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SUGGESTED SOLUTIONS TO CHAPTER 18 PROBLEMS
1. Texas Computers (TC) recently has begun selling overseas. It currently has 30 foreign orders outstanding, with the typical order averaging $2,500. TC is considering the following three alternatives to protect itself against credit risk on these foreign sales:
• Request a letter of credit from each customer. The cost to the customer would be $75 plus 0.25% of the invoice amount. To remain competitive, TC would have to absorb the cost of the letter of credit.
• Factor the receivables. The factor would charge a nonrecourse fee of 1.6%.
• Buy FCIA insurance. The FCIA would charge a 1% insurance premium.
a. Which of these alternatives would you recommend to Texas Computers? Why?
Answer. The L/C will cost TC an average of $81.25 ($75 + 0.0025*$2,500) per order, or a total of $2,437.50 (30 x $81.25). The factoring alternative will cost an average of $40 (0.016 x $2,500) per order, or $1,200 in all. The FCIA insurance will cost an average of $25 (0.01 x $2,500) per order, or $750 in all. Thus, the least expensive alternative is the FCIA insurance.
b. Suppose that TC's average order size rose to $250,000. How would that affect your decision?
Answer. If TC's average order size rises to $250,000, then the L/C will cost an average of $700 per order ($75 + 0.0025 x $250,000), or $21,000 in total. The FCIA insurance will cost an average of $2,500 per order, or $75,000 in total. Thus, the L/C is now the least expensive alternative (factoring is dominated by the FCIA insurance).
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2. L.A. Cellular has received an order for phone switches from Singapore. The switches will be exported under the terms of a letter of credit issued by Sumitomo Bank on behalf of Singapore Telecommunications. Under the terms of the L/C, the face value of the export order, $12million, will be paid six months after Sumitomo accepts a draft drawn by L.A. Cellular. The current discount rate on 6-month acceptances is 8.5 percent per annum and the acceptance fee is 1.25 percent per annum. In addition, there is a flat commission, equal to 0.5 percent of the face amount of the accepted draft, that must be paid if it is sold.
a. How much cash will L.A. Cellular receive if it holds the acceptance until maturity?
Answer. If L.A. Cellular chooses to hold the acceptance, then in six months it will receive the face amount of $12 million less the acceptance fee of 0.625% (1.25%/2):
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Face amount of acceptance
Less: 1.25% per annum commission for six months
Amount received by L.A. Cellular in six months
$12,000,000
- 75,000
______
$11,925,000
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b. How much cash will it receive if it sells the acceptance at once?
Answer. By selling the acceptance at once, paying the 0.5% selling commission, and taking the 4.25% discount (8.5%/2), L.A. Cellular will receive $11,355,000 immediately:
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Face amount of acceptance
Less: 1.25% per annum commission for six months
Less: 8.5% per annum discount for six months
Less: 0.5% selling commission
Amount received by L.A. Cellular immediately
$12,000,000
- 75,000
- 510,500
- 60,000
______
$11,355,000
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c. Suppose L.A. Cellular's opportunity cost of funds is 8.75 percent per annum. If it wishes to maximize the present value of its acceptance, should it discount the acceptance?
Answer. Given that L.A. Cellular's opportunity cost of money is 8.75%, then the present value of holding onto the acceptance is $11,925,000/(1 + (.0875/2)), or $11,425,150 (remember, it must pay the $75,000 commission in any case). Since this figure exceeds the amount of money it would receive from discounting the acceptance, L.A. Cellular should hold onto the acceptance.
3. Suppose Minnesota Machines (MM) is trying to price an export order from Russia. Payment is due nine months after shipping. Given the risks involved, MM would like to factor its receivable without recourse. The factor will charge a monthly discount of 2 percent plus a fee equal to 1.5 percent of the face value of the receivable for the nonrecourse financing.
a. If Minnesota Machines desires revenue of $2.5million from the sale, after paying all factoring charges, what is the minimum acceptable price it should charge?
Answer. At a monthly discount of 2%, and an extra 1.5% fee for nonrecourse financing, Minnesota Machines will pay a total fee equal to 19.5% (9 x 2% + 1.5%) of the face amount of its price for factoring its nine-month export receivable without recourse. In other words, after paying all factoring fees, MM will clear 80.5% of the price it sets. Thus, in order to net $2.5 million on its export sale, MM must set a price P such that .805P = $2,500,000. The solution to this equation is P = $3,105,590. This is the minimum acceptable price to MM.
b. Alternatively, CountyBank has offered to discount the receivable, but with recourse, at an annual rate of 14 percent plus a 1 percent fee. What price will net MM the $2.5million it desires to clear from the sale?
Answer. If MM decides to discount the receivable with CountyBank, it will pay a total fee equal to 11.5% (.75 x 14% + 1%). Thus, in order to net $2.5 million on its export sale, MM must now set a price P* such that .885P* = $2,500,000, or P* = $2,824,859.
c. Based on your answers to parts a and b, should Minnesota Machines discount or factor its Russian receivables? MM is competing against Nippon Machines for the order, so the higher MM's price, the lower the probability that its bid will be accepted. What other considerations should influence MM's decision?
Answer. Based purely on net revenue, MM should plan on discounting its receivable. However, this would expose it to credit risk. Credit risk reduces MM's expected revenue from this sale (at the extreme it may receive nothing, if Russia defaults). This brings up two issues. First, is the price charged by the factor reasonably reflective of the risk of default or delay in receipt of payment? If so, then MM's expected revenue from the sale at a given price will be the same from discounting or factoring even though the most likely revenue will differ. Second, how risk averse is MM? The more risk averse it is, the more reason for factoring its receivable. Most likely, the factor is charging a fair price for the risks involved. In that case, MM will be receiving the benefits of the factor's credit risk analysis and collection skills. In fact, as pointed out in the text, the cost of bearing the credit risk associated with MM's Russian receivable may be substantially lower to the factor than to MM. If so, then MM will actually get a better deal with factoring then with discounting.
A more important issue here is the price that MM should charge. Although MM desires revenue of $2.5 million from this sale, that may not be its minimum acceptable revenue. As a Japanese firm, Nippon is likely to focus on market share and so will probably compete very strongly on price. MM will therefore have to price its sale as low as possible. In setting a price, MM should consider the possibility of future sales stemming from this initial order. To the extent that there will be follow-up orders for additional units, parts, and service, MM might consider settling for a lower profit this time around in the expectation that it will make higher profits on future sales.
d. What other alternatives might be available to MM to finance its sale to Russia?
Answer. MM may be able to take advantage of a government export financing agency to provide it with lower cost funds. Alternatively, MM may be able to receive low-cost government export insurance, thereby eliminating credit risk at a relatively low price.