Corporate Finance

Question

A corporation has a seasonal pattern to its business. It borrows under a line of credit from

the Bank at 1 percent over prime. Its total asset requirements now (at year-end), and estimated requirements for the coming year are as follow:                           

Total Asset requirements                                                                          

 Now                   $4,500,000                         

1st Quarter        $4,800,000         

2nd Quarter       $ 5,500,000                                                                       

3rd Quarter        $5,900,000                        

4th Quarter        $5,000,000

Assume that these requirements are level throughout the quarter. Presently, the company has $4.5 million in equity capital plus long-term debt plus the permanent component of current liabilities, and this amount will remain constant throughout the year.

T·he prime rate presently is 11 percent, and the company expects no change in this rate for the next year. The company also considering issuing intermediate term debt at an interest rate of 13.5 %. Three alternative amounts are under consideration: Zero, $500,000 and $1 million. All additional funds requirements will be borrowed under the company’s bank line of credit.  

a.           Determine the total dollar borrowing cost for short and intermediate-term debt under each of the three alternatives for the coming year. (Assume that there are no change in current liabilities other then borrowing) Explain which alternative is lowest in cost.

b.           Is there a consideration other than expected cost that deserves our attention?

Answer 1

The bank line costs prime + 1%, so the short-term borrowing rate is

11%+1%=12%.11\%+1\%=12\%.

The firm's permanent financing is currently $4.5 million. Therefore, without additional intermediate-term debt, its seasonal financing requirements are:

Q1:4.8−4.5=$0.3MQ1: 4.8-4.5=\$0.3M Q2:5.5−4.5=$1.0MQ2: 5.5-4.5=\$1.0M Q3:5.9−4.5=$1.4MQ3: 5.9-4.5=\$1.4M Q4:5.0−4.5=$0.5MQ4: 5.0-4.5=\$0.5M

Because each amount remains outstanding for one quarter, annual short-term interest is 12% times the average quarterly borrowing.

Alternative 1: $0 intermediate-term debt

Average short-term borrowing:

0.3+1.0+1.4+0.54=$0.8M\frac{0.3+1.0+1.4+0.5}{4}=\$0.8M

Interest cost:

$800,000(0.12)=$96,000\$800,000(0.12)=\boxed{\$96,000}

Alternative 2: $500,000 intermediate-term debt

The additional $500,000 eliminates the need for bank borrowing in Q1 and Q4. Remaining short-term borrowing is:

Q1=0,Q2=$0.5M,Q3=$0.9M,Q4=0.Q1=0,\quad Q2=\$0.5M,\quad Q3=\$0.9M,\quad Q4=0.

Average = $350,000, so short-term interest is

$350,000(0.12)=$42,000.\$350,000(0.12)=\$42,000.

Intermediate-term interest is

$500,000(0.135)=$67,500.\$500,000(0.135)=\$67,500.

Total:

$109,500\boxed{\$109,500}

Alternative 3: $1 million intermediate-term debt

Remaining bank borrowing is:

Q1=0,Q2=0,Q3=$0.4M,Q4=0.Q1=0,\quad Q2=0,\quad Q3=\$0.4M,\quad Q4=0.

Average = $100,000, giving short-term interest of

$100,000(0.12)=$12,000.\$100,000(0.12)=\$12,000.

Intermediate-term interest:

$1,000,000(0.135)=$135,000.\$1,000,000(0.135)=\$135,000.

Total:

$147,000\boxed{\$147,000}

Therefore:

Intermediate DebtTotal Annual Borrowing Cost$0$96,000$500,000$109,500$1,000,000$147,000\begin{array}{c|c} \text{Intermediate Debt} & \text{Total Annual Borrowing Cost}\\ \hline \$0 & \$96,000\\ \$500,000 & \$109,500\\ \$1,000,000 & \$147,000 \end{array}

Thus, using no intermediate-term debt has the lowest expected borrowing cost at $96,000.

(b) Cost is not the only consideration. The company should also consider liquidity and refinancing risk. Relying entirely on short-term bank financing is cheaper under the assumptions given, but the company is more exposed to the possibility that interest rates rise, the bank reduces or withdraws the credit line, or credit becomes difficult to obtain when funds are needed.

Intermediate-term debt costs more here, but it provides greater financing certainty. Therefore, management must balance the lower expected cost of short-term financing against the greater financial risk associated with relying on it.