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SHORT-TERM FINANCING

146

(c) The cost of commercial paper is:

A = $10,000

0.20 $600,000 X

X

Strategy (c) is best since issuance of commercial paper involves the least cost.

Cost of Accounts Receivable Financing. What is the effect of each of the following situations on

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the cost of accounts receivable financing? ( a ) A more thorough credit check is undertaken. (6)

Receivables are sold without recourse. (c) The minimum invoice amount for a credit sale is

decreased. ( d ) Credit standards are tightened.

SOLUTION

(c)

Decrease Increase

(a)

( d ) Decrease

(b) Increase

51

.7 Cost of Factoring.Drake Company is contemplating factoring its accounts receivable. The factor

will acquire $250,000 of the companyâ€™s accounts receivable every 2 months. An advance

of 75 percent is given by the factor on receivables at an annual charge of 18percent. There is a

2 percent factor fee associated with receivables purchased. What is the cost of the factoring

arrangement?

SOLUTION

$30,000

Factor fee (0.02 X $250,000 X 6)

Cost of advance (0.18 X $250,000X 0.75) 33,750

$63,750

Total cost

Bank versus Factor. Forest Corporation needs $400,000 additional financing. The company is

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considering the choice of financing with a bank or a factor. The bank loan carries a 20 percent

interest rate on a discount basis with a required compensating balance of 16 percent. The factor

charges a 3 percent commission on invoices purchased monthly. The interest rate associated with

these invoices is 11percent with interest deductible in advance. If a factor is used, there will be

a monthly savings of $1,500 per month in credit department costs. Further, an uncollectible

accounts expense of 2 percent on the factored receivables will not exist.

( a ) What amount of principal must the company borrow from the bank to receive $400,000

in proceeds? (6) What amount of accounts receivable must be factored to net the firm $400,000?

(c) What is the effective interest rate on the bank loan? ( d ) What is the total annual cost of the

bank arrangement? ( e ) What is the effective interest rate associated with the factoring

arrangement? (f)What is the total annual cost of factoring?

SOLUTION

Princi Dal 1.oo

(4 Proceeds 1.00 - (0.20 + 0.16)

1

Principal $400,000 - $400,000

_-- - $625,000

-=-=

1- 0.36 1.0 - 0.36 0.64

$400,000

$400,000 - $400,000

Accounts receivables to factor = $465,116

--=

1.0 - 0.14 0.86

interest rate --0.20

-=

Effective interest rate of bank loan = 31.3%o

proceeds, % 0.64

SHORT-TERMFINANCING 147

CHAP. 51

( d ) The cost of the bank loan is:

Interest ($400,000 X 0.313) $125,200

18,000

Credit costs ($1,500 X 12)

Uncollectible accounts ($465,116 X 0.02) 9,302

Total annual cost $152,502

(e) The effective interest rate of factoring is:

0.11

12.8%

-=

0.86

(f) The cost of factoring is:

$51,200

Interest ($400,000 X 0.128)

Factoring ($465,116 X 0.03) 13,953

Total annual cost $65,153

Bank versus Factor. Wayne Corporationâ€™s factor charges a 4 percent monthly fee.The factor lends

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Wayne up to 85 percent of receivables purchased for an additional 1; percent per month. The

monthly credit sales are $350,000.With the factoring arrangement, there is a savings in corporate

credit checking costs of $4,200 per month and in bad debts of 3 percent on credit sales.

Trust Bank has offered to lend Wayne up to 85 percent of the receivables, at an interest

charge of 2.5 percent per month plus a 5 percent processing charge on receivable lending.

The collection period is 30 days, and Wayne borrows the maximum amount permitted each

month. Should Wayne Corporation accept the bankâ€™s offer?

SOLUTION

Cost of factor:

Purchased receivables (0.04 X $350,000) $14,000

4,463

Lending fee (0.015 X $350,000 X 0.85)

Total cost $18,463

Cost of bank financing:

Interest (0.025 X $350,000x 0.85) $ 7,438

Processing charge (0.05 X $350,000 X 0.85) 14,875

Additional cost of not using factor

Credit costs 4,200

Bad debts (0.03 X $350,000) 10,500

$37,013

Total cost

Wayne Corporation should stay with the factor, since the cost of the bankâ€™s offer is

more. than twice the cost of factoring.

Factoring Accounts Receivable. Grafton Corporation is considering factoring its accounts

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receivable. Its sales are $3,600,000, and accounts receivable turnover is two times. The factor

requires: (1)an 18percent reserve on accounts receivable; (2) a commission charge of 2.5 percent

on average accounts receivable, payable when receivables are purchased; and (3) an interest

charge of 19 percent on receivables after deducting the commission charge and reserve. The

interest charge reduces the advance.

SHORT-TERM FINANCING [CHAP. 5

148

Given the facts, answer the following questions: ( a ) What is the average accounts receivable?

( b )How much will Grafton receive by factoring its accounts receivable? ( c ) What is the annual

cost of the factoring arrangement? ( d ) What is the effective annual cost of factoring?

SOLUTION

credit sales -

- $37600â€™000= $1,800,000

Average accounts receivable =

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