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Cost of borrowing

The R. Morin Construction Company needs to borrow $100,000 to help finance the cost of a new $150,000 hydraulic crane used in the firm's commercial construction business. The crane will pay for itself in one year, and the firm is considering the following alternatives for financing its purchase:

Alternative A-The firm's bank has agreed to lend the $100,000 at a rate of 14 percent. Interest would be discounted, and a 15-percent compensating balance would be required. However, the compensating-balance requirement would not be binding on R. Morin because the firm normally maintains a minimum demand deposit (checking account) balance of $25,000 in the bank.

Alternative B-The equipment dealer has agreed to finance the equipment with a 1-year loan. The $100,000 loan would require payment of principal and interest totaling $116,300.
a. Which alternative should R. Morin select?
b. If the bank's compensating-balance requirement were to necessitate idle demand deposits equal to 15 percent of the loan, what effect would this have on the cost of the bank loan alternative?

On July 1, 2003, the Southwest Forging Corporation arranged for a line of credit with the First National Bank of Dallas. The terms of the agreement call for $100,000 maximum loan with interest set at 1 percent over prime. In addition, the firm has to maintain a 20-percent compensating balance in its demand deposit account throughout the year. The prime rate is currently 12 percent.

a. If Southwest normally maintains a $20,000 to $30,000 balance in its checking account with FNB of Dallas, what is the effective cost of credit through the line-of-credit agreement when the maximum loan amount is used for a full year?
b. Recompute the effective cost of trade to Southwest if the firm borrows the compensating balance and it borrows the maximum possible under the loan agreement. Again, assume the full amount of the loan is outstanding for a whole year.

Johnson Enterprises, Inc., is involved in the manufacture and sale of electronic components used in small AM/FM radios. The firm needs $300,000 to finance an anticipated expansion in receivables due to increased sales. Johnson's credit terms are net 60, and its average monthly credit sales are $200,000. In general, the firm's customers pay within the credit period; thus the firm's average accounts receivable balance is $400,000. Chuck Idol, Johnson's comptroller, approached the firm's bank with a request for a loan for the $300,000 using the firm's accounts receivable as collateral. The bank offered to make a loan at a rate of 2 percent over prime plus a 1-percent processing charge on all receivables pledged ($200,000 per month). Furthermore, the bank agreed to lend up to 75 percent of the face value of the receivables pledged.

a. Estimate the cost of the receivables loan to Johnson when the firm borrows the $300,000. The prime rate is currently 11 percent.
b. Idol also requested a line of credit for $300,000 from the bank. The bank agreed to grant the necessary line of credit at a rate of 3 percent over prime and required a 15-percent compensating balance. Johnson currently maintains an average demand deposit of $80,000. Estimate the cost of the line of credit to Johnson.
c. Which source of credit should Johnson select? Why?

MDM, Inc., is considering factoring its receivables. The firm has credit sales of $400,000 per month and has an average receivables balance of $800,000 with 60-day credit terms. The factor has offered to extend credit equal to 90 percent of the receivables factored less interest on the loan at a rate of 1½ percent per month. The 10-percent difference in the advance and the face value of all receivables factored consists of a 1-percent factoring fee plus a 9-percent reserve, which the factor maintains. In addition, if MDM, Inc., decides to factor its receivables, it will sell them all, so that it can reduce its credit department costs by $1,500 a month.

a. What is the cost of borrowing the maximum amount of credit available to MDM, Inc., through the factoring agreement?
b. What considerations other than cost should be accounted for by MDM, Inc., in determining whether to enter the factoring agreement?

Solution Summary

The solution explains how to calculate the cost of borrowing under different conditions