13 Evaluating alternative sources of financing. Oldsyl Ltd expects to need to borrow an average of £550,000 during the next year. Borrowing is expected to be as low as £500,000 at some times during the year, and as high as £600,000 at others. Four alternative sources are being considered.

(1) A £600,000 overdraft facility at an annual interest rate of base rate plus 2 per cent. The overdraft would have an arrangement fee of 0.5 per cent of the total facility and an annual commitment fee of 0.25 per cent per year of any unused facility, both fees payable at the end of the year. Interest on the overdraft is compounded on a daily basis.

(2) An acceptance credit facility for up to £600,000. Credits can be sold at an initial discount of 1 1/8 per month, with an annual 0.25 per cent bank commission on the entire, facility.

(3) A short-term loan of £600,000 at an interest rate of 14 per cent per year compounded annually.

(4) ECU (European Currency Unit) loan at 10 per cent per year compounded annually. A loan of 800,000 ECUs has been offered by a European bank.

Current exchange rates are:

ECU/£

Spot 1.4520–1.4600 One year forward 0.0430–0.0390 ECU pm Surplus funds may be invested in money market deposits at an interest rate of 9.25 per cent per year.

Base rate is currently 11 per cent.

Required:

(a) Evaluate which of the financing sources Oldsyl should use. Relevant calculations as well as discussion of risk and other relevant factors should form part of your evaluation.

(b) Ignoring your calculations in

(a) above, if the overdraft was chosen but Oldsyl was concerned about possible increases in interest rates by up to 3 per cent during the year, discuss how the company could protect itself against such interest rate changes.

Author’s note: Students not familiar with foreign exchange may simply ignore item

(4), the ECU loan.