Establishing a Line of Credit. Luther Company produces and sells a complete line of infant and toddler toys. Its sales, characteristic of the entire toy industry, are very seasonal. The company offers favorable credit to those customers who will place their Christmas orders early and who will accept a shipment schedule arranged to fit the production schedules of Luther. The customer must place orders by May 15 and be willing to accept shipments beginning August 15; Luther guarantees shipment no later than October 15. Customers willing to accept these conditions are not required to pay for their Christmas purchases until January 30.
The suppliers of the raw materials used by Luther in the manufacture of toys offer more normal credit terms. The usual terms for the raw materials are 2/10, net/30. Luther Company makes payment within the 10-day discount period during the first 6 months of the year; however, in the summer and fall, it does not even meet the 30-day terms. The company regularly pays invoices for raw materials 80 to 90 days after the invoice date during this latter period. Suppliers have come to accept this pattern because it has existed for many years. In addition, this payment pattern has not affected Luther's credit rating or ability to acquire the necessary raw materials.
Luther recently hired a new financial vice-president. He feels quite uncomfortable with the unusually large accounts receivable and payable balances in the fall and winter and with the poor payment practice of Luther. He would like to consider alternatives to the present method of financing the accounts receivable.
One proposal being considered is to establish a line of credit at a local bank. The company could then draw against this line of credit in order to pay the invoices within the 10-day discount period and pay off the debt in February when the accounts receivable are collected. The effective interest rate for this arrangement would be 12 percent. (a) Would establishing a line of credit reduce Luther's cost of doing business? Support your answer with appropriate calculations. (b) Would long-term financing (debt and common stock) be a sound alternative means of financing Luther's generous accounts receivable terms?