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). 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
100,00020% compensating balance requirement
Interest plus fees
The loan with the compensating requirement has the lower effective cost (10.312%/10.850%).
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.) [pic]
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?
The cost of not taking the cash discount is greater than the cost of the loan (13.680% vs. 10.312%) so the firm should take the cash discount.
d.Assume the firm actually takes 80 days to pay its bills and would continued to do so in the future if it did not take the cash discount. Should the company take the cash discount?
The firm deciding to pay it off in 80 days and not take the cash discount would stick the firm with the money for...