To meet short term cash needs X inc is considering obtaining funding through adv

Question

To meet short term cash needs X inc is considering obtaining funding through advances against receivables. Total annual credit sales are 600,000, terms are net 30 days, and payment is made on the average of 30 days. Western National Bank will advance funds under pledging arrangement for 13 percent annual interest. On average, 75 percent of credit sales will be accepted as collateral. Finance Bank offers factoring on a nonrecourse basis for a 1 percent factoring commission, charging 1.5 percent per month on advances and requiring a 15 percent factor`s reeserve. Under this plan, the firm would factor all accoounts and close its credit and collections department, saving 10,000 per year. What is the effective interest interest rate and the average amount of funds available under pledging and under factoring? Which plan do you recommend and why?

Explanation / Answer

Answer:(a) Calculation of the effective interest interest rate and the average amount of funds available under pledging and under factoring:

Western National Bank (pledging)

=($600000/12)*0.75=$37500 funds available

Commodity Finance (factoring) :

Average accounts receivable ($600,000/12) $50,000

Less: Reserve (15%)    7,500

Less: Factoring Commission    500

Funds available for advance    $42,000

Less: Interest on advance (1.5% × $42,000) 630

Proceeds from advance $41,370

Western National effective interest rate =              13%

Commodity Finance effective interest rate=($630/$41370)*(12)=18.27%

Answer:(b) Western National

Annual interest cost = 37,500 × 0.13 = $4,875

Commodity Finance

Annual interest cost              $ 7,560 ( = 630 * 12)

Factor's commission      $ 6,000 ( = 500 * 12)

Total Cost                           $13,560

-benefit of closing credit department               10,000

Net Cost                                                           $ 3,560

Since the net cost of factoring receivables is less expensive than pledging receivables and also provides more available funds, Aunt Tilly's Feeds, Inc. should choose Commodity Finance.

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