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Assignment
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The Watson Corporation is negotiating a loan from PNC Bank. The company needs to borrow $300,000.
The bank offers a rate of 7% with a 30% compensating balance requirement, or as an alternative, 10% with additional fees of $4,700 to cover the 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.
- What loan carries the lower effective rate? Consider the fees to be the equivalent of other interest. $300,000*7% = 21,100 Interest (loan) 300,000* (30% Comp. Balance Required)90,000 = 210,000 Available funds
Effective Rate – Interest/available funds – 21,000/210,000 – 10.0%
Fee’s added loan:
300,000 * 10% = 30,000
Interest Plus Fees:
30,000 + 4,700 = 34,700
Effective Interest Rate – Interest Fees/Loan – 34,700/300,000 – 11.57%
Compensating Balance Requirement loan has the lower effective rate (10.0% vs. 11.57%)
- If the loan with a 30% 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.)
Effective rate in installment loan – 2*annual number of payments * interest / (total number of payments + 1) * principle
2*12-21,000/(12+1)*210,000 – 504,000/2,730,000 – 18.462%
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 us the loan costs from part a. If the terms of the cash discount are 2/10, net 60, should the firm borrow the funds to take the discount?
d. Assume the firm actually takes 90 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 loan 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 the same amount. What would then be the effective rate on the loan with compensating balances?
f. In order to hedge against the possible rate increase described in part e, the Watson Corporation decides to hedger its position in the futures market. Assume it sells $300,000 worth of 12 month futures contracts on Treasury bonds. One year later, interest rates go up 2% across the board and the Treasury bond futures have gone down to $280,000. Has the firm effectively hedged the 2% increase in interest rates on the bank loan as described in part e? Determine the answer in dollar amounts.