Midland Chemical Loans

Midland Chemical Loans

Option 1- $500,000 at 8.25% with a 20% compensating balance requirement.

Interest accrued- $41,250

Available balance- $400,000

Effective rate- 10.31%

Option 2- $500,000 at 9.75% with $5,500 additional fees

Interest accrued- $48,750

Additional fees- $5,500

Total cost- $54,250

Effective rate- 10.85%

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.

1. Which loan carries the lower effective rate? Consider fees to be the equivalent of other interest.-Option 2 has the lower effective rate.

2. 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 x 12 x 41,250) / ((12+1) x 400,000) = 19.038%

3. 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? (1.5 / (100 – 1.5)) x (360 / (50 – 10)) = 13.68%

4. 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? (1.5 / (100 – 1.5)) x (360 / (80 – 10)) = 7.83% vs. 10.31%, Midland Chemical should not take the discount.

5. 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. Loan amount- $500,000 Compensating balance required- $500,000@20%= $100,000...