}\text{ratio}=\left(\frac{\$1,500,000+\$700,000}{\$3,000,000}\right)\\ =73\%\end{array}$

Current ratio: The current ratio seems to be low, however current assets might cover current liabilities if all assets are collected and if inventory can be liquidated at its book value.

$\begin{array}{c}\text{Current}\text{ratio}=\left(\frac{\$1,800,000}{\$1,500,000}\right)\\ =1.20\end{array}$

Quick ratio: Quick ratio indicates current assets, and excluding inventory, are solely adequate to cover 27% of current liabilities which is considered as worse.

$\begin{array}{c}\text{Quick}\text{ratio}=\left(\frac{\$400,000}{\$1,500,000}\right)\\ =0.27\end{array}$

Therefore, the company seems to be carrying additional inventory and financing extensively with debt. Bank borrowings are already high and therefore the liquidity situation is poor. Based on these observations the loan could be unused, and therefore, the treasurer should be suggested to seek permanent capital, particularly equity capital.