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    Midland Chemical Co.

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    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
    other interest.

    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
    your calculation.

    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
    dollar amounts.

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    Solution Summary

    The solution explains the calculations relating to compensating balances, cash discount, hedging, effective rates