Costs Of Capital – Costs of Short term Financing Instruments
Cost of Trade Credit – To the buyer, trade credit is a cost-free credit if there is no interest charges attached to it and if the price of the goods is not increased as a result of the trade credit.
The supplier bears the opportunity cost of money tied down in account receivable and the cost of any cash discount granted to the buyer. In a situation where the owner of the goods is scheduled to make gain, the cost associated with the goods has to be added when the price of the goods is been calculated.
In another situation where the buyer decides to forgoes the cash discount, if he wants to use the provision of credit granted by the supplier goods and if it goes beyond the period the discount will be recorded, that were he get to pays cash equal to the invoice value of the supplied goods, else he gets to pays less than the invoice value and avoids the opportunity cost of not taking the cash discount.
A good financial management should obtain funds from a source with interest cost lower than the cost of losing trade discount in order to take advantage of the discount and make savings. Stretching the Account payable (i.e. paying later than the credit period) reduces the cost of trade credit, but it is unethical in business. Suppliers with excess capacity may allow it but it will downgrade the creditworthiness of the buyer. Moreover, situations similar to this can be regathered as bad financial management where you decide to make payment before the discount period.
The opportunity cost (OC) attached to not accepting cash discount could be found when the following formula is applied:
Opportunity Cost = Discount Percent X
Or Implicit Cost
360(or 365)
100 – Discount Percent Credit period – Discount Period
= Discount Percent
100-Discount Percent
X
360(or 365)
Number of days credit was used after the discount Period
Costs Of Capital | Cost of bank Credit
The Costs Of Capital – The cost of bank loans depend on the riskiness of the borrower, the size of the loan, level of interest rate in the economy, the maturity of the loan and the monetary policy of the government. The interest rate charge on loan is based on prime plus (i.e P +). When we talk about prime we make reference to prime rate of interest on the charges banks offer on their valued credits or their revered customers who are credit-worthy when short term credits is offered. There are situation where the banks may decide to offer their largest customers loans at a rate that is below the amount published to the entire public.
Interest rate on bank loans are calculated in four ways viz:
(i) Simple or regular Interest
(ii) Discounted interest
(iii) Installment loan interest
(iv) Compensating balance interest
(i) Simple or Regular Interest Loan:
(a) When interest is paid at the maturity of the loan, the stated or
nominal interest rate is also the effective rate of interest.
Therefore Simplé Interest = Effective rate = Interest
Borrowed Amount
(b) If the loan had been written for less than one year, interest charges (interest rate per day)(Number of days)(Amount Borrowed)./
(c) If interest would have to be paid every 90 days i.e. quarterly, rather than all at year end, because of the compounding effect.
PS – Note that the annualized interest rate is less for discounted loans with shorter maturities than for longer maturities because the firm, on the average, obtain use of a larger amount of money.
Costs Of Capital – Installment Loans
Under this method, the principal repayments are made periodically (e.g.monthly), over the term of the loan, on a one year loan. Usually the borrower should have the full amount for his repayment either the first month and by the last month. That is to say the idea is to pay back by the eleventh to twelfths of the period the loan was collected. The effective rate i.e. the Annual Percentage Rate (APR) on an installment loan is significantly higher than the stated rate. Two ways the installment loans can be arranged are: Add-on installment loan and Discounted installment loan.
(a) Add-on Installment Loan
The term add-on means that the interest is calculated based on the nominal rate and then added to the amount borrowed to obtain the loan’s face value.
For example if
Amount Borrowed = Stated Interest rate
Interest Amount
N20,000
10%
10% (N20,000) = N2000
Add-on Installment loan face value = N(20,000 + 2000) = N22,000
(b) Discounted installment loan: Under this type, interest amount is removed
in advance. If, for example, the
Amount Borrowed
Nominal Interest rate
N20,000
= 10%
= N2,000
Interest Amount = 10% (N20,000)
Amount received by the borrower = N(20,000 – 2,000)
Monthly Installment = N20,000/12
Costs Of Capital – Loans with Compensating Balance
Loans with compensating balances tend to raise the effective rate on a loan. If both compensating balance and discounting are used then it is called Discount interest with compensating balance (CB) loan and this makes the rate higher. To illustrate this, suppose a firm needs N1million to pay for some equipment that it recently purchased. A bank offers to lend the company money for one year at a 21 percent simple interest rate, but the firm must maintain a compensating balance (CB) equal to 20 per
cent of the loan. The effective annual rate of interest on the loan is calculated thus:
Cost of Inventory Financing
The fixed costs of a field warehousing arrangements are relatively high hence, such financing is therefore, not suitable for a very small firm. The charge is normally a minimum fixed charge plus some percentage of the amount of credit extended to the borrower. In addition, the lender charges interest at a rate above the prevailing prime rate.
For Example – Mangrover Ltd is considering two methods of raising working capital: (1) a commercial bank loan secured by accounts receivable, and (2) factoring accounts receivable. Mangrover’s bank has agreed to lend the firm 75 percent of its average monthly accounts receivable balance of N250,000 at an annual interest rate of 18 per cent. The bank loans can also be classified as a series of 30 day loans schedule, in essence, when a loan is when a loan is issued, 20 percent would be discounted, and then a compensating balance will as well be paid to settle both sides.
A factor has agreed to purchase Mangrover’s accounts receivable and to advance 85 per cent of the balance to the firm. The 15 per cent of receivables not loaned to the firm under the factoring arrangement is held in a reserve account. Now you should also consider that a 3.5 per cent should be added as charge.
Commission and annual interest of 18 per cent on the invoice price, less both the factoring commission and the reserve account. The monthly interest payment would be deducted from the advance. If Mangrover chooses the factoring arrangement, it can eliminate its credit department
and reduce operating expenses by (four thousand naira) N4000 per month. In addition, bad debts losses of 2 per cent of the monthly receivables would be avoided.
Consider The annual Cost Required For The Financing arrangement?
It is important to conclude on all the discussion some considerations. These costs that can influence a company’s management decision should as well be considered when you want to take loan from a commercial bank.
Solution:
(i) Commercial Bank loan secured by Accounts Receivable:
Computation of the Amount Received monthly by Mangrover from Bank
Monthly Amount loaned = 75% (N250,000) = N187,500
Monthly Interest Amount discounted = (18%/12) (N187,500) = N2,812.50
Monthly Compensating balance = 20% (N187,500) = N37,500
Amount Received monthly = (N187,500 – N2812.50-N37,500) = N147,187.50