Explore BrainMass

Effective interest rates and hedge

Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust.
The small chemical company's amount to be borrowed is: $500,000

The bank offers a rate of 9 percent with a 20 percent compensating balance
requirement, or as an alternative, 11.5 percent with additional fees of $5,575
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. Calculate the effective rate for both loan scenarios. Consider fees to be the
equivalent of "other interest" for Scenario 2.

b. If the loan with the 20% compensating balance were to be paid off
in 12 monthly payments, what would the effective rate be?
(Principal equals amount borrowed minus compensating balance.)

c. 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 rate to dollars
as the first step in your calculation.

d. Assume the proceeds from the loan with the compensating balance
requirement will be used to take cash discounts.
If the terms of the cash discount are 2/10, net 60, should the firm
borrow the funds to take the discount?
Use the loan cost from part A as the basis and validate by showing your answer in
percentage amounts.

e. In order to hedge against the possible rate increase, Midland Chemical Co.
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 2.5 percent across the board and the Treasury bond futures have gone
down to $479,000. Has the firm effectively hedged the 2.5 percent increase in
interest rates on the bank loan of $650,000? Determine the answer in dollar amounts.

Solution Summary

The solution explains how to calculate the effective interest rate and hedging against increase in interest rates