146 SHORT-TERM FINANCING [CHAP.

(c) The cost of commercial paper is:

0.20 X $600,000 X A = $10,000
Strategy (c) is best since issuance of commercial paper involves the least cost.

5.16 Cost of Accounts Receivable Financing. What is the effect of each of the following situations on
the cost of accounts receivable financing? ( a ) A more thorough credit check is undertaken. (6)
Receivables are sold without recourse. (c) The minimum invoice amount for a credit sale is
decreased. ( d ) Credit standards are tightened.

SOLUTION
(a) Decrease (c) Increase
(b) Increase ( d ) Decrease

5.17 Cost of Factoring. Drake Company is contemplating factoring its accounts receivable. The factor
will acquire $250,000 of the company’s accounts receivable every 2 months. An advance
of 75 percent is given by the factor on receivables at an annual charge of 18percent. There is a
2 percent factor fee associated with receivables purchased. What is the cost of the factoring
arrangement?

SOLUTION

Factor fee (0.02 X $250,000 X 6) $30,000

Cost of advance (0.18 X $250,000 X 0.75) 33,750
Total cost $63,750

5.18 Bank versus Factor. Forest Corporation needs $400,000 additional financing. The company is
considering the choice of financing with a bank or a factor. The bank loan carries a 20 percent
interest rate on a discount basis with a required compensating balance of 16 percent. The factor
charges a 3 percent commission on invoices purchased monthly. The interest rate associated with
these invoices is 11percent with interest deductible in advance. If a factor is used, there will be
a monthly savings of $1,500 per month in credit department costs. Further, an uncollectible
accounts expense of 2 percent on the factored receivables will not exist.
( a ) What amount of principal must the company borrow from the bank to receive $400,000
in proceeds? (6) What amount of accounts receivable must be factored to net the firm $400,000?
(c) What is the effective interest rate on the bank loan? ( d ) What is the total annual cost of the
bank arrangement? ( e ) What is the effective interest rate associated with the factoring
arrangement? (f)What is the total annual cost of factoring?

SOLUTION
Princi Dal 1.oo
(4 Proceeds 1.00 - (0.20 + 0.16)
Principal 1 $400,000 -
_--$400,000 - $625,000
-=-=
$400,000 1 - 0.36 1.0 - 0.36 0.64
$400,000 - $400,000
Accounts receivables to factor = --= $465,116
1.0 - 0.14 0.86
interest rate - 0.20
--=
Effective interest rate of bank loan = 31.3%o
proceeds, % 0.64