[HelpHelpHelp :)]

Hi everyone! What am I doing wrong here?

The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified four alternative sources of funds:

1. Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expense over the year. Assume that the fee and interest are not deductible in advance.
2. Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
3. Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every six months.)
4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year on all of your calculations.

The cost of Alternative 3 is:

A. 10.0%.

B. 11.1%.

C. 18.2%.

Correct D.20.0%

The cost for Frame Supply Company to issue $110,000 of 6-month commercial paper to net $100,000 every six months is calculated as follows:
To retain $100,000 for a full 12 months requires two issues at $110,000 each.
Therefore, interest would be $10,000 + $10,000 = $20,000.
The cost would be $20,000 ÷ $100,000 = .20 or 20%.

But why is it $20,000 ÷ $100,000 instead of $20,000 ÷ $200,000? Aren’t they getting $200k over the course of the year?

Thanks in advance to anyone who can help! 🙂

The happiest people don't have the best of everything, they just MAKE the best of everything!

We can do it!! 🙂

[sancasuki]

Maybe they pay it back after the 6 months and then borrow $100,000 again.

[HelpHelpHelp :)]

Right, but then they're only paying $10,000 interest each time – so if the interest counts twice, why doesn't the principal count twice?

The happiest people don't have the best of everything, they just MAKE the best of everything!

We can do it!! 🙂

[sancasuki]

The interest is $20,000 total for the year. The principal would be= ($100,000 * .5) + ($100,000 * .5)

The average amount of principal borrowed over the year. $100,000 for 6 months and another $100,000 for 6 months.

[nolan7120]

Throughout the year, the WC is only increased by $100,000 total. It matures in 6 months and they're issuing new paper immediately to maintain the $100,000 increase in WC for the remainder of the year. So to maintain the sustained $100,000 WC increase, it costs them $20,000 total throughout the year to do so, so the interest cost is 20%.

FAR (6/9/16) - 81

[HelpHelpHelp :)]

I think I see… you're saying that it's kind of like $100,000 – 100,000 + 100,000 = $100,000 for the year?
(100k for the first commercial paper, then -100k when they pay that back, then another 100k for the second)

The happiest people don't have the best of everything, they just MAKE the best of everything!

We can do it!! 🙂

[nolan7120]

Exactly

FAR (6/9/16) - 81

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