Question

Dellvoe had expected a really strong market for office equipment for the year just ended, and in anticipation of strong sales, the firm increased its inventory purchases. However, sales for the last quarter of the year did not meet its expectations, and now Dellvoe finds itself short on cash. The firm expects that its cash shortage will be temporary, only lasting 3 months. (The inventory has been paid for and cannot be returned to suppliers.) Dellvoe has decided to use inventory financing to meet its short-term cash needs. It estimates that it will require $800,000 for inventory financing during this three-month period. Dellvoe has negotiated with the bank for a three-month, $1,000,000 line of credit with terms of 10% annual interest on the used portion, a 1% commitment fee on the unused portion, and a $125,000 compensating balance at all times.

                                             Expected inventory levels to be financed are as follows:

Month                                                Amount

January                                            $800,000

February                                            500,000

March                                                300,000

                                             Calculate the cost of funds from this source, including interest charges and commitment fees. (Hint: Each month’s borrowings will be $125,000 greater than the inventory level to be financed because of the compensating balance requirement.)

Answer 1

Monthly Cost = 10%/12 =0.1/12

Jan borrowing = 800,000+125,000 = 925,0000

Interest cost for Jan =0.1/12*925000 + 0.01/12*(1000000-925000) = 7,770.83333

Feb Borrowing = 500,000+125,000 = 625,000

Interest cost for Feb =0.1/12*625000 + 0.01/12*(1000000-625000) = 5,520.83333

Mar Borrowing = 300,000+125,000 = 425,000

Interest cost for Mar =0.1/12*425000 + 0.01/12*(1000000-425000) = 4,020.8333

Total cost of funds = 7770.83 +5520.83 +4020.83 = $17,312.50

Cost of funds % = 17,312.50/800,000 = 2.164% for the 3 month period