Question

Sunny Coast Enterprises (A). Sunny Coast Enterprises has sold a combination of films and DVDs to Hong Kong Media Incorporated for US$101,000, with payment due in five months. Sunny Coast Enterprises has the following alternatives for financing this receivable: 1) Use its bank credit line. Interest would be at the prime rate of 4.8% plus 150 basis points per annum. 2) Use its bank credit line but purchase export credit insurance for a 0.9% fee. Because of the reduced risk, the bank interest rate would be reduced to 4.8% per annum without any points. In both cases Sunny Coast would need to maintain a compensating balance of 22% of the loan's face amount, and no interest will be paid on the compensating balance by the bank. a. What are the annualized percentage all-in costs of each alternative? b. What are the advantages and disadvantages of each alternative? c. Which alternative would you recommend? (NOTE: Assume a 360-day year.) a. What are the annualized percentage all-in costs of each alternative? Alternative 1: Bank Credit Line The bank interest expense on the receivable is $ . (Round to the nearest cent.)

Answer 1

a. Annualized percentage of all in costs are as follows:

Alternative 1: Bank credit line

Interest expense - [1,01,000 * 5/12 * (4.8+1.5)%] = USD 2651.25
Opportunity cost of Compensating - [1,01,000*22%* 4.8% *5/12] = USD 444.4

Therefore, Total expense under alternative 1 for 5 months = USD 3095.65
Therefore, Annualized percentage of all costs = [(12/5)*3095.65]/1,01,000 = 7.356%

Alternative 2: Bank credit line & Export credit insurance:

Interest expense - [1,01,000 * 5/12 * 4.8% = USD 2020
Opportunity cost of Compensating - [1,01,000*22%* 4.8% *5/12] = USD 444.4
Insurance fee [1,01,000 * 0.9%] = USD 909

Therefore, Total expense under alternative 2 for 5 months = USD 3373.4     

Therefore, Annualized percentage of all costs = [(12/5)*3373.4]/1,01,000 = 8.016%

In both the alternatives opportunity cost is assumed to be at 4.8% as the same is not provided in the question.

b. The advantages and disadvantages of the alternatives are as follows:
i.Even though from purely financial perspective alternative 1 is the beneficial one. However, alternative 2 provides insurance cover in case of default which is not provided under alternative 1. Therefore, in case of default in alternative 1 the exporter is at risk of not receiving money from the customer and also he will have to pay the costs of factoring.
ii. Financing receivables provides immediate liquidity to such exporter on payment of interest expenses.

c. Considering the financial aspects, alternative 1 should be selected as the total expenses under such alternative are lower compared to alternative 2.
However if the customer is a new customer or there is a doubt regarding his creditworthiness or his ability to repay such amount, alternative 2 is recommended.