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Chapter 8 Discussion Questions 8-1.

Under what circumstances would it be advisable to borrow money to take a cash discount? It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of foregoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding an alternate source of funds for 8 to 10 percent.

8-2.

Discuss the relative use of credit between large and small firms. Which group is generally in the net creditor position, and why? Larger firms tend to be in a net creditor position because they have the financial resources to be suppliers to credit. The smaller firm must look to the larger manufacturer or wholesaler to help carry the firm's financing requirements.

8-3.

How have new banking laws influenced competition? New banking laws allowed more competition and gave banks the right to expand across state lines to create larger, more competitive markets. They also increased bank mergers.

8-4.

What is the prime interest rate? How does the average bank customer fare in regard to the prime interest rate? The prime rate is the rate that a bank charges its most creditworthy customers. The average customer can expect to pay one or two percent (or more) above prime.

8-5.

What does LIBOR mean? Is LIBOR normally higher or lower than the U.S. prime interest rate? LIBOR stands for London Interbank Offered Rate. As indicated in Figure 8-1, it is consistently below the prime rate.

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Copyright © 2005 by The McGraw-Hill Companies, Inc.

8-6.

What advantages do compensating balances have for banks? Are the advantages to banks necessarily disadvantages to corporations? The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are actually made available to the borrower. A $125,000 loan with a $25,000 compensating balance requirement means only $100,000 is being provided on a net basis. This benefit to the lender need not be a disadvantage to the borrower. The borrower may, in turn, receive a lower quoted interest rate and certain gratuitous services because of the compensating balance requirement.

8-7.

A borrower is often confronted with a stated interest rate and an effective interest rate. What is the difference, and which one should the financial manager recognize as the true cost of borrowing? The stated interest rate is the percentage rate unadjusted for time or method of repayment. The effective interest rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days provides a 20 percent effective rate. The financial manager should recognize the effective rate as the true cost of borrowing. The effective rate is also referred to as the APR (Annual Percentage Rate).

8-8.

Commercial paper may show up on corporate balance sheets as either a current asset or a current liability. Explain this statement. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporation's commercial paper as a short-term investment, it is a current asset. Conversely, if a corporation issues its own commercial paper, it is a current liability.

8-9.

What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage? In comparison to bank borrowing, commercial paper can generally be issued at below the prime rate. Furthermore, there are no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank. Finally, there is a certain degree of prestige associated with the issuance of commercial paper. The drawback is that commercial paper may be an uncertain source of funds. When money gets tight or confidence in the commercial paper market diminishes, funds may not be available. There is no loyalty factor such as that which exists between a bank and its best borrowers.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-10.

What is the difference between pledging accounts receivable and factoring accounts receivable? Pledging accounts receivable means receivables are used as collateral for a loan; factoring account receivables means they are sold outright to a finance company.

8-11.

What is an asset-backed public offering? A public offering is backed by an asset (accounts receivable) as collateral. Essentially a firm sells its receivables into the securities markets.

8-12.

Briefly discuss three types of lender control used in inventory financing. Three types of lender control used in inventory financing are: a. Blanket inventory – lien-general claim against inventory or collateral. No specific items are marked or designated. b. Trust receipt – borrower holds the inventory in trust for the lender. Each item is marked and has a serial number. When the inventory is sold, the trust receipt is canceled and the funds go into the lender's account. c. Warehousing – the inventory is physically identified, segregated, and stored under the direction of an independent warehouse company that controls the movement of the goods. If done on the premises of the warehousing firm, it is termed public warehousing. An alternate arrangement is field warehousing whereby the same procedures are conducted on the borrower's property.

8-13.

What is meant by hedging in the financial futures market to offset interest rate risks? Hedging means to engage in a transaction that partially or fully reduces a prior risk exposure. In selling a financial futures contract, if interest rates go up, one is able to buy back the contract at a profit. This will help to offset the higher interest charges to a corporation or other business entity.

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Problems 8-1.

Compute the cost of not taking the following cash discounts. a. b. c. d.

2/10, net 40. 2/15, net 30. 2/10, net 45. 3/10, net 90.

Solution: Cost of not = taking a cash discount

Discount % 100 % − Disc. %

×

360 F i n ad lu de a t-e D i s c opnetr i o d

a. Cost of = lost discount

2% 360 × 98 % 40 − 10

= 2.04% x 12.00 = 24.48%

b. Cost of = lost discount

2% 360 × 98 % 30 − 15

= 2.04 % x 24.00 = 48.96%

c. Cost of = lost discount

2% 360 × 98% 45 − 10

= 2.04% x 10.29 = 20.99%

d. Cost of = lost discount

3% 360 × 97% 90 − 10

= 3.09% x 4.50 = 13.91%

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-2.

