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Midland Chemical Co: Compensating Balances, Cash Discount and Hedging

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, 9 3.4 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.)

c. 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 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 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.

Solution Preview

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.

Compensating Balance Loan – In this loan some part is kept as compensating balance and only the balance is given. The interest is on total loan but funds used are after compensating balance
Total interest = 500,000X8.25% = 41,250
Compensating balance = 500,000X20%=100,000
Funds used = 500,000-100,000=400,000
Effective rate = 41,250/400,000=10.312%

Loan With fee
Total interest = 500,000X9.75% = 48,750
Fee paid = 5,500
Total amount paid = 54,250
Amount borrowed = 500,000
Effective rate = ...

Solution Summary

The solution explains various calculations relating to compensating balances, cash discount and hedging. Work and answers are provided in the attached Word document.

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