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 ercent
to miss a discount! we would be much better off finding an alternate source of
funds for 8 to 1" ercent.
8-#. $iscuss the relative use of credit between large and small firms. %hich grou is
generally in the net creditor osition! and why?
&arger firms tend to be in a net creditor osition because they have the financial
resources to be suliers to credit. 'he smaller firm must look to the larger
manufacturer or wholesaler to hel carry the firm(s financing re)uirements.
8-3. *ow have new banking laws influenced cometition?
+ew banking laws allowed more cometition and gave banks the right to
e,and across state lines to create larger! more cometitive markets. 'hey also
increased bank mergers.
8--. %hat is the rime interest rate? *ow does the average bank customer fare in
regard to the rime interest rate?
'he rime rate is the rate that a bank charges its most creditworthy customers.
'he average customer can e,ect to ay one or two ercent .or more/ above
rime.
8-0. %hat does &I123 mean? Is &I123 normally higher or lower than the U.4.
rime interest rate?
&I123 stands for &ondon Interbank 2ffered 3ate. 5s indicated in 6igure 8-1! it
is consistently below the rime rate.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-17
8-6. %hat advantages do comensating balances have for banks? 5re the advantages
to banks necessarily disadvantages to cororations?
'he use of a comensating balance or minimum re)uired account balance
allows the banker to generate a higher return on a loan because not all funds are
actually made available to the borrower. 5 81#0!""" loan with a 8#0!"""
comensating balance re)uirement means only 81""!""" is being rovided on a
net basis. 'his benefit to the lender need not be a disadvantage to the borrower.
'he borrower may! in turn! receive a lower )uoted interest rate and certain
gratuitous services because of the comensating balance re)uirement.
8-7. 5 borrower is often confronted with a stated interest rate and an effective
interest rate. %hat is the difference! and which one should the financial
manager recogni9e as the true cost of borrowing?
'he stated interest rate is the ercentage rate unad:usted for time or method of
reayment. 'he effective interest rate is the true rate and considers all these
variables. 5 0 ercent stated rate for ;" days rovides a #" ercent effective
rate. 'he financial manager should recogni9e the effective rate as the true cost
of borrowing. 'he effective rate is also referred to as the 5<3 .5nnual
<ercentage 3ate/.
8-8. =ommercial aer may show u on cororate balance sheets as either a current
asset or a current liability. >,lain this statement.
=ommercial aer can be either urchased or issued by a cororation. 'o the
e,tent one cororation urchases another cororation(s commercial aer as a
short-term investment! it is a current asset. =onversely! if a cororation issues
its own commercial aer! it is a current liability.
8-;. %hat are the advantages of commercial aer in comarison with bank
borrowing at the rime rate? %hat is a disadvantage?
In comarison to bank borrowing! commercial aer can generally be issued at
below the rime rate. 6urthermore! there are no comensating balance
re)uirements! though the firm is re)uired to maintain aroved credit lines at a
bank. 6inally! there is a certain degree of restige associated with the issuance
of commercial aer.
'he drawback is that commercial aer may be an uncertain source of funds.
%hen money gets tight or confidence in the commercial aer market
diminishes! funds may not be available. 'here is no loyalty factor such as that
which e,ists between a bank and its best borrowers.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-18
8-1". %hat is the difference between ledging accounts receivable and factoring
accounts receivable?
<ledging accounts receivable means receivables are used as collateral for a
loan? factoring account receivables means they are sold outright to a finance
comany.
8-11. %hat is an asset-backed ublic offering?
5 ublic offering is backed by an asset .accounts receivable/ as collateral.
>ssentially a firm sells its receivables into the securities markets.
8-1#. 1riefly discuss three tyes of lender control used in inventory financing.
'hree tyes of lender control used in inventory financing are@
a. 1lanket inventory A lien-general claim against inventory or collateral.
+o secific items are marked or designated.
b. 'rust receit A borrower holds the inventory in trust for the lender. >ach
item is marked and has a serial number. %hen the inventory is sold! the trust
receit is canceled and the funds go into the lender(s account.
c. %arehousing A the inventory is hysically identified! segregated! and
stored under the direction of an indeendent warehouse comany that
controls the movement of the goods. If done on the remises of the
warehousing firm! it is termed ublic warehousing. 5n alternate
arrangement is field warehousing whereby the same rocedures are
conducted on the borrower(s roerty.
8-13. %hat is meant by hedging in the financial futures market to offset interest rate
risks?
*edging means to engage in a transaction that artially or fully reduces a rior
risk e,osure. In selling a financial futures contract! if interest rates go u! one
is able to buy back the contract at a rofit. 'his will hel to offset the higher
interest charges to a cororation or other business entity.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-1;
Problems
8-1. =omute the cost of not taking the following cash discounts.
a. #B1"! net -".
b. #B10! net 3".
c. #B1"! net -0.
d. 3B1"! net ;".
Solution:
=ost of not C
taking a cash
discount
D $isc. D 1""
D $iscount