Delilah’s Haircuts can borrow from its bank at 13 percent to take a cash discount. The terms of the cash discount are 2/15, net 55. Should the firm borrow the funds?

Solution: Delilah’s Haircuts First, compute the cost of not taking the cash discount and compare this figure to the cost of the loan. Cost of not taking a cash discount

=

Discount % 360 × 100 % − Disc. % final due date − discount period

=

2% 360 × 98 % 55 −15

= 2.04 % ×9 =18 .36 %

The cost of not taking the cash discount is greater than the cost of the loan (18.36% vs. 13%). The firm should borrow the money and take the cash discount. 8-3.

Your bank will lend you $4,000 for 45 days at a cost of $50 interest. What is your effective rate of interest?

Solution: Effective rate =

Interest Days in the year (360) × Principal Days loan is outstandin g

$50 360 × $4,000 45 =1.25 % ×8 =10 % =

8-4.

Your bank will lend you $3,000 for 50 days at a cost of $45 interest. What is your effective rate of interest?

Solution:

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Effective rate =

Interest Days in the year (360) × Principal Days loan is outstandin g

$45 360 × $3,000 50 =1.5% ×7.2 =10 .80 % =

8-5.

I.M. Boring borrows $5,000 for one year at 13 percent interest. What is the effective rate of interest if the loan is discounted?

Solution: I.M. Boring Effective rate on a discounted loan

=

Interest Days per year (360) × Princ. − Int. Days loan is outstandin

=

$650 360 $650 × = ×1 $5,000 −$650 360 $4,350

=14 .94 %

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g

8-6.

Ida Kline borrows $8,000 for 90 days and pays $180 interest. What is the effective rate of interest if the loan is discounted?

Solution: Ida Kline Effective rate on a discounted loan

=

Interest Days per year (360) × Princ. − Int. Days loan is outstandin

=

$180 360 $180 × = ×4 $8,000 −$180 90 $7,820

g

= 2.30 % ×4 = 9.20 %

8-7.

Mo and Chris’ Sporting Goods, Inc., borrows $14,500 for 20 days at 12 percent interest. What is the dollar cost of the loan? Use the formula: Dollar cost of loan = Amount borrowed × Interest rate ×

Days loan is outstandin g Days in the year ( 360 )

Solution: Mo and Chris’ Sporting Goods Dollar cost of loan = Amount Borrowed x Interest rate x

Days loan is outstandin g Days in the year (360) 20 = $14 ,500 ×12 % × 360 1 = $14 ,500 ×12 % × 18

= $14,500 × .67% = $97.15

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8-8.

Sampson Orange Juice Company normally takes 20 days to pay for its average daily credit purchases of $6,000. Its average daily sales are $7,000, and it collects accounts in 28 days. a. What is its net credit position? That is, compute its accounts receivable and accounts payable and subtract the latter from the former. Accounts receivable = Average daily credit sales x Average collection period Accounts payable = Average daily credit purchases x Average payment period b. If the firm extends its average payment period from 20 days to 35 days (and all else remains the same), what is the firm's new net credit position? Has it improved its cash flow?

Solution: Sampson Orange Juice Company a. Net credit position = accounts receivable – accounts payable Accts rec. = Average Daily Credit Purchases x Average Payment Period = $7,000 x 28 = $196,000 Accounts payable = Average Daily Credit Purchases x Average Payment Period = $6,000 x 20 = $120,000 Net Credit Position = $196,000 – $120,000 = $76,000 b. Accounts Receivable will remain at Accounts Payable = $6,000 x 35 = Net Credit Position

$196,000 210,000 ($14,000)

The firm has improved its cash flow position. Instead of extending $76,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $14,000 in credit.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-9.

Maxim Air Filters, Inc. plans to borrow $300,000 for one year. Northeast National Bank will lend the money at 10 percent interest and require a compensating balance of 20 percent. What is the effective rate of interest?

Solution: Maxim Air Filters, Inc. Effective rate of interest with 20% compensating balance = Interest rate 10 % 10 % = = = 12.5% (1 − C ) ( 1 − .2 ) .8

or Principal

=

Interest − Compensati

ng balance

×

Days of the Year (360) Days loan is outstandin g

$30 ,000 $30 ,000 ×1 = ×1 =12 .5% $300 ,000 −$60 ,000 $240 ,000

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8-10.

