# Midland Chemical Co: Compensating Balances, Cash Discount and Hedging

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, 9 3.4 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.

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 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 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, 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.

#### Solution Preview

...4,250/500,000 = 10.85%

The compensating balance loan has a 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.)

On an installment loan, the effective rate is calculated as

Effective rate = (2Xannual number of payments X interest)/((total number of payments +1)X Principal)

(2Xannual payments X interest) = 2X12X41,250 = 990,000

(total number of payments+1)X principal = (12+1)X400,000 = 5,200,000

Effective rate = 990,000/5,200,000 = 19.038%

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?

We first find the cost of not taking the cash discount. The cost is given as

Nominal annual cost = % discount/(100-% ...