eriod $iscont
- date due 6inal
36"

a. =ost of C
lost discount
1" -"
36"
D ;8
D #

C #."-D , 1#."" C #-.-8D

b. =ost of C
lost discount
10 3"
36"
D ;8
D #

C #."- D , #-."" C -8.;6D

c. =ost of C
lost discount
1" -0
36"
D ;8
D #

C #."-D , 1".#; C #".;;D

d. =ost of C
lost discount
1" ;"
36"
D ;7
D 3

C 3.";D , -.0" C 13.;1D

Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#"
8-#. $elilahEs *aircuts can borrow from its bank at 13 ercent to take a cash
discount. 'he terms of the cash discount are #B10! net 00. 4hould the firm
borrow the funds?
Solution:
Delilahs Haircuts
6irst! comute the cost of not taking the cash discount and comare
this figure to the cost of the loan.
=ost of not
taking a cash
discount
D 36 . 18 ; D "- . #
10 00
36"
D ;8
D #
eriod discount date due final
36"
D $isc. D 1""
D $iscount
= =

=
'he cost of not taking the cash discount is greater than the cost of the
loan .18.36D vs. 13D/. 'he firm should borrow the money and take
the cash discount.
8-3. Four bank will lend you 8-!""" for -0 days at a cost of 80" interest. %hat is
your effective rate of interest?
Solution:
D 1" 8 D #0 . 1
-0
36"
""" ! - 8
0" 8
g outstandin is loan $ays
.36"/ year in the $ays
<rincial
Interest
rate >ffective
= =
=
=
8--. Four bank will lend you 83!""" for 0" days at a cost of 8-0 interest. %hat is
your effective rate of interest?
Solution:
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#1
D 8" . 1" # . 7 D 0 . 1
0"
36"
""" ! 3 8
-0 8
g outstandin is loan $ays
.36"/ year in the $ays
<rincial
Interest
rate >ffective
= =
=
=
8-0. I.G. 1oring borrows 80!""" for one year at 13 ercent interest. %hat is the
effective rate of interest if the loan is discounted?
Solution:
I.M. Boring
>ffective rate on a
discounted loan
D ;- . 1-
1
30" ! - 8
60" 8
36"
36"
60" 8 """ ! 0 8
60" 8
g outstandin is loan $ays
.36"/ year er $ays
Int. <rinc.
Interest
=
=

=
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-##
8-6. Ida Hline borrows 88!""" for ;" days and ays 818" interest. %hat is the
effective rate of interest if the loan is discounted?
Solution:
Ida line
>ffective rate on a
discounted loan
D #" . ; - D 3" . #
-
8#" ! 7 8
18" 8
;"
36"
18" 8 """ ! 8 8
18" 8
g outstandin is loan $ays
.36"/ year er $ays
Int. <rinc.
Interest
= =
=

=
8-7. Go and =hrisE 4orting Ioods! Inc.! borrows 81-!0"" for #" days at 1# ercent
interest. %hat is the dollar cost of the loan?
Use the formula@
( ) 36" year in the $ays
g outstandin is loan $ays
rate Interest borrowed 5mount loan of cost $ollar =
Solution:
Mo and Chris Sporting !oods
$ollar cost of loan C
5mount 1orrowed , Interest rate ,
.36"/ year in the $ays
g outstandin is loan $ays
18
1
D 1# 0"" ! 1- 8
36"
#"
D 1# 0"" ! 1- 8
=
=
C 81-!0""

