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(a) The Chuma Ngumu Company needs to finance a seasonal rise in
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(a)         The Chuma Ngumu Company needs to finance a seasonal rise in inventories of Sh.4 million.  The funds are needed for six months.  The company is considering using the following possibilities to finance the inventories:

1.          A warehouse loan from a finance company.  The terms are 18 per cent annualized with an 80% advance against the value of the inventory.  The warehousing costs are Sh.350,000 for the six-month period.  The residual financing requirement which is Sh.4 million less the amount advanced will need to be financed by forgoing cash discounts on its payables.  Standard terms are 2/10 net 30: however the company feels it can postpone payment until the fortieth day without adverse effect.

2.          A floating lien arrangement from the supplier of the inventory at an effective interest rate of 24 per cent.  The supplier will advance the full value of the inventory.

3.          A bank loan from the company?s bank for Sh.4 million.  The bank can lend at the rate of 22%.  In addition, a 10% compensating balance will be required which otherwise would not be maintained by the company.

Required:

            Which is the cheapest option for the company?                                                   (15 marks)


Financing options

 

(i)

 


 

Warehouse loan

 

Warehousing costs

 

Interest

 


 

80% x 4,000,000 x18% x 6

 


 

% cost of discount =

 


 

350,000

 

288,000

 

12

 


 

2

 

360

 

x

 

100 2% 40 10

 


 

Cost of foregone discount

 


 

638,000

 

=...

 







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