Gleim CPA Review Updates to Business 2011 Edition, 1st Printing March 8, 2011

Transcription

1 Page 1 of 6 Gleim CPA Review Updates to Business 2011 Edition, 1st Printing March 8, 2011 NOTE: Text that should be deleted from the outline is displayed with a line through the text. New text is shown with a blue background. Study Unit 9 Short-Term Financing and Capital Budgeting I Pages 271 through 273, Subunit 9.1: The following errors in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. 9.1 SHORT-TERM FINANCING: BANKS 1. Entities can obtain financing for short-term operations in three basic categories: a. Spontaneous sources (as described in item 3. under Study Unit 8, Subunit 1) b. Commercial banks c. Other forms 2. Cost of Not Taking a Discount a. If a supplier offers an early payment discount, it is usually to the entity s advantage to avail itself of the discount. The annualized cost of not taking a discount can be calculated with the following formula: Discount % 100 % Discount % =/ x Days in year Total payment period Discount period A vendor has delivered goods and invoiced the company on terms of 2/10, net 30. The company has chosen to pay on day 30. The effective rate the company paid by foregoing the discount is calculated as follows (using a 360-day year): Cost of not taking discount = [2% (100% 2%)] [360 days (30 days 10 days)] = (2% 98%) (360 days 20 days) = % 18 = 36.73% Only entities in dire cash flow situations would incur a 36.73% cost of funds. 3. Formal Financing Arrangements a. Commercial banks offer short-term financing in the form of term loans and lines of credit. 1) A term loan is one that must be repaid by a date certain, such as a note. 2) A line of credit allows the company to continuously reborrow amounts up to a certain ceiling, as long as certain minimum payments are made each month (similar to a consumer s credit card).

2 4. Simple Interest Loans Page 2 of 6 a. A simple interest loan is one in which the interest is paid at the end of the loan term. The effective rate on the loan is the same as the nominal (stated) rate. The relevant formulas are presented here: Amount needed = Invoice amount x (1.0 Discount %) Interest expense = Amount needed x Stated rate A company has received an invoice for $120,000 with terms of 2/10, net 30. The entity s bank can lend it the necessary amount for 20 days so the discount can be taken on the 10th day at a nominal annual rate of 6%, due at the end of 20 days. Amount needed = Invoice amount (1.0 Discount %) = $120,000 (100% 2%) = $120,000 98% = $117,600 Interest expense (annualized) = Amount needed Stated rate = $117,600 6% = $7,056 The number of 20-day periods in a year is 18 (360 20). The amount of 20-day interest expense associated with the simple interest loan structure can thus be derived ($7, = $392). Contrast this with the exorbitant amount incurred by delaying the payment of the invoice for 20 days ($117, % 18 = $2,387). 5. Effective Interest Rate on a Loan a. The effective rate on any financing arrangement is the ratio of the amount the entity must pay to the amount the entity gets use of. The most basic statement of this ratio uses the dollar amounts generated by the equations illustrated above. Effective interest rate x = Net interest expense Usable funds b. As mentioned above, the effective rate and the nominal rate on a simple interest loan are the same. The entity calculates the effective rate on this loan as follows: 6. Discounted Loans Effective rate = Net interest expense (annualized) Usable funds = $7,056 $117,600 = 6.0% a. A discounted loan is one in which the interest is paid at the beginning of the loan term. Proceeds of discounted loan = Fact amount x (1.0 Stated rate) A company is seeking to borrow $1 million. Its bank has offered to extend this amount at an 8% nominal rate on a discounted basis. Proceeds of discounted loan = Face amount (1.0 Stated rate) = $1,000,000 (100% 8%) = $1,000,000 92% = $920,000

3 Page 3 of 6 b. Because the borrower gets the use of a smaller amount, the effective rate on a discounted loan is higher than its nominal rate: Effective rate = Net interest expense (annualized) Usable funds = ($1,000,000 $920,000) $920,000 = $80,000 $920,000 = 8.696% c. As with all financing arrangements, the effective rate can be calculated without reference to dollar amounts: Effective rate on discounted loan x = The entity calculates the effective rate on this loan without using dollar amounts: Effective rate = Stated rate (1.0 Stated rate) = 8% (100% 8%) = 8% 92% = 8.696% 7. Loans with Compensating Balances Stated rate (1.0 Stated rate) a. Rather than charge cash interest, banks will sometimes require borrowers to maintain a compensating balance during the term of a financing arrangement. Total borrowings x = Amount needed (1.0 Compensating balance % ) A company has received an invoice for $120,000 with terms of 2/10, net 30. The entity s bank will lend it the necessary amount for 30 days at a nominal annual rate of 6% with a compensating balance of 10%. Total borrowings = Amount needed (1.0 Compensated balance %) = ($120,000 98%) (100% 10%) = $117,600 90% = $130,667 b. As with a discounted loan, the borrower has access to a smaller amount than the face amount of the loan and so pays an effective rate higher than the nominal rate. Effective rate = Net interest expense (annualized) Usable funds = ($130,667 6%) $117,600 = $7,840 $117,600 = 6.667%

