Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The small chemical company needs to borrow $500,000. The bank offers a rate of 8 ¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9 ¾ percent with additional fees of $5,500 to cover services the bank is providing. In either case the rate on the loan is floating (changes as the prime interest rate changes), and the loan would be for one year. a. Which loan carries the lower effective rate? Consider fees to be the equivalent of other interest.
Compensating Balance Loan
$ 41,250 Interest
100,000 20% compensating balance requirement
$400,000 Available funds
Effective rate = Interest/Available funds = $41,250/400,000 = 10.312%
$ 48,750 Interest
Effective rate = Interest plus fees/Loan = $54,250/500,000 = 10.850%
The lower effective cost is the loan with the compensating requirement.
b. If the loan with a 20 percent compensating balance requirement were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowed minus the compensating balance.)
Effective rate on installment loan
= (2 x annual no. payments x interest)/(total no. of payments + 1) x principal = (2 x 12 x $41,250)/(12 + 1) x $400,000
c. Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about installment payments and use the loan cost from part a. If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds to take the discount?
Cost of failing to take a cash discount =
Discount Percent/ (100 percent – Discount percent) x 360/(Final due date – Discount Period) = (1.5%/98.5%) x 360/(50-10)
= 1.52% x 9
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