Financial Management case study 1 - Essay Example

A dollar now is worth more than a dollar in the future. This is the principle of the time value of money (Ross, Westerfield, & Jaffe, 2005). A receivable in place of cash payments by customers for purchases essentially means that payments will be received later (Weston, Besley, & Brigham, 1996). Hence, interest represents the cost to the customer of financing their purchases with credit terms, which can be construed as borrowing in another sense. The below table shows how the 3.5% interest rate as recommended by the bank consultant for one of XYZ's best customers, Shanghai Winters is derived:Components of Interest RateInterest RateInflation Expectations2.

5%Credit Risk1%ProfitNot applicable for best customersTotal Interest Rate3.5%The first component of the interest rate of 3.5% per annum offered to the best customer is the inflation component. The inflation component preserves the purchasing power of money (Ross, Westerfield, & Jaffe, 2005). Based on economic reports, a 2.5% inflation rate over the next 5 years would sufficiently account for inflation.The second component of the interest rate is the credit risk. The interest rate offered to customers with poor credit worthiness is higher to compensate for the higher risk of lending to them (Weston, Besley, & Brigham, 1996).

Based on the credit rate range established by the credit department, the best customer would be assigned a 1% credit rate.The last component of the interest rate is the profit component. This component is the profit from financing activities of XYZ. Since Shanghai Winters is one of the best customers, this component is not applicable to it.As for XYZ's worst customer, the interest rate is determined as follows: Components of Interest RateInterest RateInflation Expectations2.5%Credit Risk5%Profit1.

5%Total Interest Rate9%Notice that this interest rate is higher than the 8.0% going rate on a $70,000 five-year note receivable. The higher rate is to compensate for the credit risk of extending credit to such a customer. Also built inside the 8.0% is the profit component, which has not been charged to the best customers.REFERENCERoss, SA, Westerfield, RW, & Jaffe, J 2005, Corporate Finance, McGraw-Hill, USA.Weston, JF, Besley, S, & Brigham EF 1996, Essentials of Managerial Finance, The Dryden Press, USA.