Question

1. If the company needs $1,000,000 to pay the taxes urgently. It has three choices to source this amount.(REQUIRED FOR ONE MONTH)

1. Drawing down on a line of credit at 3 percent with a 1/4 percent commitment fee on the full amount. Note: One-twelfth of the cost of the commitment fee (which gives an option to borrow any time during the year) is allocated to the first month.
2. A banker’s acceptance at 2.80 percent, an all-inclusive rate.
3. Commercial paper at 2.20 percent with a dealer’s commission of 1/6 percent and a backup line cost of 1/4 percent, both of which would be assessed on the $1 million of commercial paper issued.

Calculate the cost of borrowing for all the above sources.

Answer 1

Line cost = [(Interest + Commitment fee) /Net Proceed] *12

= [{(0.03*$1,000,000*1/12) + (0.0025*$1,000,000*1/12)} / $1,000,000] * 12

= [($2,500 + $208.33) / $1,000,000] * 12

= [$2,708.33 / $1,000,000] * 12

= 0.00271 * 12 = 0.0325, or 3.25%

Banker's acceptance cost = [Interest/NetProceed] *12

= [(0.028*$1,000,000*1/12) / {$1,000,000 - (0.028*$1,000,000*1/12)}] * 12

= [$2,333.33 / ($1,000,000 - $2,333.33)] * 12

= [$2,333.33 / $997,666.67] * 12

= 0.00234 * 12 = 0.0281, or 2.81%

Commercial paper cost = [(Interest + Dealer's commission + Backup costs) / Net proceed] * 12

= [{(0.022*$1,000,000*1/12) + (0.00167*$1,000,000*1/12) + (0.0025*$1,000,000*1/12)} / {$1,000,000 - (0.022*$1,000,000*1/12)}] * 12

= [$1,833.33 + $138.89 + $208.33) / ($1,000,000 - $1,833.33)] * 12

= [$2,180.56 / $998,166.67] * 12

= 0.00218 * 12 = 0.0262, or 2.62%

It would select commercial cost. as it has lowest cost.