Corporate Finance Homework

1.

As a financial manager, how would you decide whether or not to extend short-term credit to new customers in order to increase sales? Explain.

2. AIG needs an additional $50 million in cash to pay retention bonuses to key corporate executives. It takes out a one year loan with a 20% compensating balance. The stated rate of interest is 9%. The loan will be repaid in 12 monthly installments. (a) How much should AIG actually borrow to meet its cash needs? (b) What will AIG’s monthly payment be? (c) Is 9% AIG’s “true cost” of borrowed funds? Analyze using formula 8-6 and discuss your results. (see below for formula 8-6)

3. Your finance professor insists that when it comes to managing working capital: (a) the more cash a corporation has on its balance sheet the better; (b) small firms are more likely to hedge against exchange rate risk than larger, multinational corporations; and, (c) aging schedules can be used to minimize ordering costs. Do you agree or disagree with your professor’s statements? Explain.

Formula 8-6 – Rate on Installment loans (use for question 2)

The most confusing borrowing arrangement to the average bank customer or a consumer is the installment loan. An installment loan calls for a series of equal payments over the life of the loan. Though federal legislation prohibits a misrepresentation of interest rates on loans to customers, a loan officer or overanxious salesperson may quote a rate on an installment loan that is approximately half the true rate.

Assume that you borrow $1,000 on a 12 month installment basis, with regular monthly payments to apply to interest and principal, and the interest requirement is $60. While it might be suggested that the rate of the loan is 6%, this is clearly not the case. Though you are paying a total of $60 in interest, you do not have the use of $1000 for one year – rather, you are paying back the $1000 on a monthly basis, with an average outstanding loan balance for the year of approximately $500. The effective rate of interest is 11.08%.

Effective Rate on Installment Loan = 2 x Annual no. of payments x Interest

(Total no. of payments + 1) x Principal

= 2 x 12 x $60 = $1,440 = 11.08%

13 x $1,000 $13,000

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