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.
a. Which loan carries the lower effective rate? Consider fees to be the equivalent of
b. If the loan with a 20 percent compensating balance requirement were to be paid
off in 12 monthly payments, what would the effective rate be? (Principal equals
amount borrowed minus the compensating balance.)
Assume the proceeds from the loan with the compensating balance requirement
will be used to take cash discounts. Disregard part b about installment payments
and use the loan cost from part a.
If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds
to take the discount?
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
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 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
f. In order to hedge against the possible rate increase described in part e, Midland
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 percent across the board and the Treasury bond futures have gone
down to $488,000. Has the firm effectively hedged the 2 percent increase in
interest rates on the bank loan as described in part e? Determine the answer in
The solution explains the calculations relating to compensating balances, cash discount, hedging, effective rates