Factors

Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack business administration skills.

The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large multinational car manufacturing companies and are often late in paying their invoices. Oscar Co is a rapidly growing company and revenue has doubled in the last four years. Oscar Co has focused in this time on product development and customer service, and managing trade receivables has been neglected.

Oscar Co’s average trade receivables are currently $5.37m, and bad debts are 2% of credit sales revenue. Partly as a result of poor credit control, the company has suffered a shortage of cash and has recently reached its overdraft limit. The four founders have spent large amounts of time chasing customers for payment. In an attempt to improve trade receivables management, Oscar Co has approached a factoring company.

The factoring company has offered two possible options:

Option 1
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a full recourse basis. The factor would charge a service fee of 0.5% of credit sales revenue per year. Oscar Co estimates that this would result in savings of $30,000 per year in administration costs. Under this arrangement the average trade receivables collection period would be 30 days.

Option 2
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a non-recourse basis. The factor would charge a service fee of 1.5% of credit sales revenue per year. Administration cost savings and average trade receivables collection period would be as Option 1. Oscar Co would be required to accept an advance of 80% of credit sales when invoices are raised at an interest rate of 9% per year.

Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per year.

(a) Calculate the costs and benefits of each of Option 1 and Option 2 and comment on your findings.
My problem lies in option 2. The examiner has calculated an increase in finance cost like this; 2,301,370(Revised receivables) x 0·80 x 0·02. Why multiply the new receivables with 80% instead of credit sales and what is that 0.02 about ?
I calculated the finance cost like this ; 28000000*80%*9% which is obviously very wrong.