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Compensating Balance. Wilson Company borrows $500,000 from the bank and is required to maintain a 15 percent compensating balance. Further, Wilson has an unused line of credit of $200,000, with a required 11 percent compensating balance. What is the total required compensating balance the firm must maintain?

SOLUTION
ð$500,000 _ 0:15Þ þ ð$200,000 _ 0:11Þ ¼ $97,000

Proceeds of Loan. Assume the same information as in Problem 5.4, except that interest is deducted in advance. (a) What is the amount of proceeds the company will receive at the time of the loan? (b) What is the effective interest rate?

144 SHORT-TERM FINANCING [CHAP. 5
Asif Warsi
SOLUTION
(a) Interest ¼ $70,000 _ 0:19 ¼ $13,300
Proceeds ¼ principal _ interest ¼ $70,000 _ $13,300 ¼ $56,700 (b)
Effective interest rate ¼
interest
proceeds ¼
$13,300
$56,700 ¼ 23:5%

Effective Interest Rate and Compensating Balance. Wilson Corporation has a credit line of $800,000. The compensating balance requirement on outstanding loans is 14 percent, and 8 percent on the unused credit line. The company borrows $500,000 at a 20 percent interest rate. (a) What is the required compensating balance? (b) What is the effective interest rate? SOLUTION

(a) The required compensating balance is:
Loan 0.14_$500,000 $70,000
Unused credit 0.08_$300,000 24,000
$94,000
(b)
Effective interest rate ¼
interest
proceeds ¼
0:20 _ $500,000
$500,000 _ $94,000 ¼
$100,000
$406,000 ¼ 24:6%

Average Loan Balance. Wise Corporation borrows $70,000 payable in 12 monthly installments. The interest rate is 15 percent. (a) What is the average loan balance? (b) What is the effective interest rate?

SOLUTION
(a)
Average loan balance ¼
$70,000
2 ¼ $35,000
(b) Effective interest rate ¼
0:15 _ $70,000
$35,000 ¼
$10,500
$35,000 ¼ 30%

Average Loan Balance. Assume the same information as in Problem 5.10, except that the loan is on a discount basis. (a) What is the average loan balance? (b) What is the effective interest rate?
SOLUTION
(a) Proceeds ¼ $70,000 _ $10,500 ¼ $59,500
Average loan balance ¼
$59,500
2 ¼ $29,750
(b) Effective interest rate ¼
$10,500
$29,750 ¼ 35:3%

Cost of Commercial Paper. Nelson Corporation issues $800,000 of commercial paper every 3 months at a 16 percent rate. Each issuance involves a placement cost of $2,000. What is the annual percentage cost of the commercial paper?

SOLUTION
Interest ($800,000_0.16) $128,000
Placement cost ($2,000_4) 8,000
Total cost $136,000
Cost of commercial paper ¼
$136,000
$800,000 ¼ 17:0%

5.14 Cost of Commercial Paper. Cho Corporation issues $500,000, 20 percent, 120-day commercial paper. However, the funds are needed for only 90 days. The excess funds can be invested in securities earning 19 percent. The brokerage fee for the marketable security transaction is 1.0 percent. What is the net cost to the company for issuing the commercial paper? SOLUTION

Interest [0.20_$500,000_(120/360)] $33,333
Brokerage fee (0.01_$500,000) 5,000
Total cost $38,333
Less: Return on marketable securities
[0.19_$500,000_(30/360)]
7,917
Net cost $30,416

Financing Strategy. Johnson Company expects that it will need $600,000 cash for March 20X2. Possible means of financing are: (a) Establish a 1-year credit line for $600,000. The bank requires a 2 percent commitment fee. The interest rate is 21 percent. Funds are needed for 30 days. (b) Fail to take a 2/10, net/40 discount on a $600,000 credit purchase. (c) Issue $600,000, 20 percent commercial paper for 30 days. Which financing strategy should be selected? SOLUTION

(a) The credit line cost is:
Commitment fee [0.02_$600,000_(11/12)] $11,000
Interest [0.21_$600,000_(1/12)] 10,500
Total cost $21,500
(b) The cost of not taking discount is:
0:02 _ $600,000 ¼ $12,000
(c) The cost of commercial paper is:
0:20 _ $600,000 _ 1
12 ¼ $10,000
Strategy (c) is best since issuance of commercial paper involves the least cost.

Bank versus Factor. Forest Corporation needs...
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