Morton Mercado, the CFO of Kanton Company, carefully developed the estimates of the firm's total funds requirements for the coming year. These are shown in the following table:
Month
|
Total Funds
|
Month
|
Total Funds
|
January
|
$1,000,000
|
July
|
$6,000,000
|
February
|
$1,000,000
|
August
|
$5,000,000
|
March
|
$2,000,000
|
September
|
$5,000,000
|
April
|
$3,000,000
|
October
|
$4,000,000
|
May
|
$5,000,000
|
November
|
$2,000,000
|
June
|
$7,000,000
|
December
|
$1,000,000
|
In addition, Morton expects short-term financing costs of about 10% and long-term financing costs of about 14% during that period. He developed the three possible financing strategies that follow:
Strategy 1 - Aggressive: Finance seasonal needs with short-term finds and permanent needs with long-term funds.
Strategy 2 - Conservative: Finance an amount equal to the peak need with long-term funds and use short-term funds only in an emergency.
Strategy 3 - Tradeoff:Finance $3,000,000 with long-term funds and finance the remaining funds requirements with short-term funds.
Using data on the firm's total funds requirements, Morton estimated the average annual short-term and long-term financing requirements for each strategy in the coming year, as shown in the following table.
|
AVERAGE
|
ANNUAL
|
FINANCING
|
Type of Financing
|
Strategy 1 Aggressive
|
Strategy 2 Conservative
|
Strategy 3 Tradeoff
|
Short-term
|
$2,500,000
|
$0
|
$1,666,667
|
Long-term
|
$1,000,000
|
$7,000,000
|
$3,000,000
|
To ensure that, along with spontaneous financing from accounts payable and accruals, adequate short-term financing will be available, Morton plans to establish an unsecured short-term borrowing arrangement with its local bank, Third National. The bank has offered either a line-of-credit agreement or a revolving credit agreement. Third National's terms for a line of credit are an interest rate of 2.50% above the prime rate, and the borrowing must be reduced to zero for a 30-day period during the year. On an equivalent revolving credit agreement, the interest rate would be 3% above prime with a commitment fee of 0.50% on the average unused balance.
Under both loans, a compensating balance equal to 20% of the amount borrowed would be required. The prime rate is currently 7%. Both the line-of-credit agreement and the revolving credit agreement would have borrowing limits of $1,000,000. For purposes of his analysis, Morton estimates that Kanton will borrow $600,000 on the average during the year, regardless of which financing strategy and loan arrangement it chooses. (Note: assume a 365-day year.)
d. Find theeffective annual rateunder: 1) the line-of-credit agreement and 2) the revolving credit agreement. (Hint:
Find the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of.)?