Page 154 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 9: Cash Flows Forecasting and Treasury Management

HP Apples Company has a seasonal pattern of its business. It borrows under a line of credit from Notes
Central Bank at 1.50 per cent over prime. Its total asset requirements were (at year end) and
estimated requirement for the coming year are:
th
rd
Now 1 Quarter 2 Quarter 3 Quarter 4 Quarter
st
nd
Amount ` 90 cr. ` 96 cr. ` 110 cr. ` 118 cr. ` 100 cr.
The prime rate at present is 10.50 per cent, and the company expects no change in this rate for the
next year, H.P. Apples Company is also considering issuing intermediate term debt at an interest
rate of 14.00 per cent. In this regard three alternative amounts are under consideration: Zero,
` 10 crore, and ` 20 crore. All additional funds requirements will be borrowed under the company’s
bank line of credit.

(a) Determine the total borrowing costs for short-and intermediate-term debt under each of
the three alternatives for the coming year, assuming there are no changes in current
liabilities other than borrowings. Which is lowest?
(b) Are there other consideration in addition to expected cost?
Solution:

1 Quarter 2 Quarter 3 Quarter 4 Quarter Total
rd
nd
th
st

Alternative 1: ` 6 crore `20 crore `28 crore `10 crore
incremental borrowings `18 crore `60 crore `84 crore `30 crore `1.92 crore
Bank loan cost crore (10.5%
+ !%)/ 4 = 3% per quarter
Alternative 2:
Term loan cost (`20 crore at 14%) `1.40 crore
incremental borrowings ` 10 crore `18 crore
Bank loan cost crore `30 crore `54 crore `84 crore
` 2.24 crore
Alternative 3:
Term loan cost ` 2.80 crore
(`20 crore at 14%)
incremental borrowings `8 crore
Bank loan cost `24 crore `24 crore
`3.04 crore
(a) Alternative is lowest in cost because the company borrows at a lower rate, 12 per cent
versus 14 per cent, and because it does not pay interest on funds employed when they are
not needed.
(b) While alternative I is cheapest it entails financing the expected build up in permanent
funds requirements (`10 crore) on a short-term basis. There is a risk consideration in that
if things turn bad the company is dependent on its back for continuing support. There is
risk of renewal and of interest rates changing. Alternative 2 involves borrowing the
expected increase in permanent funds requirements on a term basis. As a result, only the
expected seasonal component of total needs would be financed with short-term debt.
Alternative 3, the most conservative financing plan of the three, involves financing on a
term basis more than the expected building-up in permanent funds requirements. In all
three cases, there is the risk that actual total funds requirements will differ from those that
are expected.

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