Digital Access, Inc. needs $400,000 in funds for a project. a. With a compensating balance requirement of 20%, how much will the firm need to borrow? b. Given your answer to part a and a stated interest rate of 9 percent on the total amount borrowed, what is the effective rate on the $400,000 actually being used?

Solution: Digital Access, Inc. a. Amount to be borrowed =

=

Amount needed (1 − C ) $400 ,000 $400 ,000 = (1 − .20 ) .80

= $500 ,000

b. $500,000 9% $ 45,000

total amount borrowed Interest rate Interest

$45 ,000 =11 .5% $400 ,000

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-11.

Carey Company is borrowing $200,000 for one year at 12 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. What is the effective rate of interest? What would the effective rate be if Carey were required to make 12 equal monthly payments to retire the loan? The principal, as used in Formula 8-6, refers to funds the firm can effectively utilize (Amount borrowed – Compensating balance).

Solution: Carey Company Effective rate of interest with 20% compensating balance = Interest Principal − Compensati =

ng balance

×

Days in the year ( 360 ) Days loan is outstandin g

$24 ,000 360 $24 ,000 360 × = × =15 % $200 ,000 − $40 ,000 360 $160 ,000 360

Installment loan with compensating balance 2 × Annual no. payments × Interest ( Total no. of payments + 1) × Principal =

2 ×12 × $24,000 (12 +1) × ( $200 ,000 − $40,000 )

=

$576 ,000 $576 ,000 = = 27 .69 % 13 × $160 ,000 $2,080 ,000

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8-12.

Capone Child Care Centers, Inc., plans to borrow $250,000 for one year at 10 percent from the Chicago Bank and Trust Company. There is a 20 percent compensating balance requirement. Capone keeps minimum transaction balances of $18,000 in the normal course of business. This idle cash counts toward meeting the compensating balance requirement. What is the effective rate of interest?

Solution: Capone Child Care Centers, Inc. Effective rate of interest = Interest Days in the year ( 360 ) × Principal − Compensati ng balance Days loan is outstandin g $25,000 360 $25,000 × = = 11.47% $250,000 − $32,000 * 360 $218,000

*Compensating Balance = 20% x 250,000 = $50,000 Normal Funds = 18,000 Restricted Compensating Balance $32,000

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8-13.

The treasurer for Neiman Supermarkets is seeking a $30,000 loan for 180 days from Wrigley Bank and Trust. The stated interest rate is 10 percent, and there is a 15 percent compensating balance requirement. The treasurer always keeps a minimum of $2,500 in the firm’s checking accounts. These funds count toward meeting any compensating balance requirements. What is the effective rate of interest on this loan?

Solution: Neiman Supermarkets Effective rate of interest = Interest * Days in the year ( 360 ) × Principal − Compensati ng balance Days loan is outstandin g =

$1,500 360 × = 5.36 % × 2 =10 .72 % $30 ,000 − $2,000 * * 180

(10 % × $30 ,000 ) × 180

360

*

= $1,500

**Compensating Balance = 15% x 30,000 = $4,500 Normal Funds = 2,500 Restricted Compensating Balance $2,000

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8-14.

Tucker Drilling Corp. plans to borrow $200,000. Northern National Bank will lend the money at one half percentage point over the prime rate of 8 ½ percent (9 percent total) and requires a compensating balance of 20 percent. Principal in this case refers to funds that the firm can effectively use in the business. What is the effective rate of interest? What would the effective rate be if Tucker Drilling were required to make four quarterly payments to retire the loan?

Solution: Tucker Drilling Corp. Effective rate of interest with 20% compensating balance = $18,000/($200,000 – $40,000) = $18,000/$160,000 = 11.25% Installment Loan with compensating balance =

2 × 4 × $18,000 = $144 ,000 / $800 ,000 = 18 .0% ( 5 × $160 ,000 )

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8-15.

Your company plans to borrow $5 million for 12 months, and your banker gives you a stated rate of 14 percent interest. You would like to know the effective rate of interest for the following types of loans. (Each of the following parts stands alone.) a. b. c. d.

Simple 14 percent interest with a 10 percent compensating balance. Discounted interest. An installment loan (12 payments). Discounted interest with a 5 percent compensating balance.

