Answers to Review Questions

1. How is finance related to the disciplines of accounting and economics?

Financial management is essentially a combination of accounting and economics. First,

financial managers use accounting information—balance sheets, income statements, and so
on—to analyze, plan, and allocate financial resources for business firms. Second, financial
managers use economic principles to guide them in making financial decisions that are in the
best interest of the firm. In other words, finance is an applied area of economics that relies on
accounting for input.

2. List and describe the three career opportunities in the field of finance.

Finance has three main career paths: financial management, financial markets and
institutions, and investments.

Financial management involves managing the finances of a business. Financial managers—

people who manage a business firm's finances—perform a number of tasks. They analyze and
forecast a firm's finances; assess risk, evaluate investment opportunities, decide when and
where to find money sources and how much money to raise, and decide how much money to
return to the firm's investors.

Bankers, stockbrokers, and others who work in financial markets and institutions focus on the
flow of money through financial institutions and the markets in which financial assets are
exchanged. They track the impact of interest rates on the flow of that money.

People who work in the field of investments locate, select, and manage income-producing
assets. For instance, security analysts and mutual fund managers both operate in the
investment field.

3. Describe the duties of the financial manager in a business firm.

Financial managers measure the firm's performance, determine what the financial
consequences will be if the firm maintains its present course or changes it, and recommend
how the firm should use its assets. Financial managers also locate external financing sources
and recommend the most beneficial mix of financing sources, and they determine the
financial expectations of the firm's owners.

All financial managers must be able to communicate, analyze, and make decisions based on
information from many sources. To do this, they need to be able to analyze financial
statements, forecast and plan, and determine the effect of size, risk, and timing of cash flows.

4. What is the basic goal of a business?

 The primary financial goal of the business firm is to maximize the wealth of the firm's
owners. Wealth, in turn, refers to value. If a group of people owns a business firm, the
contribution that firm makes to that group's wealth is determined by the market value of that
firm.

5. List and explain the three financial factors that influence the value of a business.

The three factors that affect the value of a firm's stock price are cash flow, timing, and risk.

The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the
firm receives in exchange for its products and services. Cash is therefore of ultimate
importance, and the expectation that the firm will generate cash in the future is one of the
factors that gives the firm its value.

The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can
expect to receive cash and when they can expect to pay out cash. All other factors being
equal, the sooner companies expect to receive cash and the later they expect to pay out cash,
the more valuable the firm and the higher its stock price will be.

The Influence of Risk: Risk affects value because the less certain owners and investors are
about a firm's expected future cash flows, the lower they will value the company. The more
certain owners and investors are about a firm's expected future cash flows, the higher they
will value the company. In short, companies whose expected future cash flows are doubtful
will have lower values than companies whose expected future cash flows are virtually
certain.

6. Explain why accounting profits and cash flows are not the same thing.

Stock value depends on future cash flows, their timing, and their riskiness. Profit
calculations do not consider these three factors. Profit, as defined in accounting, is simply
the difference between sales revenue and expenses. It is true that more profits are generally
better than less profits, but when the pursuit of short-term profits adversely affects the size of
future cash flows, their timing, or their riskiness, then these profit maximization efforts are
detrimental to the firm.

7. What is an agent? What are the responsibilities of an agent?

An agent is a person who has the implied or actual authority to act on behalf of another. The
owners whom the agents represent are the principals. Agents have a legal and ethical
responsibility to make decisions that further the interests of the principals.

8. Describe how society's interests can influence financial managers.

 Sometimes the interests of a business firm's owners are not the same as the interests of
society. For instance, the cost of properly disposing of toxic waste can be so high that
companies may be tempted to simply dump their waste in nearby rivers. In so doing, the
companies can keep costs low and profits high, and drive their stock prices higher (if they are
not caught). However, many people suffer from the polluted environment. This is why we
have environmental and other similar laws: So that society's best interests take precedence
over the interests of individual company owners.

When businesses take a long-term view, the interests of the owners and society often (but not
always) coincide. When companies encourage recycling, sponsor programs for
disadvantaged young people, run media campaigns promoting the responsible use of alcohol,
and contribute money to worthwhile civic causes, the goodwill generated as a result of these
activities causes long-term increases in the firm's sales and cash flows, which translate into
additional wealth for the firm's owners.