.67D C 8;7.10
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#3
8-8. 4amson 2range Juice =omany normally takes #" days to ay for its average
daily credit urchases of 86!""". Its average daily sales are 87!"""! and it
collects accounts in #8 days.
a. %hat is its net credit osition? 'hat is! comute its accounts receivable and
accounts ayable and subtract the latter from the former.
5ccounts receivable C 5verage daily credit sales , 5verage collection eriod
5ccounts ayable C 5verage daily credit urchases , 5verage ayment eriod
b. If the firm e,tends its average ayment eriod from #" days to 30 days .and
all else remains the same/! what is the firm(s new net credit osition? *as it
imroved its cash flow?
Solution:
Sampson "range #uice Compan$
a. +et credit osition C accounts receivable A accounts ayable
5ccts rec. C 5verage $aily =redit <urchases , 5verage <ayment
<eriod C 87!""" , #8 C 81;6!"""
5ccounts ayable C 5verage $aily =redit <urchases , 5verage
<ayment <eriod C 86!""" , #"
C 81#"!"""
+et =redit <osition C 81;6!""" A 81#"!""" C 876!"""
b. 5ccounts 3eceivable will remain at 81;6!"""
5ccounts <ayable C 86!""" , 30 C #1"!"""
+et =redit <osition .81-!"""/
'he firm has imroved its cash flow osition. Instead of e,tending
876!""" more in credit .funds/ than it is receiving! it has reversed
the osition and is the net reciient of 81-!""" in credit.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#-
8-;. Ga,im 5ir 6ilters! Inc. lans to borrow 83""!""" for one year. +ortheast
+ational 1ank will lend the money at 1" ercent interest and re)uire a
comensating balance of #" ercent. %hat is the effective rate of interest?
Solution:
Ma%im &ir 'ilters( Inc.
>ffective rate of interest with #"D comensating balance C
( ) ( )
D 0 . 1#
8 .
D 1"
# . 1
D 1"
= 1
rate Interest
= =

or
D 0 . 1# 1
""" ! #-" 8
""" ! 3" 8
1
""" ! 6" 8 """ ! 3"" 8
""" ! 3" 8
g outstandin is loan $ays
.36"/ Fear the of $ays
balance ng =omensati <rincial
Interest
= =

Copyright 2005 by The McGraw-Hill Companies, Inc.

4-#0
8-1". $igital 5ccess! Inc. needs 8-""!""" in funds for a ro:ect.
a. %ith a comensating balance re)uirement of #"D! how much will the firm
need to borrow?
b. Iiven your answer to art a and a stated interest rate of ; ercent on the
total amount borrowed! what is the effective rate on the 8-""!""" actually
being used?
Solution:
Digital &ccess( Inc.
( )
( )
""" ! 0"" 8
8" .
""" ! -"" 8
#" . 1
""" ! -"" 8
= 1
needed 5mount
borrowed be 5mount to a.
=
=

=
b. 80""!""" total amount borrowed
;D Interest rate
8 -0!""" Interest
D 0 . 11
""" ! -"" 8
""" ! -0 8
=
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#6
8-11. =arey =omany is borrowing 8#""!""" for one year at 1# ercent from 4econd
Intrastate 1ank. 'he bank re)uires a #" ercent comensating balance. %hat is
the effective rate of interest? %hat would the effective rate be if =arey were
re)uired to make 1# e)ual monthly ayments to retire the loan? 'he rincial!
as used in 6ormula 8-6! refers to funds the firm can effectively utili9e .5mount
borrowed A =omensating balance/.
Solution:
Care$ Compan$
>ffective rate of interest with #"D comensating balance C
( )
D 10
36"
36"
""" ! 16" 8
""" ! #- 8
36"
36"
""" ! -" 8 """ ! #"" 8
""" ! #- 8
g outstandin is loan $ays
36" year in the $ays
balance ng =omensati <rincial
Interest
= =

Installment loan with comensating balance

( )
( ) ( )
D 6; . #7
""" ! "8" ! # 8
""" ! 076 8
""" ! 16" 8 13
""" ! 076 8
""" ! -" 8 """ ! #"" 8 1 1#
""" ! #- 8 1# #
<rincial 1 ayments of no. 'otal
Interest ayments no. 5nnual #
= =

