Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The small chemical company needs to borrow is $650,000. The bank offers a rate of 8 percent with a 20 percent compensating balance requirement, or as an alternative, 11 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.
Scenario 1: Then bank offers a compensating balance loan: Interest Rate 9.00% Compensating balance requirement 20%
Scenario 2: The bank offers a fee-added loan: Interest rate 11.50% Additional Bank $5,575
a. Calculate the effective rate for both loan scenarios. Consider fees to be the equivalent of “other interest” for Scenario 2.
b. If the loan with a 20 percent compensating balance were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowed minus the compensating balance.)
c. Because the interest rate on the loans is floating, it can go up as interest rates go up. Assume that the prime rate goes up by 2 percent and the quoted rate on the loan goes up the same amount. What would then be the effective rate on the loan with compensating balances? Convert the interest to dollars as the first step in your calculation.
d. Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. If the terms of the cash discount are 2/10, net 60, should the firm borrow the funds to take the discount? Assume the loan cost from part A as the basis and validate your answer in percentage amounts.
e. In order to hedge against the possible rate increase described in part e, the Midland Chemical Co. decides to hedge its position in the futures market. Assume it sells $500,000 worth of 12-month futures contracts on Treasury bonds. One year later, interest rates go up 2.5 percent across the board and the Treasury bond futures have gone down to $479,000. Has the firm effectively hedged the 2.5 percent increase in interest rates on the bank loan of $600,000? Determine the answer in dollar amounts.
SOLUTION PREVIEW
Midland Chemical Co.
a. Compensating Balance Loan
Interest (650,000 x 8%) $52,000
Loan $650,000
Compensating balance
requirement (20%) 130,000
Available funds $520,000
Effective rate = Interest / Available funds
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