9. Briefly define the terms proprietorship, partnership, and corporation.

A proprietorship is a business owned by one person.

Two or more people who join together to form a business make up a partnership. This can be
done on an informal basis without a written partnership agreement, or a contract can spell out
the rights and responsibilities of each partner.

A limited liability company is a hybrid between a partnership and a corporation. Profits and
losses pass through to the members. Members generally enjoy limited liability.

Corporations are legal entities separate from their owners. To form a corporation, the owners
specify the governing rules for the running of the business in a contract known as the articles
of incorporation. They submit the articles to the government of the state in which the
corporation is formed, and the state issues a charter that creates the separate legal entity.

10. Compare and contrast the potential liability of owners of proprietorships, partnerships
(general partners), and corporations.

The sole proprietor has unlimited liability for matters relating to the business. This means
that the sole proprietor is responsible for all the obligations of the business, even if those
obligations exceed the amount the proprietor has invested in the business.

Each partner in a partnership is usually liable for the activities of the partnership as a whole.
Even if there are a hundred partners, each one is technically responsible for all the debts of
the partnership. If ninety-nine partners declare personal bankruptcy, the hundredth partner
still is responsible for all the partnership's debts.

A corporation is a legal entity that is liable for its own activities. Stockholders, the
corporation's owners, have limited liability for the corporation's activities. They cannot lose
more than the amount they paid to buy the corporation’s stock.
Answers to End-of-Chapter Problems

1. An accountant prepares financial statements while a financial analyst interprets them.

2. A financial manager’s role in a publicly traded company is to make financial decisions so

as to best serve the principal stockholders.

3. a. The value of the firm would go down due to the increase in the amount of time it takes
to receive the cash inflows.

b. The value of the firm would go up due to the increase in expected cash inflows.

c. If expected future cash flows do not change the value of the firm would go down due
to the increased riskiness of the firm.

4. This practice obviously takes advantage of people who are in a difficult financial
situation. This transaction is voluntary, however, and high risk loans have high interest
rates.

5. LLCs have a small number of members like partnerships and each of these members is
likely to have an active voice in the company like a partnership. The LLC is taxed like a
partnership. Unlike a partnership, and more like a corporation, the owners generally
enjoy limited liability.

Answers to Review Questions

1. What are financial markets? Why do they exist?

Financial markets are where financial securities are bought and sold. They exist primarily to
bring deficit economic units (those needing money) and surplus economic units (those having
extra money) together.

2. What is a security?

Securities are claims on financial assets. They can be described as “claim checks” that give
their owners the right to receive funds in the future. Securities are traded in both the money
and capital markets. Money market securities include Treasury bills, negotiable certificates of
 deposit, commercial paper, and banker’s acceptances. Capital market securities include bonds
and stock.

3. What are the characteristics of an efficient market?

The term market efficiency refers to the ease, speed, and cost of trading securities. In an
efficient market, securities can be traded easily, quickly, and at low cost. Markets lacking
these qualities are considered to be inefficient.

4. How are financial trades made on an organized exchange?

Each exchange-listed security is traded at a specified location on the trading floor called the
post. The trading is supervised by specialists who act either as brokers (bringing together
buyers and sellers) or as dealers (buying or selling the stock themselves). Prominent
international securities exchanges include the New York Stock Exchange (NYSE) and major
exchanges in Tokyo, London, Amsterdam, Frankfurt, Paris, Hong Kong, and Mexico.

5. How are financial trades made in an over-the-counter market? Discuss the role of a dealer in
the OTC market.

In contrast to the organized exchanges, which have physical locations, the over-the-counter
market has no fixed location,or more correctly, it is everywhere. The over-the-counter
market, or OTC, is a network of dealers around the world who maintain inventories of
securities for sale. If you wanted to buy a security that is traded OTC, you would call your
broker, who would then shop among competing dealers who have the security in their
inventory. After locating the dealer with the best price, your broker would buy the security on
your behalf.

The role of dealers: Dealers make their living buying securities and reselling them to others.
They operate just like car dealers who buy cars from manufacturers for resale to others.
Dealers make money by buying securities for one price (called the bid price) and selling them
for a higher price, (called the ask price). The difference, or spread, between the bid price and
the ask price represents the dealer’s fee.

