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.

Question

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.

Answer 1

A. To determine which loan carries the lower effective rate, we need to compare the costs of both options.

1. Loan with a 20% compensating balance:
- Loan amount: $500,000
- Compensating balance requirement: 20% of the loan amount
=> Compensating balance = 20% * $500,000 = $100,000
- Interest rate: 8 1/4% (floating rate, tied to prime rate)
=> Interest paid = loan amount - compensating balance = $500,000 - $100,000 = $400,000
=> Interest cost = 8.25% * $400,000

2. Loan with additional fees:
- Loan amount: $500,000
- Interest rate: 9 3/4% (floating rate, tied to prime rate)
=> Interest cost = 9.75% * $500,000
- Additional fees: $5,500

To compare the effective rates, we need to calculate the total cost of each loan option (including both interest and fees) and then divide by the loan amount.

1. Loan with a 20% compensating balance:
=> Total cost = (Interest cost + Compensating balance) / Loan amount

2. Loan with additional fees:
=> Total cost = (Interest cost + Additional fees) / Loan amount

Calculate the total costs for both loan options using the above formulas and compare them to determine which loan carries the lower effective rate.

B. To calculate the effective rate for the loan with a 20% compensating balance requirement, assuming it is paid off in 12 monthly payments, we need to consider the monthly payment amount. The principal amount is the loan amount minus the compensating balance.

1. Principal amount = Loan amount - Compensating balance
2. Monthly payment = Total loan amount / Number of months
3. Effective rate = (Total interest paid / Principal amount) * (12 / Number of months)

Calculate the monthly payment, effective rate, and any other necessary values using the given information to determine the effective rate.

C. Since this part disregards part B about loan installment payments and instead uses the loan cost from part A, we can focus on the loan cost. Assuming the loan with the compensating balance requirement is used to take cash discounts, we need to calculate the interest savings from taking the discounts and compare it to the loan cost.

1. Calculate the interest cost for the loan with the compensating balance requirement.
2. Calculate the potential interest savings from taking cash discounts using the loan proceeds.
3. Compare the interest savings to the loan cost to determine whether it is beneficial to take the cash discount.

D. To determine whether the small chemical company should take the cash discount, we need to compare the cash discount savings to the cost of the loan with the compensating balance requirement.

1. Calculate the cash discount savings considering the firm's 80-day payment cycle.
2. Compare the cash discount savings to the loan cost to decide if it is beneficial to take the cash discount.

E. In this scenario, the prime rate goes up by 2% and the quoted rate on the loan also goes up by the same amount. To calculate the new effective rate on the loan with compensating balances, we need to convert the interest rate to dollars as the first step.

1. Calculate the additional interest cost due to the 2% increase in both the prime rate and the quoted rate.
2. Convert the additional interest cost to dollars by multiplying it by the loan amount.
3. Calculate the new effective rate using the total interest cost (including the additional cost) and the loan amount.

F. To determine if the firm effectively hedged the 2% increase in interest rates on the bank loan using Treasury bond futures:

1. Calculate the initial value of the Treasury bond futures sold.
2. Calculate the decrease in value after the interest rates increase by 2%.
3. Compare the initial value to the decreased value to determine if the firm effectively hedged the interest rate increase. Convert the amounts to dollars to determine the result.