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KANTON COMPANY Firm's Total Funds Requirements Selecting Kanton Company's Financing Strategy and Unsecured Short-Term Borrowing Arrangement. To ensure that, along with spontaneous financing from accounts payable and accruals, adequate short-term financing will be available, Morton plans to establish an unsecured short-term borrowing arrangement with its Morton Mercado, the CFO of Kanton Company, carefully developed the estimates of the firm's total funds local bank. Third National. The bank has offered either a line-of-credit agreement or a revolving credit agreement. requirements for the coming year. These are shown in the following table: Third National's terms for a line of credit are an interest rate of 2.50%% above the prime rate, and the borrowing Month Total Funds Month Total Funds must be reduced to zero for a 30-day period during the year. On an equivalent revolving credit agreement, the January $1,000,000 July $6,000,000 interest rate would be 3% above prime with a commitment fee of 0.50%% on the average unused balance. February $1,000,000 August $5,000,000 Under both loans, a compensating balance equal to 20% of the amount borrowed would be required. The prime March $2,000,000 September $5,000,000 rate is currently 7%. Both the line of credit agreement and the revolving credit agreement would have borrowing April $3,000,000 October $4.000,000 limits of $1,000.000. For purposes of his analysis, Morton estimates that Kanton will borrow $600,000 on the May $5,000,000 November $2,000,000 average during the year, regardless of which financing strategy and loan arrangement it chooses. (Note: assume a June $7,000,000 December $1,000,000 365-day year.) Estimates of the Firm's Total Funds Case Study Questions: In addition, Morton expects short-term financing costs of about 10% and long-term financing costs of about 14% during that period. He developed the three possible financing strategies that follow: a. Determine the total annual cost of each of the three possible financing strategies. Strategy 1 - Aggressive: Finance seasonal needs with short-term finds and permanent needs with long-term funds, b. Assuming that the firm expects its current assets to total $4 million throughout the year, determine the Strategy 2 - Conservative: Finance an amount equal to the peak need with long-term funds and use short-term average amount of net working capital under each financing strategy. (Hint: Current liabilities equal average funds only in an emergency. short-term financing.) Strategy 3- Tradeoff: Finance $3,000,000 with long-term funds and finance the remaining funds requirements with c. Using the net working capital found in part b as a measure of risk, discuss the profitability-risk trade off short-term funds. associated with each financing strategy. Which strategy would you recommend to Morton Mercado for Kanton Company? Why? Using data on the firm's total funds requirements, Morton estimated the average annual short-term and long-term financing requirements for each strategy in the coming year, as shown in the following table. d. Find the effective annual rate under: 1) the line-of-credit agreement and 2) the revolving credit agreement. AVERAGE ANNUAL FINANCING (Hint: Find the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of) Type of Strategy 1 Strategy 2 Strategy 3 Financing Aggressive Conservative Tradeoff e. If the firm expects to borrow an average of $600.000, which borrowing arrangement would you recommend to Kanton? Why? Short- $2,500,000 $0 $1,666,667 term Long-term $1,000,000 $7,000,000 $3,000,000