Solution: a. Simple interest with a 10% compensating balance $700 ,000 $700 ,000 ×1 = =15 .56 % $5,000 ,000 −$500 ,000 $4,500 ,000

b. Discounted interest $700 ,000 $700 ,000 ×1 = = 16 .28 % $5,000 ,000 − $700 ,000 $4,300 ,000

c. An installment loan with 12 payments 2 ×12 × $700 ,000 $16 ,800 ,000 = = 25 .85 % 13 × $5,000 ,000 $65,000 ,000

d. Discounted interest with a 5% compensating balance $700,000/($5,000,000 – $700,000 – $250,000) = 17.28%

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8-16.

If you borrow $12,000 at $900 interest for one year, what is your effective interest cost for the following payment plans? a. b. c. d.

Annual payment. Semiannual payments. Quarterly payments. Monthly payments.

Solution: a. $900/$12,000 = 7.5% Use formula 8-6 for b, c, and d. Rate on installment loan =

2 × Annual no. of payments × Interest ( Total no. of payments + 1) × Principal

b. (2 x 2 x $900)/(3 x $12,000) = $3,600/$36,000

= 10.00%

c. (2 x 4 x $900)/(5 x $12,000) = $7,200/$60,000

= 12.00%

d. (2 x 12 x $900)/(13 x $12,000) = $21,600/$156,000

= 13.85%

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8-17.

Vroom Motorcycle Company is borrowing $30,000 from First State Bank. The total interest charge is $9,000. The loan will be paid by making equal monthly payments for the next three years. What is the effective rate of interest on this installment loan?

Solution: Vroom Motorcycle Company Rate on installment loan = 2 ×Annual no. of payments × Interest no. of payments +1) ×Principal

( Total =

2 ×12 ×$9,000 $216 ,000 = =19 .46 % ( 36 +1) ×$30 ,000 $1,110 ,000

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8-18.

Mr. Paul Promptly is a very cautious businessman. His supplier offers trade credit terms of 3/10, net 70. Mr. Promptly never takes the discount offered, but he pays his suppliers in 60 days rather than the 70 days allowed so he is sure the payments are never late. What is Mr. Promptly’s cost of not taking the cash discount?

Solution: Paul Promptly Cost of not taking a cash discount

D iscount % 360 = × 10 0 %− D isc. % P aym ent d ate − D iscount period 3% 360 = × 10 0 %− 3% 60 − 10 = 3.09 % × 7 .2 = 22 .25 %

In this problem, Mr. Promptly has the use of funds for 50 extra days (60-10), instead of 60 extra days (70-10). Mr. Promptly’s suppliers are offering terms of 3/10, net 70. Mr. Promptly is effectively accepting terms of 3/10, net 60.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-19.

The Ogden Timber Company buys from its suppliers on terms of 2/10, net 35. Ogden has not been utilizing the discount offered and has been taking 50 days to pay its bills. The suppliers seem to accept this payment pattern, and Ogden’s credit rating has not been hurt. Mr. Wood, Ogden Timber Company’s vice president, has suggested that the company begin to take the discount offered. Mr. Wood proposes the company borrow from its bank at a stated rate of 15 percent. The bank requires a 25 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement. Do you agree with Mr. Wood’s proposal?

Solution: The Ogden Timber Company Cost of not taking a cash discount

=

=

D i s c %o u n t 3 6 0 × 1 0%0− D i %s c F. i nd audl e a −t e D i s c po eu rni ot d 2% 360 × = 2.04% × 9 = 18.36% 98% 50 − 10

We use 50 days instead of 35 days as the final due date because Ogden’s suppliers have effectively made this the due date even though the stated due date is 35 days. Effective rate of interest with a 25% compensating balance requirement: = Interest rate/(1 – C) = 15%/(1 – .25) = 15%/(.75) = 20% The effective cost of the loan, 20%, is more than the cost of passing up the discount, 18.36%. Ogden Timber Company should continue to pay in 50 days and pass up the discount. S-35

Copyright © 2005 by The McGraw-Hill Companies, Inc.

8-20.

In problem 19, if the compensating balance requirement were 10 percent instead of 25 percent, would you change your answer? Do the appropriate calculation.

Solution: The Ogden Time Company (Continued) Effective rate of interest with a 10% compensating balance requirement: =

Interest rate 15 % 15 % = = = 16 .67% (1 − C ) (1 − .1) ( .9)

The answer now changes. The effective cost of the loan, 16.67%, is less than the cost of passing up the discount. Ogden Timber Company should borrow the funds and take the discount. 8-21.