6. What is the role of a broker in security transactions? How are brokers compensated?

Brokers handle orders to buy or sell securities. Brokers are agents who work on behalf of an
investor. When investors call with an order, brokers work on their behalf to find someone to
take the other side of the proposed trade. If investors want to buy, brokers find sellers. If
investors want to sell, brokers find buyers. Brokers are compensated for their services when
the person whom they represent, the investor, pays them a commission on the sale or
purchase of securities.
7. What is a Treasury bill? How risky is it?

Treasury bills are short-term debt instruments issued by the U.S. Treasury that are sold at a
discount and pay face value at maturity. They are very nearly risk-free as they are backed by
the U.S. Government which could, if need by, print money to pay their holders at maturity.

8. Would there be positive interest rates on bonds in a world with absolutely no risk (no default

risk, maturity risk, and so on)? Why would a lender demand, and a borrower be willing to pay, a

positive interest rate in such a no-risk world?

Yes, there would be a positive rate of interest in a risk-free world. This is because regardless
of risk, lenders of money must postpone spending during the time the money is loaned.
Lenders, then, lose the opportunity to invest their money for that period of time. To
compensate for the cost of losing investment opportunities while they postpone their
spending, lenders demand, and borrowers pay, a basic rate of return, the real rate of interest.

Answers to Review Questions

1. Why do total assets equal the sum of total liabilities and equity? Explain.

Assets = Liabilities + Equity

Assets are the items of value a business owns. Liabilities are claims on the business by non-
owners, and equity is the owners' claim on the business. The sum of the liabilities and equity
is the total capital contributed to the business, which, by definition, equals the total value of
the assets.

2. What are the time dimensions of the income statement, the balance sheet, and the statement
of cash flows? Hint: Are they videos or still pictures? Explain.

The income statement is like a video: It measures a firm's profitability over a period of time
(which can be a week, a month, a year, or any other time period).

The balance sheet is like a still photograph. The balance sheet shows the firm's assets,
liabilities, and equity at a given point in time.

This cash flow statement like the income statement, can be compared to a video: It shows
how cash flows into and out of a company over a given period of time.
 3. Define depreciation expense as it appears on the income statement. How does depreciation

affect cash flow?

Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation
expense on an income statement is the amount of the asset=s initial cost allocated to the period
covered by the income statement.

Depreciation expense is not a cash flow. Depreciation as an expense category affects cash
flow, however, because it is tax-deductible. Depreciation expense lowers a company’s
taxable income and, therefore its income tax liability. In this way depreciation reduces cash
outflows..

4. What are retained earnings? Why are they important?

Retained earnings represents the sum of all the earnings available to common stockholders of
a business during its entire history, minus the sum of all the common stock dividends which
it has ever paid. Those earnings that were not paid out were, by definition, retained.

Retained earnings are important because they represent amounts reinvested in a company on
behalf of the company’s owners instead of being paid out in the form of dividends.
5. Explain how earnings available to common stockholders and common stock dividends paid
from the current income statement affect the balance sheet item retained earnings.

The change in the retained earnings account from one balance sheet to the next equals net
income less preferred stock dividends (which is the amount of earnings available to common
stockholders) less common stock dividends.

6. What is accumulated depreciation?

Depreciation is the allocation of an asset's initial cost over time. Accumulated depreciation is
the total of all the depreciation expense that has been recognized to date.

7. What are the three major sections of the statement of cash flows?

Cash flows from Operations

Cash flows from investing activities
Cash flows from financing activities
Net change in cash balance
Cash balance at beginning of period
Cash balance at end of period

8. How do financial managers calculate the average tax rate?

 Average tax rates are calculated by dividing tax dollars paid by earnings before taxes (EBT).

9. Why do financial managers calculate the marginal tax rate?

Financial managers use marginal tax rates to estimate the future after-tax cash flows from
investments. Since they are interested in how much of the next dollar earned from new
investments will have to be paid in taxes, they use the marginal tax rate (rather than the
average tax rate) to calculate the tax liability.

