P16–20 Inventory financing Raymond Manufacturing faces a liquidity crisis: It ne
ID: 2719676 • Letter: P
Question
P16–20 Inventory financing Raymond Manufacturing faces a liquidity crisis: 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’s accounts receivable are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Note: Assume a 365-day year.)
(1) 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% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
(2) 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%.
(3) Citizens’ 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 levied 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.
a. Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
b. Which plan do you recommend? Why?
c. 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’s profitability to give up the discount and not borrow as recommended in part b? Why or why not?
Explanation / Answer
Question a. Option 1 Option 2 Option 3 Loan amount 100000 100000 60000 Interest rate 12% 13% 15% Interest Cost 12000 13000 9000 Administrative fees 0.25% 0 0.50% Administrative cost 250 0 300 Total Cost 12250 13000 9300 Question b. Plan 3 will be addopted. It is because the loan cost is lowest. Question c. 2% discount on 100,000 = 100000x 2% = 2000 effective annual rate = 2/10*365 = 73% So effective cost of discount is much higher than the cost of loan. Hence, Give up discount and not to borrow the loan will not increase profit of the firm.
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