=
+

=
+

Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#7
8-1#. =aone =hild =are =enters! Inc.! lans to borrow 8#0"!""" for one year at 1"
ercent from the =hicago 1ank and 'rust =omany. 'here is a #" ercent
comensating balance re)uirement. =aone kees minimum transaction
balances of 818!""" in the normal course of business. 'his idle cash counts
toward meeting the comensating balance re)uirement. %hat is the effective
rate of interest?
Solution:
Capone Child Care Centers( Inc.
)**ecti+e rate o* interest ,
( )
D -7 . 11
""" ! #18 8
""" ! #0 8
36"
36"
K """ ! 3# 8 """ ! #0" 8
""" ! #0 8
g outstandin is loan $ays
36" year in the $ays
balance ng =omensati <rincial
Interest
= =

K=omensating 1alance C #"D , #0"!""" C 80"!"""

+ormal 6unds C 18!"""
3estricted =omensating 1alance 83#!"""
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#8
8-13. 'he treasurer for +eiman 4uermarkets is seeking a 83"!""" loan for 18" days
from %rigley 1ank and 'rust. 'he stated interest rate is 1" ercent! and there is
a 10 ercent comensating balance re)uirement. 'he treasurer always kees a
minimum of 8#!0"" in the firmEs checking accounts. 'hese funds count toward
meeting any comensating balance re)uirements. %hat is the effective rate of
interest on this loan?
Solution:
-eiman Supermar.ets
>ffective rate of interest C
( )
D 7# . 1" # D 36 . 0
18"
36"
K K """ ! # 8 """ ! 3" 8
0"" ! 1 8
g outstandin is loan $ays
36" year in the $ays
balance ng =omensati <rincial
K Interest
= =

K
( ) 0"" ! 1 8
36"
18"
""" ! 3" 8 D 1" =
KK=omensating 1alance C 10D , 3"!""" C 8-!0""
+ormal 6unds C #!0""
3estricted =omensating 1alance 8#!"""
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-#;
8-1-. 'ucker $rilling =or. lans to borrow 8#""!""". +orthern +ational 1ank will
lend the money at one half ercentage oint over the rime rate of 8 L ercent
.; ercent total/ and re)uires a comensating balance of #" ercent. <rincial in
this case refers to funds that the firm can effectively use in the business.
%hat is the effective rate of interest? %hat would the effective rate be if 'ucker
$rilling were re)uired to make four )uarterly ayments to retire the loan?
Solution:
/uc.er Drilling Corp.
>ffective rate of interest with #"D comensating balance
C 818!"""B.8#""!""" A 8-"!"""/ C 818!"""B816"!""" C 11.#0D
Installment &oan with comensating balance
( )
D " . 18 """ ! 8"" 8 B """ ! 1-- 8
""" ! 16" 8 0
""" ! 18 8 - #
= =

=
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-3"
8-10. Four comany lans to borrow 80 million for 1# months! and your banker gives
you a stated rate of 1- ercent interest. Fou would like to know the effective
rate of interest for the following tyes of loans. .>ach of the following arts
stands alone./
a. 4imle 1- ercent interest with a 1" ercent comensating balance.
b. $iscounted interest.
c. 5n installment loan .1# ayments/.
d. $iscounted interest with a 0 ercent comensating balance.
Solution:
a. 4imle interest with a 1"D comensating balance
D 06 . 10
""" ! 0"" ! - 8
""" ! 7"" 8
1
""" ! 0"" 8 """ ! """ ! 0 8
""" ! 7"" 8
= =

b. $iscounted interest
D #8 . 16
""" ! 3"" ! - 8
""" ! 7"" 8
1
""" ! 7"" 8 """ ! """ ! 0 8
""" ! 7"" 8
= =

c. 5n installment loan with 1# ayments

D 80 . #0
""" ! """ ! 60 8
""" ! 8"" ! 16 8
""" ! """ ! 0 8 13
""" ! 7"" 8 1# #
= =

d. $iscounted interest with a 0D comensating balance
87""!"""B.80!"""!""" A 87""!""" A 8#0"!"""/ C 17.#8D
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-31
8-16. If you borrow 81#!""" at 8;"" interest for one year! what is your effective
interest cost for the following ayment lans?
a. 5nnual ayment.
b. 4emiannual ayments.
c. Muarterly ayments.
d. Gonthly ayments.
Solution:
a. 8;""B81#!""" C 7.0D
Use formula 8-6 for b! c! and d.
3ate on installment loan C
( ) <rincial 1 ayments of no. 'otal
Interest ayments of no. 5nnual #
+