10. Identify whether the following items belong on the income statement or the balance sheet.

a. Interest Expense IS l. Cash BS

b. Preferred Stock Dividends Paid IS m. Capital in Excess of Par BS
c. Plant and Equipment BS n. Operating Income IS
d. Sales IS o. Depreciation Expense IS
e. Notes Payable BS p. Marketable Securities BS
f. Common Stock BS q. Accounts Payable BS
g. Accounts Receivable BS r. Prepaid Expenses BS
h. Accrued Expenses BS s. Inventory BS
i. Cost of Goods Sold IS t. Net Income IS
j. Preferred Stock BS u. Retained Earnings BS
k. Long-Term Debt BS
11. Indicate in which section the following balance items belong (current assets, fixed assets,
current liabilities, long-term liabilities, or equity).

a. Cash CA h. Capital in Excess of Par EQ

b. Notes Payable CL i. Marketable Securities CA
c. Common Stock EQ j. Accounts Payable CL
d. Accounts Receivable CA k. Prepaid Expenses CA
e. Accrued Expenses CL l. Inventory CA
f. Preferred Stock EQ m. Retained Earnings EQ
g. Plant and Equipment FA

Answers to Review Questions

1. What is a financial ratio?

A financial ratio is a number that expresses the value of one financial variable relative to
another. Put more simply, a financial ratio is the result you get when you divide one
financial number by another. Calculating an individual ratio is simple, but each ratio must be
analyzed carefully to effectively measure a firm's performance.

2. Why do analysts calculate financial ratios?

 Ratios are comparative measures. Because the ratios show relative value, they allow
financial analysts to compare information that could not be compared in its raw form. For
example, ratios may be used to compare one ratio to a related ratio, a firm's performance to
management's goals, a firm's past and present performance, or a firm's performance to similar
firms

3. Which ratios would a banker be most interested in when considering whether to approve an

application for a short-term business loan? Explain.

Bankers and other lenders use liquidity ratios to see whether to extend short-term credit to a
firm. Liquidity ratios measure the ability of a firm to meet its short-term obligations. These
ratios are important because failure to pay such obligations can lead to bankruptcy.
Generally, the higher the liquidity ratio, the more able a firm is to pay its short-term
obligations.

4. Which ratios would a potential long-term bond investor be most interested in? Explain.

Current and potential lenders of long-term funds, such as banks and bondholders, are
interested in debt ratios. When a business's debt ratios increase significantly, bondholder and
lender risk increases because more creditors compete for that firm's resources if the company
runs into financial trouble.

5. Under what circumstances would market to book value ratios be misleading? Explain.

The Market to Book ratio is useful, but it is only a rough approximation of how liquidation
and going concern values compare. This is because the Market to Book ratio uses
accounting-based book values. The actual liquidation value of a firm is likely to be different
than the book value. For instance, the assets of a firm may be worth more or less than the
value at which they are currently carried on the company's balance sheet. In addition, the
current market price of the company's bonds and preferred stock may also differ from the
accounting value of these claims.

6. Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may be
calculated more simply? Explain.

Actually, an analyst would not use the Modified Du Pont equation to calculate ROE for
precisely the reason stated above. What an analyst would use the Modified Du Pont equation
for is to help analyze the factors that contribute to a firm's ROE. In other words, analysts use
the Modified Du Pont system to “take apart” ROE to see what factors are influencing it.
7. Why are trend analysis and industry comparison important to financial ratio analysis?

Trend analysis helps financial managers and analysts see whether a company's current
financial situation is improving or deteriorating.

Cross-sectional analysis, or industry comparison, allows analysts to put the value of a firm's
ratios in the context of its industry.

Answers to Review Questions

1. What is the time value of money?

The time value of money means that money you hold in your hand today is worth more than
money you expect to receive in the future. Similarly, money you must pay out today is a
greater burden than the same amount paid in the future.

2. Why does money have time value?

Positive interest rates indicate that money has time value. When one person lets another
borrow money, the first person requires compensation in exchange for reducing current
consumption. The person who borrows the money is willing to pay to increase current
consumption. The required rate of return on an investment reflects the pure time value of
money, an adjustment for expected inflation, and any risk premiums present.

3. What is compound interest? Compare compound interest to discounting.

Compound interest occurs when interest is earned on interest and on the original principal of
an investment. Discounting is the inverse of compounding. Compound interest causes the
value of a beginning amount to increase at an increasing rate. Discounting causes the present
value of a future amount to decrease at an increasing rate.

4. How is present value affected by a change in the discount rate?

Present value is inversely related to the discount rate. In other words, present value moves in
the opposite direction of the discount rate. If the discount rate increases, present value
decreases. If the discount rate decreases, present value increases.

5. What is an annuity?

An annuity is a series of equal cash flows, spaced evenly over time.

