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.

S-17 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. S-18

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.

S-19 Copyright © 2005 by The McGraw-Hill Companies, Inc.

Problems
8-1. Compute the cost of not taking the following cash discounts.

a. 2/10, net 40.

b. 2/15, net 30.
c. 2/10, net 45.
d. 3/10, net 90.

Solution:

Cost of not = Discount %

360
taking a cash 100 % − Disc. % ×
discount
F i n ad lu de a t-e
D i s c opnetr i o d

a. Cost of = 2% 360 = 2.04% x 12.00 = 24.48%

×
98 % 40 − 10
lost discount

b. Cost of = 2% 360 = 2.04 % x 24.00 = 48.96%

×
98 % 30 − 15
lost discount
c. Cost of = 2% 360 = 2.04% x 10.29 = 20.99%
×
98% 45 − 10
lost discount
d. Cost of = 3% 360 = 3.09% x 4.50 = 13.91%
×
97% 90 − 10
lost discount

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-20

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.
Discount % 360
Cost of not = ×
100 % − Disc. % final due date − discount period
taking a cash
discount 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:
Interest Days in the year (360)
Effective rate = ×
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:

S-21 Copyright © 2005 by The McGraw-Hill Companies, Inc.

 Interest Days in the year (360)
Effective rate = ×
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
Interest Days per year (360)
Effective rate on a = ×
Princ. − Int. Days loan is outstandin g
discounted loan
$650 360 $650
= × = ×1
$5,000 −$650 360 $4,350

=14 .94 %

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-22

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
Interest Days per year (360)
Effective rate on a = ×
Princ. − Int. Days loan is outstandin g
discounted loan
$180 360 $180
= × = ×4
$8,000 −$180 90 $7,820

= 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:

Days loan is outstandin g

Dollar cost of loan = Amount borrowed × Interest rate ×
Days in the year ( 360 )
Solution:
Mo and Chris’ Sporting Goods

Dollar cost of loan =

Days loan is outstandin g
Amount Borrowed x Interest rate x Days in the year (360)
20
= $14 ,500 ×12 % ×
360
1
= $14 ,500 ×12 % ×
18
= $14,500 × .67% = $97.15

S-23 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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 $196,000

Accounts Payable = $6,000 x 35 = 210,000
Net Credit Position ($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. S-24

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
Interest Days of the Year (360)
×
Principal − Compensati ng balance Days loan is outstandin g

$30 ,000 $30 ,000

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

S-25 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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.
Amount needed
a. Amount to be borrowed =
(1 − C )

$400 ,000 $400 ,000

= =
(1 − .20 ) .80

= $500 ,000

b. $500,000 total amount borrowed

9% Interest rate
$ 45,000 Interest
$45 ,000
=11 .5%
$400 ,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-26

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 Days in the year ( 360 )
×
Principal − Compensati ng balance 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

S-27 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-28

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 = $1,500

360

**Compensating Balance = 15% x 30,000 = $4,500

Normal Funds = 2,500
Restricted Compensating Balance $2,000

S-29 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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 )

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-30

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. Simple 14 percent interest with a 10 percent compensating balance.

b. Discounted interest.
c. An installment loan (12 payments).
d. 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%

S-31 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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. Annual payment.
b. Semiannual payments.
c. Quarterly payments.
d. 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%

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-32

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
( Total
no. of payments +1) ×Principal

2 ×12 ×$9,000 $216 ,000

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

S-33 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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
Discount % 360
Cost of not taking =
0 %−
10 D
isc. %
×
Paym ent d
ate −
a cash discount Discount period

3% 360
= ×
0 %−
10 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. S-34

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 D i s c %o u n t 3 6 0

discount = ×
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. S-36

8-21. Continued

Solution:
Bosworth Petroleum
$8,100 360
a. Effective rate of interest = ×
$500,000 60

= 1.62 % × 6 = 9.72 %

2% 360
b. Cost of lost discount = ×
98 % ( 70 − 10 )

= 2.04 % × 6 = 12 .24 %

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

$500,000 $500 ,000 $500 ,000 Amount needed

d. = = = $625 ,000
(1 − C ) (1 −.20 ) .80
to be borrowed
$13,000 360
e. Effective interest rate = ×
$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.

S-37 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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 %

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-38

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:

Bankcorp Cleveland
Interest Cost with Comp/Bal. 22.86% 20.51%
Without Comp/Bal. 17.78% 18.46%
Difference in cost 5.08% 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.

S-39 Copyright © 2005 by The McGraw-Hill Companies, Inc.

8-23. Texas Oil Supplies sells to the 12 accounts listed below.

Average Age of the

Receivable Balance Account over the Last
Account Outstanding Year
A............... $ 50,000 35
B............... 80,000 25
C............... 120,000 47
D............... 10,000 15
E............... 250,000 35
F............... 60,000 51
G............... 40,000 18
H............... 180,000 60
I................ 15,000 43
J................ 25,000 33
K............... 200,000 41
L............... 60,000 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. S-40

8-23. Continued

Solution:
Texas Oil Supplies

a. 0-30 days Amount

B $ 80,000
D 10,000
G 40,000
L   60,000
Total 190,000
loan %     90%
loan $171,000

31-40 days Amount

A $ 50,000
E 250,000
J   25,000
Total $325,000
loan %     80%
loan $260,000

41-45 days Amount

I $ 15,000
K  200,000
Total $215,000
loan %     70%
loan $150,500

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

b. Loan balances $ 581,500

Interest, 15% annual   (1.25%) per month
One month’s interest $7,268.75

S-41 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-42

8-24. Continued

c. Increased interest cost $60,800

Profit from hedging 52,500
Net cost $ 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.

S-43 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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. S-44

CP 8-1. Continued

Solution:
Midland Chemical Co.

a. Compensating Balance Loan

$500,000
8.25%
$ 41,250 Interest
$500,000 Loan
100,000 20% compensating balance requirement
$400,000 Available funds
Interest $41,250
Effective rate = = = 10 .312 %
Available funds 400 ,000

Fee-added Loan

$500,000
9.75%
$ 48,750 Interest

Interest plus fees

$48,750 Interest
5,500 Fees
$54,250
Interest plus fees $54 ,250
Effective rate = = = 10 .850 %
Loan 500 ,000

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

S-45 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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 osto f failin gto D iscounPt ercent

c. =
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. S-46

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

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

S-47 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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. S-48