This post addresses financing an expansion.
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The Thompson Corporation projects an increase in sales from $18 million to $25 million, but it needs an additional $500,000 of current assets to support this expansion. Thompson purchases under terms of 2/10, net 60 and currently pays on the 10th day, taking discounts. The CFO is considering using trade credit to finance the additional working capital required. Alternatively, Thompson can finance its expansion with a one-year loan from its bank. The bank has quoted the following alternative loan terms:
a) 12 percent rate on a simple interest loan, with monthly interest payments.
b) 10 percent annual rate on a discount interest basis with no compensating balance.
c) 8.75 percent annual rate on a discount interest basis, with a 10 percent compensating balance.
d) 8 percent add-on interest, with monthly payments.
Based strictly on cost considerations only, what should Thompson do to finance its expansion?
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Solution Summary
The solution provides all calculations needed to determine how Thompson should finance their expansion based on the elements of the scenario given.
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a) 12 percent rate on a simple interest loan, with monthly interest payments.
Effective Interest Rate = [1 + (0.12 / 12)]12 - 1 = 12.68%
b) 10 percent annual rate on a discount interest basis with no compensating balance.
Effective Interest Rate ...
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