Question

Danger Enterprises is considering pledging its receivables to finance a needed increase in working capital. Its commercial bank will lend 80 percent of the pledged receivables at 1.5 percentage points above the prime rate, which is currently 3.25 percent. In addition, the bank will charge a service fee equal to 1.05 percent of the pledged receivables. Both interest and the service fee are payable at the end of the borrowing period. Danger's average collection period is 45 days and it has receivables totaling $5 million that the bank has indicated are acceptable as collateral. What is the annual financing cost (AFC) of the pledged receivables?

Answer 1

The annual financing cost (AFC) for Danger Enterprises is calculated by annualizing the interest and service fee on the amount borrowed against its receivables. Following this calculation, the AFC includes the interest on the 80% of receivables that are borrowed and the service fee on the total amount of acceptable receivables.

Step-by-step explanation:

The question at hand requires us to calculate the annual financing cost (AFC) of pledging receivables for Danger Enterprises. This involves not only the direct interest rate applied to the borrowed amount but also additional service fees.

The bank is willing to lend 80 percent of the receivables at a rate of 1.5 percentage points above the prime rate, which is 3.25 percent. Therefore, the effective interest rate is 3.25% + 1.5% = 4.75%. The bank also charges a 1.05% service fee on the amount of the receivables pledged.

To calculate the AFC, we need to consider both the interest and the service fee. First, calculate the borrowed amount, which is 80% of $5 million, which equals $4 million. Annualizing the interest and fee for a 45-day borrowing period involves multiplying the combined costs by the number of 45-day periods in a year, which is 365 days divided by 45.

The annualized interest cost would be $4 million * 4.75% * (365/45), and the annualized service fee would be $5 million * 1.05% * (365/45). Summing both gives us the AFC, which should be calculated to provide a precise dollar amount.