6. Suppose you are planning to make regular contributions in equal payments to an investment
fund for your retirement. Which formula would you use to figure out how much your
investments will be worth at retirement time, given an assumed rate of return on your
investments?

To figure out how much your investments will be worth at retirement time, given an assumed
rate of return on your investments, you would use the future value of an annuity formula:

Future Value of an Annuity Formula

(1+k )n −1
FVA=PMT
k[ ]
where: FVA = Future Value of an Annuity
PMT = Amount of each annuity payment
k = Interest rate per time period
n = Number of annuity payments

7. How does continuous compounding benefit an investor?

The effect of increasing the number of compounding periods per year is to increase the future
value of the investment. The more frequently interest is compounded, the greater the future
value. The smallest compounding period is used when we do continuous compounding--
compounding that occurs every tiny unit of time (the smallest unit of time imaginable).

8. If you are doing PVA and FVA problems, what difference does it make if the annuities are
"ordinary annuities" or "annuities due"?

In FVA or a PVA of annuity due problems, annuity payments earning interest one period
sooner than in ordinary annuity problems. So, higher FVA and PVA values result with an
annuity due. The first payment occurs sooner in the case of a future value of an annuity due.
In present value of annuity due problems, each annuity payment occurs one period sooner, so
the payments are discounted less severely.

9. Which formula would you use to solve for the payment required for a car loan if you know
the interest rate, length of the loan, and the borrowed amount? Explain.

To solve for k when the known values are PVA, n, and PMT, start with the present value of
an annuity formula, Equation 8-3b, as follows:

Present Value of an Annuity Formula, Table Method

PVA = PMT(PVIFA k, n)
 Next, rearrange terms and solve for (PVIFA k, n) as follows

PVA / PMT = (PVIFA k, n)

Now refer to the PVIFA values in the text, Table IV. You know n, so find the n row
corresponding to the number of periods in your problem on the left hand side of the table.
You have also determined the PVIFA, so move across the n row until you find (or come close
to) the value of PVIFA that you have solved for. The percent column in which the value is
located is the interest rate.
Answers to Review Questions

1. How does a mortgage bond compare to a debenture?

A mortgage bond is a secured bond while a debenture is an unsecured bond.

2. How does a sinking fund function in the retirement of an outstanding bond issue?

A sinking fund is where a company puts payments that are then used to buy back outstanding
bonds.

3. What are some examples of restrictive covenants that might be specified in a bond’s
indenture?

An indenture might include limitations on future borrowings, restrictions on dividend

payments, and/or requirements that working capital be maintained at least at some minimum
level.

4. Define the following terms that relate to a convertible bond: conversion ratio, conversion
value, and straight bond value.

The conversion ratio is the number of shares of common stock that would be obtained if a
convertible bond were converted. The conversion value is the total value of the common
stock that would be obtained. The straight bond is the value a convertible bond would have
without the conversion feature.

5. If a convertible bond has a conversion ratio of 20, a face value of $1,000, a coupon rate of 8
percent, and the market price for the company’s stock is $15 per share, what is the
convertible bond’s conversion value?

The conversion value would equal the conversion ratio of 20 times the $15 market price of
the stock or $300.
6. What is a callable bond? What is a putable bond? How do each of these features affect their
respective market interest rates?

A callable bond can be retired early at the discretion of the issuer. A putable can be retired
early at the discretion of the investor. A call provision increases the market interest rate and
a put provision decreases it.

Answers to Review Questions

1. What are some of the government requirements imposed on a public corporation that are not
imposed on a private, closely held corporation?

Public corporations must submit audited financial statements to the government for release to
the public. Private corporations can keep their financial information confidential.

2. How are the members of the board of directors of a corporation chosen and to whom do these
board members owe their primary allegiance?

Members of a corporation’s board of directors are elected by the common stockholders and
owe their allegiance to these stockholders

3. What are the advantages and the disadvantages of a new stock issue?

A new stock issue raises funds and decreases the riskiness of the firm. It also tends to send a
negative signal to the market since many investors believe a company would only sell new
stock if future financial prospects were dim.

4. What does an investment banker do when underwriting a new security issue for a
corporation?

When underwriting a new security issue an investment banker buys it and then resells it to
investors.

