Week 5 Team Problem
Due 9:30 pm on Sunday (24 hour since I post the assignment )
Resource: Principles of Managerial Finance, Ch. 16
Complete the following case study: Integrative Case Casa Diseno p. 681 .( Chapter 16)
Only complete the YELLOW HIGHLIGHTED AREA. ONLY DO the probelm highlighted in question D
I have copied and paste chapter 16 and highlighted my part of the assignment. remember it’s a team assignment.
16 Current Liabilities ManagementLearning GoalsLG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms. LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals. LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans. LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans. LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral. LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral. Why This Chapter Matters to You
In your professional life
ACCOUNTING You need to understand how to analyze supplier credit terms to decide whether the firm should take or give up cash discounts; you also need to understand the various types of short-term loans, both unsecured and secured, that you will be required to record and report.
INFORMATION SYSTEMS You need to understand what data the firm will need to process accounts payable, track accruals, and meet bank loans and other short-term debt obligations in a timely manner.
MANAGEMENT You need to know the sources of short-term loans so that, if short-term financing is needed, you will understand its availability and cost.
MARKETING You need to understand how accounts receivable and inventory can be used as loan collateral; the procedures used by the firm to secure short-term loans with such collateral could affect customer relationships.
OPERATIONS You need to understand the use of accounts payable as a form of short-term financing and the effect on one’s suppliers of stretching payables; you also need to understand the process by which a firm uses inventory as collateral.
In your personal life
Management of current liabilities is an important part of your financial strategy. It takes discipline to avoid viewing cash and credit purchases equally. You need to borrow for a purpose, not convenience. You need to repay credit purchases in a timely fashion. Excessive use of short-term credit, particularly with credit cards, can create personal liquidity problems and, at the extreme, personal bankruptcy.FastPay Getting Cash into the Hands of Online Media Companies
Digital advertising revenues hit $36.6 billion in 2012, a 15 percent increase over 2011, which was itself a record-breaking year. Online ads are everywhere, from Google search pages to YouTube videos to your Facebook News Feed. A challenge for the publishers of online ads is collecting money for those ads. The industry standard calls for publishers of online ads to send invoices within 30 days after an ad campaign is complete, and the advertiser then has 30 days or more to pay for the ad. Thus, companies that sell online advertising can accumulate large receivables balances, and collecting cash can be a slow process.
That’s where the company FastPay comes in. FastPay makes loans to publishers, ad-tech companies, and other digital media businesses based on those firms’ accounts receivable. FastPay lends up to $5 million per borrower, with the terms of the loan based on the quality of the receivable. For example, if Pepsi were to enter into an agreement with YouTube to place online ads in videos, FastPay would grant a loan to YouTube on relatively favorable terms because it views Pepsi as a good credit risk. One area in which FastPay is expanding rapidly is in making loans to Facebook Preferred Marketing Developers, a network of small and mediumsized businesses that builds advertising apps on Facebook, manages ad campaigns, and helps Facebook develop new marketing strategies.
Firms rely on a wide array of short-term financing vehicles. In this chapter, you’ll learn about the ways companies can use short-term finance to help maximize the wealth of their shareholders.16.1 Spontaneous Liabilities
LG 1
LG 2
Spontaneous liabilities arise from the normal course of business. For example, when a retailer orders goods for inventory, the manufacturer of those goods usually does not demand immediate payment but instead extends a short-term loan to the retailer that appears on the retailer’s balance sheet under accounts payable. The more goods the retailer orders, the greater will be the accounts payable balance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addition, both are forms of unsecured short-term financing , short-term financing obtained without pledging specific assets as collateral. The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible.spontaneous liabilities
Financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals.unsecured short-term financing
Short-term financing obtained without pledging specific assets as collateral.ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are the major source of unsecured short-term financing for business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser.Role in the Cash Conversion Cycle
The average payment period is the final component of the cash conversion cycle introduced in Chapter 15 . The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In Chapter 15 , we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is accounts payable management .accounts payable management
Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier.
