The Phulchoki Supply Company needs to increase its working capital by Rs. 4,400,000. The following financing alternatives are available (assume a 365 day year): 1. Forgo cash discounts (granted on a…

(a) Selection of the Best Financing Alternative

To determine the most cost-effective financing option, we calculate the annualized cost of each alternative. The company needs Rs. 4,400,000 in working capital.

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Alternative 1: Forgoing Cash Discounts (3/10, net 30)

• Discount: 3% if paid within 10 days; otherwise, full payment due in 30 days.

• Effective Cost of Forgoing Discount:

  • Cost of Trade Credit = Discount % / (100% - Discount %) $$\text{Effective Cost}=\frac{3\%}{97\%}\approx 3.09\%$$
  • Annualized Cost (assuming 365-day year): $$\text{Annual Cost}=\frac{3.09\%\times 365}{20}=55.67\%$$ (Since the discount period is 20 days: 30 - 10)

• Total Cost for Rs. 4,400,000: $$\text{Annual Cost}=4,400,000\times 55.67\%=\text{Rs. }2,449,480$$

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Alternative 2: Bank Loan (15% Interest + 12% Compensating Balance)

• Loan Amount: Rs. 5,000,000 (since 12% must be kept as compensating balance).
• Net Funds Available: $$5,000,000-(12\%\times 5,000,000)=5,000,000-600,000=\text{Rs. }4,400,000$$
• Interest Cost: $$15\%\times 5,000,000=\text{Rs. }750,000$$
• Effective Cost:
  • Compensating Balance Cost: $$\frac{600,000}{4,400,000}\times 100\%=13.64\%$$
  • Total Annual Cost: $$15\%+13.64\%=28.64\%$$
  • Total Cost for Rs. 4,400,000: $$4,400,000\times 28.64\%=\text{Rs. }1,260,160$$

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Alternative 3: Six-Month Commercial Paper (Discount Basis)

• Face Value: Rs. 4,700,000 (to net Rs. 4,400,000).
• Discount: Rs. 300,000 (since 4,700,000 - 4,400,000 = 300,000).
• Discount Rate: $$\text{Discount Rate}=\frac{300,000}{4,700,000}\times 100\%=6.38\%$$
• Annualized Cost (for 6 months): $$\text{Annual Cost}=6.38\%\times 2=12.76\%$$
• Total Cost for Rs. 4,400,000: $$4,400,000\times 12.76\%=\text{Rs. }561,440$$

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Comparison of Costs

Best Choice: Alternative 3 (Commercial Paper) is the least costly option.

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(b) Selecting Bank Financing with ≤ 2% Additional Cost

The company prefers bank financing but only if the additional cost (compared to commercial paper) is ≤ 2%.

• Commercial Paper Cost: 12.76%
• Bank Loan Cost: 28.64%
• Additional Cost: 28.64\% - 12.76\% = 15.88\% \quad (\text{Exceeds 2%})

Since 15.88% > 2%, the company should not choose bank financing under this condition.

Alternative: If the company insists on bank financing, it must negotiate a lower interest rate to bring the total cost within 14.76% (12.76% + 2%).

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(c) Is the Lowest-Cost Source Always the Best Choice?

No, the source with the lowest expected cost is not necessarily the best choice due to the following reasons:

Conclusion: While cost is critical, liquidity, flexibility, and strategic fit must also be considered.

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Final Answer for (a): Alternative 3 (Commercial Paper) is the most cost-effective choice. Final Answer for (b): Neither—bank financing exceeds the 2% additional cost threshold. Final Answer for (c): No, because non-financial factors (flexibility, risk, liquidity) may outweigh cost savings.