4 Page 4 of 6 Page 278, Subunit a.: The following error in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. a. A common misstep in regard to capital budgeting is the temptation to gauge the desirability of a project by using accrual accounting numbers instead of cash flows. 1) Shareholders and financial analysts use GAAP-based numbers because they are readily available. The measure usually produced this way is called book rate of return or accounting rate of return. Book rate of return x = GAAP net income from investment Book value of investment Page 285, Subunit 9.5, 1.b.: The following error in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. 1. Payback Period a. The payback period is the number of years required to return the original investment; that is, the time necessary for a new asset to pay for itself. Note that no consideration is made for the time value of money under this method. 1) Companies using the payback method set a maximum length of time within which projects must pay for themselves to be considered acceptable. b. If the cash flows are constant, the formula is Payback period x = Initial net investment Annual expected cash flow Page 288, Subunit 9.6, 2.a.: The following error in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. 2. Profitability Index a. The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest NPV. Profitability index x = NPV of future cash flows Net investment

5 Page 289, Subunit 9.1, Questions 1 and 2: The following errors in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. Page 5 of 6 1. If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40 th day is A. 2% B % C % D % Answer (C) is correct. (Publisher, adapted) REQUIRED: The equivalent annual interest charge for not taking the discount. DISCUSSION: The buyer could satisfy the $100 obligation by paying $98 on the 10th day. By choosing to wait until the 40th day, the buyer is effectively paying a $2 interest charge for the use of $98 for 30 days (40-day credit period 10-day discount period). The annualized cost of not taking this discount can be calculated as follows: Discount % 100% - Discount % =/ x Days in year Total payment period - Discount period Cost of not taking discount = [2% (100% 2%)] [360 days (40 days 10 days)] = (2% 98%) (360 days 30 days) = % 12 = 24.49% 2. Maple Motors buys axles in order to produce automobiles. Maple carries an average credit balance of $25,000,000 with its axle supplier. The axle supplier provides credit terms of 1/10 net 25. The nominal annual cost of Maple not taking the trade discount is closest to which one of the following? Assume a 360-day year. A. 14.4% B. 14.5% C. 24.0% D. 24.2% Answer (D) is correct. (Publisher, adapted) REQUIRED: The annualized cost of not taking a trade discount. DISCUSSION: The annualized cost of not taking a discount can be calculated with this formula: Discount % 100% Discount % =/ x Days in year Total payment period Discount period Cost of not taking discount = [1% (100% 1%)] [360 days (25 days 10 days)] = (1% 99%) (360 days 15 days) = % 24 = 24.24%

6 Page 6 of 6 Page 303, Subunit 9.6, Question 47: The following error in arithmetic symbols occurred due to an issue in the electronic transmission of our book to our printer. The incorrect symbol is struck through, and the correct symbol is highlighted in blue. 47. Woods, Inc. is considering four independent investment proposals. Woods has $3 million available for investment during the present period. The investment outlay for each project and its projected net present value (NPV) is presented below. Project Investment Cost NPV I $ 500,000 $ 40,000 II 900, ,000 III 1,200, ,000 IV 1,600, ,000 Which of the following project options should be recommended to Woods management? A. Projects I, II, and III only. B. Projects I, II, and IV only. C. Projects II, III, and IV only. D. Projects III and IV only. Answer (A) is correct. (Publisher, adapted) REQUIRED: The acceptable capital projects given net present value. DISCUSSION: Capital rationing exists when a firm sets a limit on the amount of funds to be invested during a given period. In such situations, a firm cannot afford to undertake all profitable projects. The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest net present value (NPV). Profitability index x = NPV of future cash flows Net investment The indexes for Woods potential projects can thus be calculated as follows: Net Investment Present Profitability Project Cost Value Index I $ 500,000 $ 40, II 900, , III 1,200, , IV 1,600, , Ranked in order of desirability, they are III, II, IV, and I. Since only $3 million is available for funding, only III, II, and I will be selected. Answer (B) is incorrect. Project III is more desirable than Project IV. Answer (C) is incorrect. While Project IV is more desirable than Project I, insufficient funding is available to engage Project IV. Answer (D) is incorrect. Projects I and II are also desirable and sufficient funding is available.