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 8¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9¾ 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.

Question

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 8¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9¾ 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.

Answer 1

Hi,

I don't have an answer but am trying to figure out how to accomplish the amount outcomes for the loans, if any help is there I would greatly appreciate it!

Answer 2

To determine the cost of the loan under each option, we first need to calculate the compensating balance requirement and the additional fees.

1. Option 1: 8¼ percent with a 20 percent compensating balance requirement:
The compensating balance requirement means that the company must keep 20 percent of the loan amount ($500,000) as a minimum balance in their bank account. Therefore, the loan amount available for use is only 80 percent of $500,000.
Compensating balance = 20% * $500,000 = $100,000
Loan amount available = $500,000 - $100,000 = $400,000

2. Option 2: 9¾ percent with additional fees of $5,500:
This option does not require a compensating balance, but it includes additional fees of $5,500.

Now, we can calculate the cost of each loan option:

1. Option 1:
Loan amount = $400,000
Interest rate = 8¼ percent = 8.25%
Interest cost = Loan amount * Interest rate = $400,000 * 0.0825 = $33,000

2. Option 2:
Loan amount = $500,000
Fees = $5,500
Interest rate = 9¾ percent = 9.75%
Interest cost = Loan amount * Interest rate = $500,000 * 0.0975 = $48,750

To compare the total cost of each option, we need to consider both the interest cost and the fees:

1. Option 1:
Total cost = Interest cost = $33,000 (no additional fees)

2. Option 2:
Total cost = Interest cost + Fees = $48,750 + $5,500 = $54,250

Therefore, the total cost of Option 1 is $33,000, while the total cost of Option 2 is $54,250. Based on these calculations, Option 1 with the compensating balance requirement is the cheaper option for Midland Chemical Co.