Question

The George Company has a policy of maintaining an end-of-month cash balance of at least $40,000. In months where a shortfall is expected, the company can draw in $1,000 increments on a line of credit it has with a local bank, at an interest rate of 12% per annum. All borrowings are assumed for budgeting purposes to occur at the beginning of the month, while all loan repayments (in $1,000 increments of principal) are assumed to occur at the end of the month. Interest is paid at the end of each month. For April, an end-of-month cash balance (prior to any financing and interest expense) of $14,000 is budgeted; for May, an excess of cash collected over cash payments (prior to any interest payments and loan repayments) of $31,200 is anticipated.

a. What is the interest payment estimated for April (there is no bank loan outstanding at the end of March)? (Do not round intermediate calculations.)
b. What is the total financing effect (cash interest plus loan transaction) for May? (Do not round intermediate calculations.)

Answer 1

For April, the George Company must borrow $26,000 at a 1% monthly interest rate with no initial outstanding loan, resulting in a $260 interest payment. In May, the company faces a total financing effect of $26,260, which includes the $260 interest from April's borrowing and the $26,000 principal repayment.

Step-by-step explanation:

The student's question revolves around understanding the financial implications of a company's policy on cash balance and the use of lines of credit. For the month of April, since there was no bank loan outstanding at the end of March, the company will not make an interest payment. However, the company must maintain a minimum cash balance of $40,000.

To ascertain the shortfall for April, we subtract the projected end-of-month cash balance from the minimum required balance: $40,000 - $14,000 = $26,000. This $26,000 would be borrowed in $1,000 increments, so 26 increments at the beginning of April. The annual interest rate is 12%, hence the monthly interest rate is 1% (12% divided by 12 months).

Interest for April = Principal borrowed × monthly interest rate = $26,000 × 0.01 = $260

For May, the cash collected over cash payment surpluses by $31,200 and is anticipated prior to interest payments and loan repayments. Assuming all April's loan is to be repaid at the end of May in $1,000 increments, no additional borrowing is required as the end-of-month cash balance is above $40,000.

Interest for May (on April's borrowing) = $26,000 × 0.01 = $260

Hence, the total financing effect for May will be the interest payment plus the principal loan repayment: $260 (interest) + $26,000 (principal) = $26,260.