5. How does a preemptive right protect the interests of existing stockholders?

A preemptive right protects the interests of existing stockholders by giving them the
opportunity to preempt other investors in the purchase of new shares. If these rights are
exercised, existing shareholders would maintain their same percentage of ownership after the
new stock issue as before.
6. Explain why warrants are rarely exercised unless the time to maturity is small?

Warrants are rarely exercised until the time to expiration is small because the market price of
the warrant is greater than the exercise value. The holder of the warrant would therefore sell
it in the secondary market instead of exercising it if he or she wanted to cash in.

7. Under what circumstances is a warrant’s value high? Explain.

A warrant’s value would be high when the stock price, time to expiration, and/or expected
stock price volatility are high.

Answers to Review Questions

1. What are the primary reasons that companies hold cash?

Companies hold cash to make necessary payments, to take advantage of opportunities as they
arise, and to cover unforeseen emergencies.

2. Explain the factors affecting the choice of a minimum cash balance amount.

The minimum cash balance amount is determined by how easy it is to raise funds when
needed, how predictable the cash flows are, and how risk averse managers are.

3. What are the negative consequences of a company holding too much cash?

A company holding too much cash would be giving up the opportunity to invest more in
income producing assets

4. Explain the factors affecting the choice of a maximum cash balance amount.

The maximum cash balance amount is determined by available investment opportunities, the
expected return on investments, and the transaction cost of making investments.

5. What is the difference between pro forma financial statements and a cash budget? Explain
why pro forma financial statements are not used to forecast cash needs.

Pro forma income statements deal with revenues and expenses that are not always cash flows
while cash budgets deal only with projected cash inflows and outflows.
6. What are the benefits of “collecting early” and how do companies attempt to do this?

Money has time value. The sooner cash is collected, the better. Companies use regional
collection centers and lock boxes to facilitate this.

7. What are the benefits of “paying late” (but not too late) and how do companies attempt to do
this?

Because money has time value, the later cash is paid, but not too late, the better. Companies
use remote disbursement banks to facilitate holding onto funds longer.

8. Refer to the Bulldog battery company’s cash budget in Table 18-7. Explain why the
company would probably not issue $1 million worth of new common stock in January to
avoid all short-term borrowing during the year.

Common stock financing is long-term financing so it would probably not be used to meet this
short-term financing need.

Answers to Review Questions

1. Companies with rapidly growing levels of sales do not need to worry about raising funds
from outside the firm. Do you agree or disagree with this statement? Explain.

Disagree. Rapidly growing firms need more assets to accommodate the increasing sales.
Such firms are more likely, not less, to seek outside financing. Internal funds are often
insufficient.

2. Banks like to make short-term, self-liquidating loans to businesses. Why?

Banks like to be able to see where the funds are likely to come from such that the borrower is
able to use to make the required loan payments. Short term, self-liquidating loans do this
since the borrowed funds are used to purchase assets that generate the needed funds.

3. What are compensating balances and why do banks require them from some customers?
Under what circumstances would banks be most likely to impose compensating balances?

Compensating balances are funds that a bank requires a customer to maintain in a non-
interest bearing account until the loan is retired. Banks sometimes impose compensating
balance requirements so as to increase the bank’s return on a loan. Compensating balances
are most likely to be used when the stated interest rate on a loan is below the bank’s required
rate of return.
4. What happens when a bank charges discount interest on a loan?

When a bank charges discount interest on a loan the required interest payment is subtracted
from the loan proceeds at the time the loan is made. This makes the effective interest rate
greater than the stated rate.

5. What is trustworthy collateral from the lenders’ perspective? Explain whether accounts
receivable and inventory are trustworthy collateral.

Assets that are readily marketable, of stable value, and not likely to “disappear” make for
trustworthy collateral. Accounts receivable and inventory could meet this test depending
upon their particular characteristics.

6. Trade credit is free credit. Do you agree or disagree with this statement? Explain.

Trade credit is not free. It has a cost. Who bears that cost depends on the terms of the
transaction between the grantor and the recipient of the trade credit.

7. What are the pros and cons of commercial paper relative to bank loans for a company seeking
short-term financing?

Commercial paper is usually a cheaper source of short-term financing for a firm, compared to
bank loans. Also, a larger amount of funds can often be raised by issuing commercial paper.
Bank loans are usually a more flexible source of short-term financing and establishing an on-
going business relationship with a bank may prove beneficial when money is tight.