Question

If Outdoor Woods has an effective cost of capital of 12% and the net margin on their sales is 10%, what would you advise them to do as their CFO ?

A: Sell all their receivables to a bank?

B. Increase their credit sales at the same terms.

C. Increase the net margin on credit sales to 12%

D. Stop all credit sales to customers.

Very briefly explain your answer.

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and

Palm Beach Yachts has a line of credit with a local bank that permits it to borrow up to $1.8 million at any time. The interest rate is .78 percent per month. The bank charges compound interest and also requires that 5 percent of the amount borrowed be deposited into a non-interest-bearing account. What is the effective annual interest rate on this loan?

A. 10.68 percent

B. 10.43 percent

C. 9.74 percent

D. 10.29 percent

E. 9.91 percent

Answer 1

Since the cost of capital is more than the net margin on sales, the company should increase the net margin on credit sales. This shall lead to increasing margin on sales and atleast the cost of capital would be recovered. This capital has been used to buy raw materials for inventory and other operational expenses. Atleast it should match the rate of cost of capital.
Hence option C is correct

A is wrong as the margin will further reduce when selling to a bank

B is wrong because increasing credit sales will not affect margin, only volume would increase

D is wrong because stopping credit sales would turn away customers and they may go to other sellers.

Monthly rate =0.0078
Annually it shall be: (1.0078^12)-1 = 9.772%
Since 5% is unavailaible:
Effective rate = 9.772/(1-0.05)=10.29%

Therefore option D is correct