Financial management revision question and answer

RITE Ltd. maintains an average monthly balance of Sh.320,000 in accounts receivable throughout the year. The company is in need of additional working capital and is considering two alternative methods of raising it.

METHOD 1 Factoring accounts receivable
METHOD 2 A commercial bank loan secured accounts receivable.

The company‚Äüs bankers have agreed to lend the firm 80% of its average accounts receivable at an interest of 30% per annum. The amount will be made available in a series of 30 day advances. The advances would be discounted and a 6% compensating balance will be required.

The factor is willing to establish a factoring arrangement on a continuing basis. It charges 2% for servicing the accounts and 15% per annum on any advances taken. Both charges are made on discount basis. In addition, the factor requires a 5% reserve to cover returned items. RITE Ltd. sells its merchandise on terms of net 30.

Required:
(a) Calculate the amount of advances RITE Ltd. can expect to have under each alternative.

(b) Calculate the effective rate of interest for each financing alternative.
(c) Which alternative would you recommend and why?

ANSWER
(a) Factoring:

(b) Factoring:

(c) Pledging is preferable because it has lower effective annual cost.

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