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Homework answers / question archive / A company is expanding and wants to increase its level of inventory to support an aggressive sales target
A company is expanding and wants to increase its level of inventory to support an aggressive sales target. They would like to finance this expansion using debt. The company currently has loan covenants that require the current ratio to be at least 1.2. The average cost of the current liabilities is 12%, and the cost of the long-term debt is 8%. Below is the current balance sheet for the company. Current assets $200,000 Current liabilities $165,000 Fixed assets 100,000 Long-term debt 100,000 Equity 35,000 Total assets $300,000 Total debt & equity $300,000 Which one of the following alternatives will provide the resources to expand the inventory while lowering the total cost of debt and satisfying the loan covenant? Basic Calculator Time Value Tables 7 D 10 11 13 A. Borrow short-term funds of $25,000, and purchase inventory of $25,000. 15 B. Sell fixed assets with a book value of $20,000 for $25,000, and use the proceeds to increase inventory 16 C. Collect $25,000 accounts receivable, use $10,000 to purchase inventory, and use the balance to reduce short-term debt. 19 D. Increase both accounts payable and inventory by $25,000.
Ans - Collect $25000 accounts receivable, use $10000 to purchase inventory and use the balance to reduce short term debt (Option 'C')
Option A is incorrect
If we borrow short term funds and purchase inventory, than New Current assets = $225000 and New current liabilities = $190000. So Current ratio will be 1.18, which is lower than the current loan covenants
Option B is incorrect
If we sell fixed assets to purchase inventory, than cost of debt will be affected
Option D is incorrect
Just like Option A above, increasing accounts payable and inventory by same amount will cause current ratio to fall to 1.18
Option C is correct
By using accounts receivable to purchase inventory and reduce short term debts, New current assets = $185000 and New current liabilities = $150000, So Current ratio will increase to 1.23. So This option is correct
