Question

1. A company needs to borrow $10 million for its working capital needs. Its considering the following three alternatives:

Forgo cash discounts granted with the credit terms of 3/10; net 30

Borrow from the bank at 15% requiring a compensating balances 12%

Issue commercial paper with 180 day maturity, at 12%. Cost of placement will $100,000.

Which alternative would be the best?

Answer 1

	The effective annual rate of the three alternatives is to
	be found out.
1]	EAR = (1+3/97)^(365/20)-1 =	74.35%
2]	Amount required $10m
	Amount to be borrowed with compensatory balance = 10/88% =	$                  11.364	million
	Interest = 11.364*15% =	$                    1.705	million
	EAR = 1.705/100 =	17.05%
3]	Required commercial paper = 10/94%	$                  10.638	million
	Total charges = 10.638-10+0.100 =	$                    0.738	million
	Interest rate for 180 days = 0.738/10 =	7.38%
	EAR = 1.0738^2-1 =	15.30%
4]	As the EAR of the commercial paper is the lowest, the
	firm should choose it.