Bosworth Petroleum needs $500,000 to take a cash discount of 2/10, net 70. A banker will loan the money for 60 days at an interest cost of $8,100. a. What is the effective rate on the bank loan? b. How much would it cost (in percentage terms) if Bosworth did not take the cash discount, but paid the bill in 70 days instead of 10 days? c. Should Bosworth borrow the money to take the discount? d. If the banker requires a 20 percent compensating balance, how much must Bosworth borrow to end up with the $500,000? e. What would be the effective interest rate in part d if the interest charge for 60 days were $13,000? Should Bosworth borrow with the 20 percent compensating balance? (There are no funds to count against the compensating balance requirement.)

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-21. Continued Solution: Bosworth Petroleum a. Effective rate of interest =

$8,100 360 × $500,000 60

= 1.62 % × 6 = 9.72 %

=

b. Cost of lost discount

2% 360 × 98 % ( 70 − 10 )

= 2.04 % × 6 = 12 .24 %

c. Yes, because the cost of borrowing is less than the cost of losing the discount. d.

$500,000 (1 − C )

=

$500 ,000 $500 ,000 = = $625 ,000 (1 −.20 ) .80

e. Effective interest rate =

=

Amount needed to be borrowed

$13,000 360 × $625,000 - 125,000 60 $13,000 × 6 = 2.6% × 6 = 15 .6% $500 ,000

No, do not borrow with a compensating balance of 20 percent since the effective rate is greater than the savings from taking the trade discount.

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8-22.

Columbus Shipping Company is negotiating with two banks for a $100,000 loan. Bankcorp of Ohio requires a 20 percent compensating balance, discounts the loan, and wants to be paid back in four quarterly payments. Cleveland Bank requires a 10 percent compensating balance, does not discount the loan, but wants to be paid back in 12 monthly installments. The stated rate for both banks is 10 percent. Compensating balances and any discounts will be subtracted from the $100,000 in determining the available funds in part a. a. Which loan should Columbus accept? b. Recompute the effective cost of interest, assuming Columbus ordinarily maintains $20,000 at each bank in deposits that will serve as compensating balances. c. How much did the compensating balances inflate the percentage interest costs? Does your choice of banks change if the assumption in part b is correct?

Solution: Columbus Shipping Company a. Bankcorp of Ohio Effective interest rate =

2 ×4 ×$10 ,000 ($100 ,000 −$20 ,000 −$10 ,000 ) ×( 4 +1)

= $80 ,000 / $350 ,000 = 22 .86 %

Cleveland Bank Effective interest rate =

2 ×12 ×$10 ,000 ( $100 ,000 −$10 ,000 ) ×(12 +1)

= $240 ,000 / $1,170 ,000 = 20 .51 %

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8-22. Continued Choose Cleveland Bank since it has the lowest effective cost. b. The numerators stay the same as in part (a) but the denominator increases to reflect the use of more money because balances are already maintained at both banks. Bankcorp of Ohio Effective rate = $80,000/($100,000 – $10,000) x 5 = 17.78% Cleveland Bank Effective rate = $240,000/($100,000 x 13) = 18.46% c. The compensating balance assumption changed interest rates as follows: Interest Cost with Comp/Bal. Without Comp/Bal. Difference in cost

Bankcorp 22.86% 17.78% 5.08%

Cleveland 20.51% 18.46% 2.05%

If compensating balances are maintained at both banks in the normal course of business, then Bankcorp of Ohio’s loan becomes cheaper than Cleveland Bank’s loan.

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8-23.

Texas Oil Supplies sells to the 12 accounts listed below.

Account A............... B............... C............... D............... E............... F............... G............... H............... I................ J................ K............... L...............

Receivable Balance Outstanding $ 50,000 80,000 120,000 10,000 250,000 60,000 40,000 180,000 15,000 25,000 200,000 60,000

Average Age of the Account over the Last Year 35 25 47 15 35 51 18 60 43 33 41 28

J & J Financial Corporation will lend 90 percent against account balances that have averaged 30 days or less; 80 percent for account balances between 30 and 40 days; and 70 percent for account balances between 40 and 45 days. Customers that take over 45 days to pay their bills are not considered as adequate accounts for a loan. The current prime rate is 12 percent, and J & J Financial Corporation charges 3 percent over prime to Texas Oil Supplies as its annual loan rate. a. Determine the maximum loan for which Texas Oil Supplies could qualify. b. Determine how much one month's interest expense would be on the loan balance determined in part a.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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8-23. Continued Solution: Texas Oil Supplies a.

