Posted by **vanessa** on Friday, October 15, 2010 at 1:49pm.

A small chemicalcompany is negotiatimg a loan from Manhatten Bank and Trust. The small chemical company needs to borrow $500,000. The bank offers a rate of 8 1/4 % with a 20% compensating balance, or as an alternative 9 3/4% with additional fees of $5,500 to cover the services the bank is providing. In either case the rate on the loan is floating (changes in the prime interest rate changes), and the loan is for one year. A. Which loan carries the lower effective rate? Consider fees to be equivalent of other interest. B. If the loan with a 20% compensating balance requirement were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowed minus compensating balance). C.Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about loan installment payments and use the loan cost in part a. D. Assume the firm actually takes 80 days to pay its bills and would continue to do so in the future if it did not take the cash discount. Should it take the cash discount? E. 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% and the quoted rate on the loan goes up by 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. F. In order to hedge against the possible rate increase in part e Midland decides to hedge its position in the futures market. Assume it sells $500,000 worth of 12-month future contracts in Treasury bonds. One year later, interest rates go up 2% across the board and Treasury bond futures have gone down to $488,000. Has the firm effectively hedged the 2% increase in interest rates on the bank loan as described in part e? Determine the answer in dollar amounts.

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