When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period.Example 16.1
In 2013, Brown-Forman Corporation (BF), manufacturer of alcoholic beverage brands such as Jack Daniels, had annual revenue of $3.8 billion, cost of revenue of $1.8 billion, and accounts payable of $468 million. BF had an average age of inventory (AAI) of 168 days, an average collection period (ACP) of 55 days, and an average payment period (APP) of 136 days (BF’s purchases were $1.3 billion). Thus, the cash conversion cycle for BF was 87 days (168 + 55 − 136).
The resources BF had invested in this cash conversion cycle (assuming a 365-day year) were
Based on BF’s APP and average accounts payable, the daily accounts payable generated by BF is about $3.5 million ($0.48 billion ÷ 136). If BF were to increase its average payment period by 5 days, its accounts payable would increase by about $17.5 million (5 × $3.5 million). As a result, BF’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $17.5 million. Clearly, if this action did not damage BF’s credit rating, it would be in the company’s best interest.Analyzing Credit Terms
The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases. Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment.
Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date.Example 16.2
Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000 − (0.02 × $1,000)] by March 10, thereby saving $20.
Giving Up the Cash Discount If the firm chooses to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, when a firm gives up a discount, it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a loan, and the length of this loan is the number of additional days that the purchaser can delay payment to the seller. This cost can be illustrated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period).cost of giving up a cash discount
The implied rate of interest paid to delay payment of an account payable for an additional number of days.FIGURE 16.1 Payment Options
Payment options for Lawrence IndustriesExample 16.3
My Finance Lab Solution Video
In Example 16.2 , we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must pay an extra $20, or $1,000 rather than $980. In other words, if the firm pays on March 30, it will pay $980 (what it could have paid on March 10) plus $20. The extra $20 is like interest on a loan, and in this case the $980 is like the loan principal. Lawrence Industries owes $980 to its supplier on March 10, but the supplier is willing to accept $980 plus $20 in interest on March 30. Figure 16.1 shows the payment options that are open to the company.
To calculate the implied interest rate associated with giving up the cash discount, we simply treat $980 as the loan principal, $20 as the interest, and 20 days (the time from March 10 to March 30) as the term of the loan. Again, the tradeoff that Lawrence faces is that it can pay $980 on March 10 or $980 plus $20 in interest 20 days later on March 30. Therefore, the interest rate that Lawrence is paying by giving up the discount is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The general expression for calculating the annual percentage cost of giving up a cash discount can be expressed as1
(16.1)
1. Equation 16.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each alternative.
where
Substituting the values for CD (2%) and N (20 days) into Equation 16.1 results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)].
A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 16.1 :
(16.2)
The smaller the cash discount, the closer the approximation to the actual cost of giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% [2% × (365 ÷ 20)].
Using the Cost of Giving Up a Cash Discount in Decision Making The financial manager must determine whether it is advisable to take a cash discount. A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other institution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier.Example 16.4
Mason Products, a large building-supply company, has four possible suppliers, each offering different credit terms. Otherwise, their products and services are identical. Table 16.1 presents the credit terms offered by suppliers A, B, C, and D and the cost of giving up the cash discounts in each transaction. The approximation method of calculating the cost of giving up a cash discount (Equation 16.2 ) has been used. The cost of giving up the cash discount from supplier A is 36.5%; from supplier B, 4.9%; from supplier C, 21.9%; and from supplier D, 29.2%.TABLE 16.1 Cash Discounts and Associated Costs for Mason Products
Supplier
Credit terms
Approximate cost of giving up a cash discount
A
2/10 net 30 EOM
36.5%
B
1/10 net 85 EOM
4.9
C
3/20 net 70 EOM
21.9
D
4/10 net 60 EOM
29.2
If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 6%, and if each of the suppliers is viewed separately, which (if any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier A, the firm takes the cash discount, because the cost of giving it up is 36.5%, and then borrows the funds it requires from its bank at 6% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of this action is less than the cost of borrowing money from the bank (4.9% versus 6%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the 6% cost of borrowing from the bank.
