Orange Brothers, a large Lemon distributor in the U.S., is selling 50,000 tons per year on credit at an average selling price of $1000 per ton. The average customer payment is for purchasing 0.055- ton lemons per customer. Treasury bills are currently yielding 5 percent per year. The current credit term of Policy 1 is net 30 (no cash discount) and the customers, on average, pay 4 days overdue. The company is considering offering an alternative credit term of 2/10, net 30 (Policy 2) and anticipates that 20 percent of its customer will take advantage of the discounts. Policy 2 will reduce the collection period to 28 days, assuming 365 days a year. Alternatively, the company can use a short-term financing from Silicon Bank charging an annual interest rate of 40 percent on the short-term loans.

The company is factoring all receivables immediately at a 2 percent discount. It is also considering opening a lockbox perpetually in Silicon Bank that provides this service for an annual fee of $25,000 plus 10 cents per check cleared for each purchase. The lockbox will make cash available to the company one day earlier than the current case.

b) Under Policy 1, what is the effective annual cost of factoring

assuming that default is extremely unlikely.

[5 marks]