b. .# , # , 8;""/B.3 , 81#!"""/ C 83!6""B836!""" C 1".""D
c. .# , - , 8;""/B.0 , 81#!"""/ C 87!#""B86"!""" C 1#.""D
d. .# , 1# , 8;""/B.13 , 81#!"""/ C 8#1!6""B8106!""" C 13.80D
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-3#
8-17. Nroom Gotorcycle =omany is borrowing 83"!""" from 6irst 4tate 1ank. 'he
total interest charge is 8;!""". 'he loan will be aid by making e)ual monthly
ayments for the ne,t three years. %hat is the effective rate of interest on this
installment loan?
Solution:
0room Motorc$cle Compan$
3ate on installment loan C
( )
( )
D -6 . 1;
""" ! 11" ! 1 8
""" ! #16 8
""" ! 3" 8 1 36
""" ! ; 8 1# #
<rincial 1 ayments of no. 'otal
Interest ayments of no. 5nnual #
= =
+

=
+

Copyright 2005 by The McGraw-Hill Companies, Inc.
4-33
8-18. Gr. <aul <romtly is a very cautious businessman. *is sulier offers trade
credit terms of 3B1"! net 7". Gr. <romtly never takes the discount offered! but
he ays his suliers in 6" days rather than the 7" days allowed so he is sure
the ayments are never late. %hat is Gr. <romtlyEs cost of not taking the cash
discount?
Solution:
Paul Promptl$
=ost of not taking
a cash discount
D #0 . ## # . 7 D "; . 3
1" 6"
36"
D 3 D 1""
D 3
eriod $iscount
date <ayment
36"
D $isc. D 1""
D $iscount
= =

=
In this roblem! Gr. <romtly has the use of funds for 0" e,tra days
.6"-1"/! instead of 6" e,tra days .7"-1"/. Gr. <romtlyEs suliers are
offering terms of 3B1"! net 7". Gr. <romtly is effectively acceting
terms of 3B1"! net 6".
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-3-
8-1;. 'he 2gden 'imber =omany buys from its suliers on terms of #B1"! net 30.
2gden has not been utili9ing the discount offered and has been taking 0" days
to ay its bills. 'he suliers seem to accet this ayment attern! and 2gdenEs
credit rating has not been hurt.
Gr. %ood! 2gden 'imber =omanyEs vice resident! has suggested that the
comany begin to take the discount offered. Gr. %ood rooses the comany
borrow from its bank at a stated rate of 10 ercent. 'he bank re)uires a #0
ercent comensating balance on these loans. =urrent account balances would
not be available to meet any of this comensating balance re)uirement. $o you
agree with Gr. %oodEs roosal?
Solution:
/he "gden /imber Compan$
=ost of not taking a cash
discount
eriod $iscount
date due 6inal
36"
D $isc. D 1""
D $iscount

=

D 36 . 18 ; D "- . #
1" 0"
36"
D ;8
D #
= =

=
%e use 0" days instead of 30 days as the final due date because
2gdenEs suliers have effectively made this the due date even though
the stated due date is 30 days.
>ffective rate of interest with a #0D comensating balance
re)uirement@
C Interest rateB.1 A =/
C 10DB.1 A .#0/
C 10DB..70/ C #"D
'he effective cost of the loan! #"D! is more than the cost of assing u
the discount! 18.36D. 2gden 'imber =omany should continue to ay
in 0" days and ass u the discount.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-30
8-#". In roblem 1;! if the comensating balance re)uirement were 1" ercent
instead of #0 ercent! would you change your answer? $o the aroriate
calculation.
Solution:
/he "gden /ime Compan$ 1Continued2
>ffective rate of interest with a 1"D comensating balance
re)uirement@
( ) ( ) ( )
D 67 . 16
; .
D 10
1 . 1
D 10
= 1
rate Interest
= =

