Question

Macco Bakers requires additional financing for a 90-day period. Four alternatives are being considered.

Additional financing required $ 580,000

a) Establish a line of credit with the bank. The bank will charge a fee to establish the line of credit.

interest rate on line of credit 8%

fee charged $ 8,000

b) Forgo trade discounts from suppliers on terms of 2/10, net 100.

c) Issue commercial paper for 90 days.

Discount rate on commercial paper   2.0%

d) Obtain a loan from the bank. Instead of charging a fee to establish the credit, the bank requires a compensating balance. Macco Bakers currently has no idle cash to apply against this compensating balance.

interest rate on loan 7%

compensating balance required $23,000

Required: Which alternative should be selected?

Answer 1

We will calculate Cost of each options and will select the lowest one:

a) Cost = Fee Charged + Interest = $8,000 + (580,000 * 8% * 90/365)

            =$8,000 + $11,441 = $ 19,441

b) Discount forgo cost Cost before discount - Discounted cost

       =( 580,000 * 100/ 98) - 580,000 =

          = $591,836 - $580,000 =$11836

Note: 2/10 net 100 means 2% discount on 10 days payment otherwise pay full in 100 days. So we can pay 98 now or 100 after 90 days.

c) Commercial paper issued at 2% discount, so we will get 98% and payment will be 100%.

For $580,000 Cost = 580,000*(100%/98%) - 580,000

= $591,836 - $580,000 = $ 11,836

d) Total loan required = $580,000 + Compensating balance = $580,000 + $23,000 =

So cost will be = 7% on $603,000 on 90 days

= $603,000 * 7% * (90/365)

= 42,210 * 0.246 = $10384

Obtain a loan from Bank is lowest cost option. To choose option d