MXY Chemical needs working capital of Tk. 500,000. There are three alternative methods of financing.

MXY Chemical needs working capital of Tk. 500,000. There are three alternative methods of financing:

·         To forgo cash discount granted on basis of 3/15, net 30;

·         To borrow from a bank at 14% interest rate per annum. The bank requires 25% compensating balance on loan amount;

·         To issue commercial paper at 15%. The cost of issuing the commercial paper would be Tk. 25,000 per year. The maturity of the journal is one year.

Requirement: Suggest the best alternative.

SOLUITION:

Case-I: Cost of Trade Credit:

Cost of Trade Credit = (CDR/100-CDR X 360 days/CP-DP)  X 100

Here,

            Cash Discount Ratio (CDR)     = 3%

            CP                                            = 30 days

DP                                            = 15 days

Effective Interest Rate (EIR)   = ?      

So, Cost of Trade Credit                      = (CDR/100-CDR X 360 days/CP-DP) X 100

                                                            = (3/100-3 X 360/30-15) X 100

                                                            = (3/97 X 360/15) X 100

                                                            = (.03 X .24) X 100

                                                            = .74 X 100

                                                            = 74.23%

Case-II: Borrowing from a Bank:

Here,

            Interest (I)                               =14%

Working Capital                      = 500,000

Compensating Balance           = 25%

Effective Interest Rate (EIR)   = ?      

I = Annual Interest                  = 500000 X 14%

                                                = 500000 X 14/100

                                                = 70,000

Compensating Balance (CB)   = 500000 X 25%

                                                = 500000 X 25/100

                                                = 1,25000

We know that,

Effective Interest Rate (EIR)  =  (I/P-CB) X 100

                                                = (70000/500000-125000) X 100

                                                = (70000/375000) X 100

                                                = .1867 X 100

                                                = 18.67%

Case-III: Cost of Commercial Paper:

We know that,

Cost of Commercial Paper     = (FV-SV/NSV x 360/DM) X 100

                                               

Here,

            Face Value (FS)           = 500,000

            Sale Value (SV)            = Sale Value – Interest

                                                = 500000 – 500000X 15%

                                                = 500000 – 75000

                                                = 425000

Net Sale Value (NSV)              = Sale Value – Other Cost

                                                = 425000 – 25000 [Other Cost=Commercial Paper Cost=25000]                                                      = 400000

Days of Maturity (DM)           = 360 Days

So,

Cost of Commercial Paper     = (FV-SV/NSV x 360/DM) x 100

                                                = {(500000-425000)/400000 x (360/360)} x 100

                                                = (75000/400000) x 1) x 100 

                                                = (.1875 x 1) x 100

                                                = .1875 x 100

                                                = 18.75%        

Comparison:

Case-I                                      = 74.23%

Case-II                                     = 18.67%

Case-III                                                = 18.75%

Decision:

Amongst the three cases, Bank Loan is the cheapest. So, MXY Chemical should choose the Case-II.