Loan Scenarios 1

Loan Scenarios

FIN/200

December 12, 2010

Jana Rideout
 Loan Scenarios 2

Loan Scenarios

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.
Option A
.0825/ (1 - .20)
.0825 / .80 = 10.31% effective rate

Option B
[48,750 + 5,500] / 500,000
54,250 / 500,000
9.05% effective rate

Option B has the lower effective rate.

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.)
[2 * 12 * 42,600] / [13 * 500,000]
1,022,400 / 6,500,000
15.73% effective rate

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?
There is a 15% discount on interest charges on this scenario. Over the course of the loan,
$36,210 would be paid instead of the original $42,600 of interest without the discount. Yes, if the
discount is available the firm should arrange financing to take advantage of the discount. This
would lower the effect rate to 13.37%.

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?
Net 80 results in an effective rate of 14.2% (2 * 5 * 42,600 / 6 * 500,000). The discounted rate
offered is a more attractive financing option so if the firm has incoming revenue adequate to
meet the needs of the discounted rate payment schedule they should take advantage of the
 Loan Scenarios 3

discounted rate.

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.
.1025 / [1 - .20] = 12.81% effective rate = $64,050 interest paid on one year loan

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.
The difference between the original 8.25% interest rate and the 10.25% after the 2% raise in
interest rates results in a payment over a year-long loan increasing by $21,450. The bond futures
drop in price results in a loss of only $12,000. The firm has effectively hedged the interest rates.