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Loans vs. bank notes

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XYZ Corporation is experiencing an average collection period of 120 days. The industry average is about 75 days. The firm has also experienced an increase in its business in the last 2 years and has been buying more inventory. The management wants to increase the amount of permanent inventory stock, and projects an increase in the accounts receivable balance.

The firm is considering two financing options: a 7-year loan at the rate of 8.5%; and a 90 note at prime plus 2%, which would help the firm with liquidity challenges.

1. Which financing option do you recommend and why? Prime rate is 5%. Explain the relevance of the matching method in making this decision.

2. Is there a scenario where both options may be used? Explain.

3. The firm's average days payable outstanding is 45, and the industry average is 60. Determine possible methods to use payables as a short-term financing strategy. Recommend the most beneficial method and include your rationale.

4. Suppose the firm's vendors offer credit terms of 2/10, net 45. Might the strategy be different in this case and why?

Can you help me make sense of this?

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The solution compares loans vs. bank notes.

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1. Which financing option do you recommend and why? Prime rate is 5%. Explain the relevance of the matching method in making this decision.

The financing option depends on various factors such as economic outlook and interest rate forecasts, ability of the firm to take interest rate risks, need for long term versus short term financing, etc. I would advise the firm to go for fixed rate longer term loan, if the need is for long term and the interest rates are expected to rise further.

Matching principle will be applicable in this scenario because the firm has to match the cash flow from financing to timing of the outflow of cash. In other words, the inflow from these financing options should match with the timing ...

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Sheetal Jain, PGDM
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  • Post Graduate Diploma in Management (Equivalent to MBA), All India Management Association
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