Axle Chemical Corporation's treasurer has forecasted a $1 million cash deficit for the next quarter. However, there is only a 50 percent chance this deficit will actually occur. The treasurer estimates that there is a 20 percent probability the company will have no deficit at all and a 30 percent probability that it will actually need $2 million in short-term financing. The company can either take out a 90-day unsecured loan for $2 million at 1 percent per month or establish a line of credit, costing 1 percent per month on the amount borrowed plus a commitment fee of $20,000. If excess cash can be reinvested at 9 percent, which source of financing gives the lower expected cost?
First calculate the expected cash required next quarter.
We have three scenarios:
Cash required Probability
2 million 30%
1 million 50%
Please check ...
This solution discusses the source of financing that would give the lower expected cost if the company was to organize a reinvestment to avoid a cash deficit.