0-30 days B D G L Total loan % loan

Amount $ 80,000 10,000 40,000   60,000 190,000     90% $171,000

Total loan % loan

Amount $ 50,000 250,000   25,000 $325,000     80% $260,000

Total loan % loan

Amount $ 15,000  200,000 $215,000     70% $150,500

31-40 days A E J

41-45 days I K

Maximum Loan = $171,000 + $260,000 + $150,500 = $581,500 b.

Loan balances Interest, 15% annual One month’s interest

$ 581,500   (1.25%) $7,268.75

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per month

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8-24.

The treasurer for Thornton Pipe and Steel Company wishes to use financial futures to hedge her interest rate exposure. She will sell five Treasury futures contracts at $105,000 per contract. It is July and the contracts must be closed out in December of this year. Long-term interest rates are currently 7.4 percent. If they increase to 8.5 percent, assume the value of the contracts will go down by 10 percent. Also if interest rates do increase by 1.1 percent, assume the firm will have additional interest expense on its business loans and other commitments of $60,800. This expense, of course, will be separate from the futures contracts. a. What will be the profit or loss on the futures contract if interest rates go to 8.5 percent? b. Explain why a profit or loss took place on the futures contracts. c. After considering the hedging in part a, what is the net cost to the firm of the increased interest expense of $60,800? What percent of this increased cost did the treasurer effectively hedge away? d. Indicate whether there would be a profit or loss on the futures contracts if interest rates went down.

Solution: Thornton Pipe and Steel Company a. Sales price, December Treasury bond contract (Sale takes place in July) 5 x $105,000 = $525,000 Purchase price, December Treasury bond contract (10% price decline) .9 x $105,000 = $ 94,500 New Price of T-Bond 5 x $94,000 = $472,500 Value of 5 T-Bond Contracts Sold 5 T-Bond Contracts in July at $525,000 Purchased 5 T-Bond Contracts in December at$472,500 Profit on futures contracts $ 52,500 b. A profit took place because the value of the bond went down due to increasing rates. This meant the subsequent price was less than the initial sales price.

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8-24. Continued c. Increased interest cost Profit from hedging Net cost

$60,800 52,500 $ 8,300

Net Cost $8,300 = = 13 .65 % Increased interest cost $60 ,800

The net cost is 13.65%. This means 86.35% of the increased interest cost was hedged away. d. If interest rates went down, there would be a loss on the futures contracts. The lower interest rates would lead to higher bond prices and a purchase price that exceeded the original sales price.

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Comprehensive Problem CP 8-1.

Additional problem not included in the text: 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? 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.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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CP 8-1. Continued Solution: Midland Chemical Co. a. Compensating Balance Loan $500,000 8.25% $ 41,250 $500,000 100,000 $400,000

Interest Loan 20% compensating balance requirement Available funds

Effective rate =

Interest $41,250 = = 10 .312 % Available funds 400 ,000

Fee-added Loan $500,000 9.75% $ 48,750

Interest

Interest plus fees $48,750 5,500 $54,250

Interest Fees

Effective rate =

Interest plus fees $54 ,250 = = 10 .850 % Loan 500 ,000

The loan with the compensating requirement has the lower effective cost (10.312% vs 10.850%).

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CP 8-1. Continued b.

Effective rate on = 2 × annual no. payments × interest installmen t loan ( total no. of payments +1) × principal =

2 ×12 × $41,250 $990 ,000 = (12 +1) × $400 ,000 5,200 ,000

= 19 .038 %

c.

D iscounPt ercent C osto f failin gto = takea cashd iscount 10 0percen−t D iscou ntp ercent ×

360 F in ald uedate− D iscou ntP eriod

=

1.5% 3 60 × 98.5% 50 − 10

= 1.52% × 9 = 13.68 0%

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.

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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CP 8-1. Continued The cost of not taking the cash discount and keeping the money for 70 more days is: =

1.5% 360 × = 1.52% × 5.14 = 7.813% 98.5% 70

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 10.25% $51,250 Interest Effective rate =

Interest $51,250 = = 12 .813 % Available funds 400 ,000

f. Profit on Treasury Bonds Sale price, Treasury bonds Price price, Treasury bonds Profit on futures contract

$500,000 488,000 $ 12,000

Extra interest cost $500,000 x 2%

$ 10,000

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CP 8-1. Continued 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. (Note a simplifying assumption in this example is that Treasury bond rates and the prime rate are moving by the magnitude. This is necessary to keep the problem reasonably workable.)

Copyright © 2005 by The McGraw-Hill Companies, Inc.

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