FIN 571 Week 3 - DQ - 7641

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Why do investors require firms issuing commercial paper to be of high credit worthiness?

 

Commercial paper is the most prevalent form of security in the money market, issued at a discount, with a yield slightly higher than Treasury bills. The main issuers of commercial paper are finance companies and banks, but also include corporations with strong credit, and even foreign corporations and sovereign issuers. Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by finance companies, banks, and corporations with excellent credit. Generally, only corporations with the highest credit rating can issue commercial paper. Some companies with weaker credit can get credit enhancements, so that they can issue commercial paper. Asset-backed commercial paper is backed by high quality collateral. Credit-supported commercial paper is often guaranteed by an organization with excellent credit, such as a bank.

Why are interest rates on short-term loans not necessarily comparable to each other? Give three possible reasons.

 

Because of its inherent characteristic like compensating balance loan requires to maintain certain portion of loan to be kept with bank. Another reason can be due to collateral requirement like security requirement. Also it could be due to tenure of loan or renewable facility of loan or due to the service charges other than interest rate.

 

Reference:

Emery, Finnerty, Stowe (2007). Corporate Financial Management (3rd ed.). New Jersey:

 

Pearson-Prentice Hall.

 

This Matter.com (2010) Commercial Paper. Retrieved May 12, 2010 from http://thismatter.com/money/bonds/types/money-market-instruments/commercial-paper.htm

 

 

 

 

 

 

Optical Supply Company offers credit terms of 2/10, net 60. If Optical Supply is considering a change in its credit terms to one of those indicated,explain whether the change should increase or decrease sales. (a) 2/10, net 30, (b) net 60, (c) 3/15, net 60, (d) 2/10, net 30, 30 extra.

 

 

a)  2/10 net 30 will decrease sales because it must be paid back within 30 days rather than 60

b) net 60 will decrease sales because it offers no incentive for paying back within 10 days

c) 3/15 net 60 will increase sales because it increases the discount and also increases the discount period

d) 2/10 net 30, 30 extra will result in no change because it is essentially the same as 2/10 net 60

 

 

In other words, the importance here is that higher discounts, longer discount periods and longer payback periods should be prefered at all times to benefit the company.

 

 

What are the five Cs of credit? Explain why each is relevant.

The 5C's

1.       Capacity to repay is the most critical of the five factors, it is the primary source of repayment - cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal or commercial- is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment.

2.       Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

3.       Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.

4.       Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business.

5.       Character is the general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of you references and the background and experience levels of your employees will also be reviewed.

 

 

Reference:

U.S. Department of Commerce. (2004). The Five C’s of Credit Analysis. Retrieved May 12, 2010 from http://www.mbda.gov/?section_id=3&bucket_id=131&content_id=2517&well=well_2

 

 

 

 

 

 

Describe the steps involved in a typical collection process.

1.       Determine the annual usage for each item.

2.       Multiply the annual usage of each item by its cost to get its total annual money usage.

3.       List the items according to their annual money usage.

4.       Calculate the cumulative annual money usage and the cumulative percentage of items.

5.       Examine the annual usage distribution and group the items into A, B, and C groups based on percentage of annual usage.

 

 

Explain the logic of an ABC system of inventory control.

According to our text, the ABC is an inventory management system that categorizes inventory into one of three groups—A, B, or C—on the basis of critical need.

First, establish the item characteristics that influence the results of inventory management.  Such characteristics include:

•        Annual money usage

•        Scarcity of material

•        Quality problems

Second, classify items into groups based on the criteria established. Third, apply a degree of control in proportion to the importance of the group.

Group A items should be observed closely and tight control on them should be applied. Group B items are less critical, therefore, they require control that is less than items A. It is sufficient to lightly monitor items in group C.

 

Reference:

Emery, Finnerty, Stowe (2007). Corporate Financial Management (3rd ed.). New Jersey:

 

Solution Description

Why do investors require firms issuing commercial paper to be of high credit worthiness?

 

Commercial paper is the most prevalent form of security in the money market, issued at a discount, with a yield slightly higher than Treasury bills. The main issuers of commercial paper are finance companies and banks, but also include corporations with strong credit, and even foreign corporations and sovereign issuers. Commercial paper are unsecured promissory notes for a specified amount to be paid at a specified date, and are issued by finance companies, banks, and corporations with excellent credit. Generally, only corporations with the highest credit rating can issue commercial paper. Some companies with weaker credit can get credit enhancements, so that they can issue commercial paper. Asset-backed commercial paper is backed by high quality collateral. Credit-supported commercial paper is often guaranteed by an organization with excellent credit, such as a bank.

Why are interest rates on short-term loans not necessarily comparable to each other? Give three possible reasons.

 

Because of its inherent characteristic like compensating balance loan requires to maintain certain portion of loan to be kept with bank. Another reason can be due to collateral requirement like security requirement. Also it could be due to tenure of loan or renewable facility of loan or due to the service charges other than interest rate.

 

Reference:

Emery, Finnerty, Stowe (2007). C