As a result of computer processing equipment operating lease obligations, the fi

Question

As a result of computer processing equipment operating lease obligations, the firm’s processing costs are uniform throughout the year (annual processing costs are uniformly spread over twelve months). The firm’s cash management policy requires the firm to maintain a minimum cash balance of $200,000. The firm’s board of directors decided that in November 2014 it would pay-out a dividend of $ 500,000. Taxes of $ 200,000 will be paid per quarter (in March, June, September, and December). A capital outlay of $750,000 will be made in both March and April.

You have had a running discussion with the Chief Financial Officer (CFO) as to the best way meet anticipated monthly cash shortfalls. The CFO believes in conservative cash management it opts for long-term financing. This entails financing the firm’s cash requirements with an annual long-term loan at 10%, which is based on covering the highest monthly cash shortfall. The unused portion of acquired funds will be fully invested on a monthly basis at a 6% (annual) interest rate.

You believe a more cost effective approach would be to finance the firm’s cash requirements through a revolving credit agreement at a cost of .5% (annual rate) of the monthly-unused portion of the credit line. The used portion of the credit line will cost 5% (annual rate). Determine who is right.

Explanation / Answer

Cash requirements are different in different months like it requires $200,000 in some months, $750,000 in some months and highest $1,150,000 in some month like March. To meet these flexible cash short fall it is better to go for revolving credit rather than traditonal long term loan. In revolving credit following are advantages:

1. We can use small amount of loan in months for which, we require small amount of cash loan to meet requirement

2. If we does not require, we can return the loan

3. Subject to Pre-approved limit, we can draw the amount of loan which is just sufficient to meet working capital requirements. so the interst cost is very low

4. Rate of interest is also very lower than long term loan

5. Revolving credit allow to draw incremental amount to meet business requirement

6. It is useful to meet ups and dowsn due to flcutuations of sale in some months

Finally, we can conclude that it is better to go for revolving credit rather than long term credit to meet working caital requirements.

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