Suncoast Boats Inc. estimates that because of the seasonal nature of its business, it will require an additional $2 million of cash for the month of July. Suncoast Boats has the following four options available for raising the needed funds:
(1) Establish a 1-year line of credit for $2 million with a commercial bank. The commitment fee will be 0.5% per year on the unused portion, and the interest charge on the used funds will be 11% per annum. Assume that the funds are needed only in July and that there are 30 days in July.
(2) Forgo the trade discount of 2/10, net 40, on $2 million of purchases during July.
(3) Issue $2 million of 30-day commercial paper at a 9.5% per annum interest rate. The total transaction fee, including the cost of a backup credit line, on using commercial paper is 0.5% of the amount of the issue.
(4) Issue $2 million of 60-day commercial paper at a 9% per annum interest rate, plus a transaction fee of 0.5%. Since the funds are required for only 30 days, the excess funds ($2 million) can be invested in 9.4% per annum marketable securities for the month of August. The total transactions cost of purchasing and selling the marketable securities is 0.4% of the amount of the issue.
a. What is the dollar cost of each financing arrangement?
b. Is the source with the lowest expected cost necessarily the one to select? Why or why not?