Designer Textiles, Inc., is considering factoring its receivables. The company's average collection period is 60 days, and its average level of receivables is $2.5 million. Designer's bad-debt losses average $15,000 a month. If the company factors its receivables, it will save $4,000 a month by eliminating its credit department.
The factor has indicated that it requires a 10 percent reserve for returns and allowances and charges a 2.5 percent factoring commission. The factor will advance Designer funds at 4 percentage points over prime, which is currently 8 percent.
a. Determine the annual financing cost, before considering cost savings and bad-debt losses.
b. Determine the annual financing cost, after considering cost savings and bad-debt losses.