MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells direct

Question

MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently decided to pledge all of its accounts receivable to its bank. The bank advances up to 80 percent of the face value of these receivables at a rate of 4 percent over the prime rate, while charging 2.5 percent on all receivables pledged for processing to cover billing and collection services. Prior to this arrangement Movie Tone was spending $50,000 a year on its credit department. The prime rate is 6 percent.

a. What is the average level of accounts receivable?

b. What is the effective cost of using this short-term credit for one year?

Explanation / Answer

As the company is providing credit to its customers on terms of net 60 that means for 2 months

Therefore, average level of accounts recievable = 2 * $350,000 = $ $700,000

B. To calculate effective cost of using short term credit for one year we need to calculate annual interest expense and processing fees first .

Annual interest expense = [ prime rate + rate over the prime rate ] * 0.80 * $700,000

=[ 6% + 4% ]* 0.80 * $700,000

= 0.10 * 0.80 * $700,000 = $56,000

Processing fees = 0.025 * 12 * $350,000 = $ 105,000(as it is calculated for 1 year thus multiplied by 12)

effective cost of using short term credit for 1 year ={ [ Annual interest expense + processing fees ] - $50,000 } / ($700,000 * 0.8) * 1 / (360 / 360 )

={ [ 56000 + 105,000 - 50,000 ] / 560,000 } * 1/ (360 /360 )

= [ $111,000 / 560,000 ]* 1/(360/360)

= 0.1982 * 1 = 0.1982 or 19.82%

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