The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain bank borrowing costs. However, other factors relative to payment strategies may also need to be considered. For example, some firms, particularly small firms and poorly managed firms, routinely give up all discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions.Effects of Stretching Accounts Payable
A strategy that is often employed by a firm is stretching accounts payable , that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduce the cost of giving up a cash discount.stretching accounts payable
Paying bills as late as possible without damaging the firm’s credit rating.Example 16.5
Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of giving up the cash discount, assuming payment on the last day of the credit period, was approximately 36.5% [2% × (365 ÷ 20)]. If the firm were able to stretch its account payable to 70 days without damaging its credit rating, the cost of giving up the cash discount would be only 12.2% [2% × (365 ÷ 60)]. Stretching accounts payable reduces the implicit cost of giving up a cash discount.
Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases.Personal Finance Example 16.6
Jack and Mary Nobel, a young married couple, are in the process of purchasing a 50-inch HD TV at a cost of $1,900. The electronics dealer currently has a special financing plan that would allow them to either (1) put $200 down and finance the balance of $1,700 at 3% annual interest over 24 months, resulting in payments of $73 per month; or (2) receive an immediate $150 cash rebate, thereby paying only $1,750 cash. The Nobels, who have saved enough to pay cash for the TV, can currently earn 5% annual interest on their savings. They wish to determine whether to borrow or to pay cash to purchase the TV.
The upfront outlay for the financing alternative is the $200 down payment, whereas the Nobels will pay out $1,750 up front under the cash purchase alternative. So, the cash purchase will require an initial outlay that is $1,550 ($1,750 − $200) greater than under the financing alternative. Assuming that they can earn a simple interest rate of 5% on savings, the cash purchase will cause the Nobels to give up an opportunity to earn $155 (2 years × 0.05 × $1,550) over the 2 years.
If they choose the financing alternative, the $1,550 would grow to $1,705 ($1,550 + $155) at the end of 2 years. But under the financing alternative, the Nobels will pay out a total of $1,752 (24 months × $73 per month) over the 2-year loan term. The cost of the financing alternative can be viewed as $1,752, and the cost of the cash payment (including forgone interest earnings) would be $1,705. Because it is less expensive, the Nobels should pay cash for the TV. The lower cost of the cash alternative is largely the result of the $150 cash rebate.ACCRUALS
The second spontaneous source of short-term business financing is accruals. Accruals are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. Because taxes are payments to the government, their accrual cannot be manipulated by the firm. However, the accrual of wages can be manipulated to some extent by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work. The pay period for employees who earn an hourly rate is often governed by union regulations or by state or federal law. However, in other cases, the frequency of payment is at the discretion of the company’s management.accruals
Liabilities for services received for which payment has yet to be made.in practice focus on ETHICS: Accruals Management
On June 2, 2010, Diebold, Inc., agreed to pay a $25 million fine to settle accounting fraud charges brought by the U.S. Securities and Exchange Commission (SEC). According to the SEC, the management of the Ohio-based manufacturer of ATMs, bank security systems, and electronic voting machines regularly received reports comparing the company’s earnings to analyst forecasts. When earnings were below forecasts, management identified opportunities, some of which amounted to accounting fraud, to close the gap.
“Diebold’s financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company’s bottom line,” SEC Enforcement Director Robert Khuzami said in a statement. “When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences.”a
A number of the SEC’s claims focused on premature revenue recognition. For example, Diebold was charged with improper use of “bill and hold” transactions. Under generally accepted accounting principles, revenue is typically recognized after a product is shipped. However, in some cases, sellers can recognize revenue before shipment for certain bill and hold transactions. The SEC claimed that Diebold improperly used bill and hold accounting to record revenue prematurely.
The SEC also claimed that Diebold manipulated various accounting accruals. Diebold was accused of understating liabilities tied to its Long Term Incentive Plan, commissions to be paid to sales personnel, and incentives to be paid to service personnel. Diebold temporarily reduced a liability account set up for payment of customer rebates. The company was also accused of overstating the value of inventory and improper inventory write-ups.
