Manufacturing faces a liquidity crisis %u2013 it needs a loan of $100,000 for 1

Question

Manufacturing faces a liquidity crisis %u2013 it needs a loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firm%u2019s accounts receivable are quite low, but its inventory is considered liquid and reasonable good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Assume a 365-day year.)

*City-Wide Bank will make a $100,000 trust receipt loan against the finished goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administrative fee levied against the $100,000 initial loan amount. Because is will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
*Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month period at an annual interest rate of 13%
*Citizens%u2019 Bank and Trust will lend $100,000 against a warehouse receipt on the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be leived against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.
1) Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
2)Which plan do you recommend? Why?
3)If the firm had made a purchase of $100,000 for which it had been given terms of 2/10 net 30, would it increase the firm%u2019s profitability to give up the discount and not borrow as recommended in part b? Why or why not?

Explanation / Answer

City-Wide Bank: ($75,000 x (.12^12)) +(.0025 x $100,000)= $1,000

Sun State Bank: $100,000 x (.13^12)= $1,083

Citizens%u2019 Bank and Trust:[$60,000 x (.15^12)] + (.005 x $60,000) = $1,050

b.City-Wide Bank is the best alternative, since it has the lowest cost.

c.Cost of giving up cash discount=(.02^.98)*(360/20) =36.73%

The effective cost of taking a loan =($1,000/$75,000)x12

=16.00%

Since the cost of giving up the discount (36.73%) is higher than borrowing at Citywide Bank (16%), the firm should borrow to take the discount.   

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