Question

The book is (Foundations of Financial Management 16th edition)

Complete the following short answers that apply the concepts in chapter 8. Please read the textbook and study the lecture to answer questions. You can submit the answers in a Word document to the course assignments.  

1. Under what circumstances would it be advisable to borrow money to take a cash discount?

2. What is the prime interest rate? How does the average bank customer fare in regard to the prime interest rate?

3. What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporate borrowers?

4. What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage?

5. Briefly discuss three types of lender control used in inventory financing.

Answer 1

1. Under what circumstances would it be advisable to borrow money to take a cash discount?

To take a cash discount when the cost of borrowing is less than the cost of foregoing the discount

if it cost us 36 percent to miss a discount, we would be much better off finding an alternate source of funds for 8 to 10 percent

2. What is the prime interest rate? How does the average bank customer fare regarding the prime interest rate?

i). It is the rate that a bank charges its most creditworthy customers, and it is scaled up proportionately to reflect the credit risk of the borrower

ii). The average customer can expect to pay one or two percent (or more) above prime, but in tight money periods, a speculative borrower may pay five or more percentage points over prime.

3. What advantages do compensate balances have for banks? Are the advantages to banks necessarily disadvantages to corporate borrowers?

a) The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are made available to the borrower.

Ex. A $125,000 loan with a $25,000 compensating balance requirement means only $100,000 is being provided on a net basis

b) No. The borrower may, in turn, receive a lower quoted interest rate and certain gratuitous services because of the compensating balance requirement.

4. What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is the disadvantage?

Advantages

-can be issued below the prime rate.
-no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank.
-degree of prestige associated with the issuance of commercial paper

Disadvantages

-maybe an uncertain source of funds.
-When money gets tight or confidence in the commercial paper market diminishes, funds may not be available.
-no loyalty factor (such as that which exists between a bank and its best borrowers)

5. Briefly discuss three types of lender control used in inventory financing.

A. Blanket Inventory

The lender has a general claim against inventory or collateral. No specific items are marked or designated or tagged and there is no physical control

B. Trust Receipt

Trust Receipts the inventory and proceeds from sales in trust for the lender. Each item is carefully marked and specified by serial number. When sold, the proceeds are transferred to the lender, and the trust receipt is canceled. Also known as floor planning this financing device is very popular among auto and industrial equipment dealers and in the television and home appliance industries. Although it provides tighter control than does the blanket inventory lien, it still does not give the lender direct control over inventory-only a better and more legally enforceable system of tracing the goods

C. Warehousing

Under this arrangement, goods are physically identified, segregated, and stored under the direction of an independent warehousing company. The firm uses a warehouse receipt to the lender, and goods can be moved only with the lender's approval

-If done on the premises of the warehousing firm, it is termed public warehousing.

-field warehousing, whereby the same procedures are conducted on the borrower's property.