Abbot Ltd needs to increase its working capital by GH¢100,000. It has decided that there are essentially three alternatives of financing available. They are:
i) Borrow from bank at 8%. This alternative would necessitate maintaining a 25% compensation balance.
ii) Issue promissory notes at 7.5%. The cost of placing the issue would be GH¢500 each six months.
iii) Forego cash discount, granted on the basis of 3/10, net 30.
The firm prefers the flexibility of bank financing, and has provided an additional cost of this flexibility to be 1%.
Required:
Assess which alternative financing method should be selected. (6 marks)
View Solution
The costs of the three alternatives are:
i) Borrowing from the bank at 8%
Since this requires on holding of 25% of the balance at bank in effect the 8% is payable on 75%:
= (8/75) x 100
= 10.6%
OR
Interest payment = 0.08*GH¢100,000 = GH¢8000
Usable amount (100-25)%* GH¢100,000 = GH¢75,000
Effective Interest Rate = (8000/75000)*100
. = 10.67%
ii) Issue Promissory notes
= 500 + 500 + (7½ of 1,000)
= GH¢8,500
= 8.5%
OR
Interest payment = 0.075* GH¢100,000 = GH¢7500
Cost of placement = GH¢500*2 = GH¢1000
. Total = GH¢8500
Effective Interest Rate = (8,500/100,000)*100 = 8.5%
iii) Forfeit cash discounts
Effective Interest = (𝐶𝐷/100−𝐶𝐷) x (365/𝑁)
CD=Discount Rate =3%
N= Number of days to delay after forfeiting discount, 30-10=20 days
= (3/97) x (365/20)
= 56.4%
Advise: Issuing promissory notes is the cheapest source and should be selected