Financial management revision question & answer

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:

i) 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.

ii) 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.

iii) A bank loan from the company‚Äüs bank for Sh.4 million. The bank can lend at the rateof 22%. In addition, a 10% compensating balance will be required which otherwise would not be maintained the company.

iv) Establish a one year line of credit. The commitment fees is 5% of the total borrowings. The interest rate is 17% p.a.

Explain
Which is the cheapest option for the company?

answer
Since the money is required for six months, the costs should be based on 6 months period (half a year)

i) Use of warehouse loan from a finance company.

Credit terms 2/10 net 30 means a 2% discount is granted for payment within 10 days otherwise pay on 30th day without any discount. Since payment can be delayed to 40th day, then credit terms are 2/10 net 40% cost p.a. =

iii) Bank loan
In presence of compensating balance, the effective annual interest rate =


The cheapest source is the floating lien from the supplier.

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