The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified the four sources of funds given below.1. Pay a factor to buy the company's receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expenses over the year. Assume the fee and interest are not deductible in advance.2. Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.3. Issue $110,000 of 6-month commercial paper to net $100,000 (New paper would be issued every 6 months.)4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.Assume a 360-day year in all of your calculations. The cost of Alternative 4. to Frame Supply Company is
Answer(s): B
The company will receive $100,000 ($125,000 x 80%) at an annual cost of $25,000, so the annual interest rate is 25% ($25,000 ÷ $100,000).
If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is
Answer(s): C
The buyer could satisfy the $100 obligation by paying $98 on the 10th day. By choosing to wait until the 40th day, the buyer is effectively paying a $2 interest charge for the use of $98 for 30 days (40-day credit period - 10-day discount period). The interest rate on what is essentially a 30-day loan is 2.04081% ($2 ÷ $98). Extrapolating this 30-day rate to a yearly rate involves multiplying by the number of periods in a year. Thus, the effective annual rate is about 24.49% [2.04081% x (360 ÷ 30 days)].
Commercial paper
Commercial paper is a form of unsecured note that is sold by only the most creditworthy companies. It is issued at a discount from its face value and has a maturity period of 270 days or less. Commercial paper usually carries a low interest rate in comparison to other means of financing. SMA 4M, Understanding Financial instruments, observes that no general (active) secondary market exists for commercial paper, but that "most dealers or organizations will repurchase an issue that they have sold."
A company enters into an agreement with a firm that will factor the company's accounts receivable. The factor agrees to buy the company's receivables, which average $100,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the annual cost of financing?
Answer(s): D
In an average month, the company will receive $80,000 at the time the receivables are sent to the factor. Over a year's time, the interest on this average advance of $80,000 would be $8,000 at 10% interest. In addition, the factor will charge a 2% factor fee, or $24,000 ($100,000 x .02 x 12) over the course of a year. However, this $24,000 fee is offset by the $18,000 savings in collection expenses, producing a net outlay of only $6,000. Adding the $6,000 to the $8,000 of interest produces an annual net cost of $14,000. Dividing the $14,000 cost by the $80,000 of advanced funds results in a cost of 17.5%.
CyberAge Outlet, a relatively new store, is a cafe that offers customers the opportunity to browse the Internet or play computer games at their tables while they drink coffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee-shirts, and computer accessories. CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge's two major vendors, including average monthly purchases and credit terms.The amount Morton Company must borrow to pay the supplier within the discount period and cover the compensating balance is
The will need $58,800 ($60,000 x 98%) to pay the invoice. In addition, it will need a compensating balance equal to 9% of the loan. The equation isThus, the loan amount needed is $64,615 ($58,800 ÷ .91)
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