Question

Global Markets, Inc. was experiencing a shortage of cash. Consequently, the President was considering two options to provide an immediate inflow of cash.

The first option was to sell $2 million of the company's accounts receivable on a nonrecourse basis. The factoring cost would amount to 15.5 percent of the value of the factored receivables.

The second option was to obtain a 60-day loan from a local bank using its outstanding receivables as collateral. Under the loan agreement, Global Markets would be charged 13 percent annual interest on the outstanding loan and would pledge receivables equal to 122 percent of the loan amount (a loan-to-value ratio of 82 percent).

Required Compare the cost under each financing option.

Factoring agreement (first option)
Increase in cash (in millions, rounded to two decimal places)	$Answer	million
Financing expense (rounded to the nearest dollar)	$Answer
Reduction in accounts receivable (in millions, rounded to two decimal places)	$Answer	million

Pledging agreement (second option)
Hint - Assume that the company elects to borrow $169,0000 instead and that the bank loan was outstanding for 60 days.
Increase in cash (in millions, rounded to two decimal places)	$Answer	million
Increase in bank loan payable (in millions, rounded to two decimal places)	$Answer	million
Receivables pledged to bank (in millions, rounded to two decimal places)	$Answer	million
Financing costs (interest costs) (rounded to the nearest dollar)	$Answer

Which option is best for the company?

Which option has the highest financing expense?	AnswerFactoring agreementPledging agreement
How much higher are the financing expenses under this option?	$Answer
If the expected bad debt expense on the $2M accounts receivable is $290,000
which option is likely a better alternative?	Answer Answer

Answer 1

Factoring agreement
Particulars	Amount ($)
Increase in cash	1,690,000.00
Accounts receivable balance	2,000,000.00
Less: Factoring expenses (2000000 x 15.5%)	310,000.00
Account receivable balance after factoring	1,690,000.00
Pledging agreement
Particulars	Amount ($)
Increase in cash	1,690,000.00
Increase in bank loan payable	1,690,000.00
Receivable pledge to bank (1690000 x 122%)	2,061,800.00
Financing cost (1690000 x 13% x 60/365)	36,115.07

Pledging agreement should be accepted as the financing cost under pledging agreement is much lower than financing expense under factoring agreement.

The financing expenses is higher for factoring agreement with $310,000.

The financing expenses under factoring option is higher by (310000 – 36155.07) = $273,884.93.

In case the expected bad debt on accounts receivable is $290,000 then factoring agreement would be the suitable agreement for the organization as the bad debt expenses along with financing cost under pledging agreement is (290000 + 36115.07) = $326,115.07 is higher than the financing cost of $310,000 under factoring agreement.