Is there another way to solve this question? I don't understand Ninja's solution.
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:
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.
Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every six months.)
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%.
Solution Explanation
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%.
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