Each of these activities allowed Diebold to inflate the company’s financial performance. According to the SEC’s complaint, Diebold’s fraudulent activities misstated reported pretax earnings by at least $127 million between 2002 and 2007. Two years prior to the settlement, Diebold restated earnings for the period covered by the charges.
The clawback provision of the 2002 Sarbanes-Oxley antifraud law requires executives to repay compensation they receive while their company misled shareholders. Diebold’s former CEO, Walden O’Dell, agreed to return $470,000 in cash, plus stock and options. The SEC is currently pursuing a lawsuit against two other former Diebold executives for their part in the matter.
Why might financial managers still be tempted to manage earnings when a clawback is a legitimate possibility?
aU.S. Securities and Exchange Commission, “SEC Charges Diebold and Former Executives with Accounting Fraud,” press release, June 2, 2010, www.sec.gov/news/press/2010/2010-93.htm . Example 16.7
Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 × $400,000). REVIEW QUESTIONS16–1
What are the two major sources of spontaneous short-term financing for a firm? How do their balances behave relative to the firm’s sales?16–2
Is there a cost associated with taking a cash discount? Is there any cost associated with giving up a cash discount? How do short-term borrowing costs affect the cash discount decision?16–3
What is “stretching accounts payable”? What effect does this action have on the cost of giving up a cash discount?16.2 Unsecured Sources of Short-Term Loans
LG 3
LG 4
Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are available to firms of all sizes; commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions.BANK LOANS
Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is the short-term, self-liquidating loan . These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. In other words, the use to which the borrowed money is put provides the mechanism through which the loan is repaid, hence the term self-liquidating.short-term, self-liquidating loan
An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid.
Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, through lines of credit, and through revolving credit agreements. Before we look at these types of loans, we consider loan interest rates.Loan Interest Rates
The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often based on the prime rate of interest. The prime rate of interest (prime rate) is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent.prime rate of interest (prime rate)
The lowest rate of interest charged by leading banks on business loans to their most important business borrowers.
Fixed- and Floating-Rate Loans Loans can have either fixed or floating interest rates. On a fixed-rate loan , the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a floating-rate loan , the increment above the prime rate is initially established, and the rate of interest is allowed to “float,” or vary, above prime as the prime rate varies until maturity. Generally, the increment above the prime rate will be lower on a floating-rate loan than on a fixed-rate loan of equivalent risk because the lender bears less risk with a floating-rate loan. Most short-term business loans are floating-rate loans.fixed-rate loan
A loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity.floating-rate loan
A loan with a rate of interest initially set at an increment above the prime rate and allowed to “float,” or vary, above prime as the prime rate varies until maturity.
Method of Computing Interest Once the nominal (or stated) annual rate is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to
(16.3)
Most bank loans to businesses require the interest payment at maturity.
When interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than is requested (and less than they must repay). Loans on which interest is paid in advance are called discount loans . The effective annual rate for a discount loan, assuming a 1-year period, is calculated asdiscount loan
Loan on which interest is paid in advance by being deducted from the amount borrowed.
(16.4)
Paying interest in advance raises the effective annual rate above the stated annual rate.Example 16.8
Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10,000 for the year. At the end of the year, Wooster will write a check to the lender for $11,000, consisting of the $1,000 interest as well as the return of the $10,000 principal. Substituting into Equation 16.3 reveals that the effective annual rate is therefore
If the money is borrowed at the same stated annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 − $1,000). The effective annual rate in this case is
In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).Single-Payment Notes
A single-payment note can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.single-payment note
A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period.Example 16.9
Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank B. The loans were incurred on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate was set at % above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at % (6% prime rate + % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × (, × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000).
Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate, or EAR, by using Equation 5.10 . Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1:
The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.
Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000).
Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:
Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.Personal Finance Example 16.10
Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.
Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable-rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:60 days from today the prime rate will rise by 1%. 90 days from today the prime rate will rise another %. 1
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