Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

(a) The Chuma Ngumu Company needs to finance a seasonal rise in inventories of Sh.4 million. The funds are needed for six months. The company is considering using the following possibilities to finance the inventories:

1. A warehouse loan from a finance company. The terms are 18 per cent annualized with an 80% advance against the value of the inventory. The warehousing costs are Sh.350,000 for the six-month period. The residual financing requirement which is Sh.4 million less the amount advanced will need to be financed forgoing cash discounts on its payables. Standard terms are 2/10 net 30: however the company feels it can postpone payment until the fortieth day without adverse effect.

2. A floating lien arrangement from the supplier of the inventory at an effective interest rate of 24 per cent. The supplier will advance the full value of the inventory.

3. A bank loan from the company‟s bank for Sh.4 million. The bank can lend at the rate of 22%. Inaddition, a 10% compensating balance will be required which otherwise would not be maintained the company.

Required:
Which is the cheapest option for the company?

(b) Highlight the limitations of using commercial paper as a form of short-term credit.
ANSWER
(a) Financing options

(i) Warehouse loan


(ii) Floating lien

(iii) Bank loan

In presence of compensating balance, the effective interest rate

The best option is the floating lien from the supplier.

(b) -During economic boom when liquidity is high, it is difficult to sell the commercial paper.
– It is used only “blue chip” firms to raise short term capital
– For the lender it is unsecured short term financial instrument
– In Kenya the use of commercial paper to raise short term credit is subject to regulatory restrictions capital market authority.

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