Mendez Metal Specialties, Inc.: Total Dollar Borrowing Costs Analysis

Mendez Metal Specialties, Inc. Financial Data Analysis

Mendez Metal Specialties, Inc. has a seasonal pattern to its business. It borrows under a line of credit from Central Bank at 1 percent over prime. Its total asset requirements now (at year end) and estimate requirements for the coming year are (in millions):

Assume that these requirements are level throughout the quarter. At present, the company has $4.5 million in equity capital plus long-term debt plus the permanent component of current liabilities, and this amount will remain constant throughout the year.

The prime rate currently is 11%, and the company expects no change in this rate for the next year. Mendez Metal specialist is also considering issuing intermediate-term debt at an interest rate of 13.5%. In this regard, three alternative amounts are under consideration: zero, $500,000, and $1 million. All additional funds requirements will be borrowed under the company’s bank line of credit.

Analysis of Total Dollar Borrowing Costs

Determine the total dollar borrowing costs for short- and intermediate-term debt under each of the three alternatives for the coming year. (Assume that there are no changes in current liabilities other than borrowings.) Which alternative is lowest in cost?

Considerations for Decision Making

Is there a consideration other than expected cost that deserves our attention?

What are the total dollar borrowing costs for short- and intermediate-term debt under each of the three alternatives for the coming year? Which alternative is the lowest in cost?

The lowest cost alternative is no intermediate-term debt, which has a total borrowing cost of $2,160,000. To determine the total dollar borrowing costs for short- and intermediate-term debt under each of the three alternatives for the coming year, we need to calculate the interest costs associated with each option. First, let's calculate the interest cost of using the line of credit from Central Bank. The current prime rate is 11%, and the company borrows at 1% over prime, so the effective borrowing rate is 12%. For each quarter, the interest cost of borrowing $4.5 million from the line of credit is: $4.5 million x 12% = $540,000. For the first quarter, the interest cost of borrowing an additional $0, $500,000, or $1 million at an interest rate of 13.5% would be: - $0 x 13.5% = $0 - $500,000 x 13.5% = $67,500 - $1 million x 13.5% = $135,000 (And so on for the second and third quarters) Therefore, the total borrowing costs for short- and intermediate-term debt under each of the three alternatives are as follows: - No intermediate-term debt: $2,160,000 - $500,000 intermediate-term debt: $2,362,500 - $1 million intermediate-term debt: $2,565,000 The lowest cost alternative is no intermediate-term debt, which has a total borrowing cost of $2,160,000. There is another consideration that deserves attention - the risk associated with using short-term debt. If the company is unable to repay the line of credit when it is due, it may have to borrow at a higher interest rate or face other consequences such as default. The company should consider its ability to repay the debt and the risks associated with different levels of borrowing when making its decision.