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 8 ¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9 ¾ 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).
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?
The Business plan on Tootsie Roll Industries Inc. Loan Package
Tootsie Roll Industries Inc. and its branches makes and sells candy including “Andes mints, Junior Mints, Charleston Chew, Mason Dots, Sugar Daddy, and the ever popular Tootsie Roll, which has been made from the same formula for over a 100 years” (Hoovers Academics, 2012) Tootsie Roll Industry’s customers include a wide variety of supermarkets, dollar stores, discount warehouse clubs, fund-raising ...
d.Assume the firm actually takes 80 days to pay its bills and would continued to do so in the future if it did not take the cash discount. Should the company 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, the 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 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
Midland Chemical Co.
a.Compensating Balance Loan
$500,000
8.25%
$ 41,250Interest
$500,000Loan
100,00020% compensating balance requirement
$400,000Available funds
Fee-added Loan
$500,000
9.75%
$ 48,750Interest
Interest plus fees
$48,750Interest
5,500Fees
$54,250
The loan with the compensating requirement has the lower effective cost (10.312% vs 10.850%).
The cost of not taking the cash discount is greater than the cost of the loan (13.680% vs. 10.312%) so the firm should take the cash discount.
d.If the firm is going to take 80 days to pay if it does take the cash discount, then it is keeping the money for an extra 70 days. The cost of not taking the cash discount and keeping the money for 70 more days is:
The cost of not taking the cash discount is less than the cost of the loan (7.183% vs. 10.312%) so the firm should not take the cash discount.
e.500,000
The Essay on Net Present Value and Appropriate Discount Rate
Energy Costs Find information on energy cost: Advantages (government websites) 2 - Cost of Equity, Appropriate Discount Rate (WACC) Cost of equity 1. Formula Risk Free Rate + (Market Premium x Overall Company Beta) 2. Each part a. Risk free rate (10-year T-bill) i. bond rating chosen * interest rate * b. Market premium c. Beta i. Appropriate Discount Rate (WACC) 1. Formula Weight of Debt x After- ...
10.25%
$51,250Interest
f.Profit on Treasury Bonds
Sale price, Treasury bonds$500,000
Price price, Treasury bonds 488,000
Profit on futures contract$ 12,000
Extra interest cost
$500,000 x 2%$ 10,000
The firm effectively hedged its position as the gain on the Treasury bond futures contract has more than offset the two percent increase in the cost of the loan.