=
'he answer now changes. 'he effective cost of the loan! 16.67D! is
less than the cost of assing u the discount. 2gden 'imber =omany
should borrow the funds and take the discount.
8-#1. 1osworth <etroleum needs 80""!""" to take a cash discount of #B1"! net 7". 5
banker will loan the money for 6" days at an interest cost of 88!1"".
a. %hat is the effective rate on the bank loan?
b. *ow much would it cost .in ercentage terms/ if 1osworth did not take the
cash discount! but aid the bill in 7" days instead of 1" days?
c. 4hould 1osworth borrow the money to take the discount?
d. If the banker re)uires a #" ercent comensating balance! how much must
1osworth borrow to end u with the 80""!"""?
e. %hat would be the effective interest rate in art if the interest charge for
6" days were 813!"""? 4hould 1osworth borrow with the #" ercent
comensating balance? .'here are no funds to count against the
comensating balance re)uirement./
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-36
8345. Continued
Solution:
Bos6orth Petroleum
D 7# . ; 6 D 6# . 1
6"
36"
80""!"""
88!1""
interest of rate >ffective a.
= =
=
( )
D #- . 1# 6 D "- . #
1" 7"
36"
D ;8
D #
discount lost of =ost b.
= =

=
c. Fes! because the cost of borrowing is less than the cost of losing the
discount.
( ) ( )
""" ! 6#0 8
8" .
""" ! 0"" 8
#" . 1
""" ! 0"" 8
= 1
80""!"""
d. = =

5mount needed
to be borrowed
D 6 . 10 6 D 6 . # 6
""" ! 0"" 8
""" ! 13 8
6"
36"
1#0!""" - 86#0!"""
813!"""
rate interest >ffective e.
= = =
=
+o! do not borrow with a comensating balance of #" ercent since
the effective rate is greater than the savings from taking the trade
discount.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-37
8-##. =olumbus 4hiing =omany is negotiating with two banks for a 81""!"""
loan. 1ankcor of 2hio re)uires a #" ercent comensating balance! discounts
the loan! and wants to be aid back in four )uarterly ayments. =leveland 1ank
re)uires a 1" ercent comensating balance! does not discount the loan! but
wants to be aid back in 1# monthly installments. 'he stated rate for both
banks is 1" ercent. =omensating balances and any discounts will be
subtracted from the 81""!""" in determining the available funds in art a.
a. %hich loan should =olumbus accet?
b. 3ecomute the effective cost of interest! assuming =olumbus ordinarily
maintains 8#"!""" at each bank in deosits that will serve as comensating
balances.
c. *ow much did the comensating balances inflate the ercentage interest
costs? $oes your choice of banks change if the assumtion in art b is
correct?
Solution:
Columbus Shipping Compan$
a. 1ankcor of 2hio
>ffective interest rate
( ) ( )
D 86 . ## """ ! 30" 8 B """ ! 8" 8
1 - """ ! 1" 8 """ ! #" 8 """ ! 1"" 8
""" ! 1" 8 - #
= =
+

=
=leveland 1ank
>ffective interest rate
( ) ( )
D 01 . #" """ ! 17" ! 1 8 B """ ! #-" 8
1 1# """ ! 1" 8 """ ! 1"" 8
""" ! 1" 8 1# #
= =
+

=
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-38
8344. Continued
=hoose =leveland 1ank since it has the lowest effective cost.
b. 'he numerators stay the same as in art .a/ but the denominator
increases to reflect the use of more money because balances are
already maintained at both banks.
1ankcor of 2hio
>ffective rate C 88"!"""B.81""!""" A 81"!"""/ , 0 C 17.78D
=leveland 1ank
>ffective rate C 8#-"!"""B.81""!""" , 13/ C 18.-6D
c. 'he comensating balance assumtion changed interest rates as
follows@
Ban.corp Cle+eland
Interest =ost with =omB1al. ##.86D #".01D
%ithout =omB1al. 17.78D 18.-6D
$ifference in cost 0."8D #."0D
If comensating balances are maintained at both banks in the normal
course of business! then 1ankcor of 2hioEs loan becomes cheaer than
=leveland 1ankEs loan.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4-3;
8-#3. 'e,as 2il 4ulies sells to the 1# accounts listed below.
&ccount
7ecei+able Balance
"utstanding
&+erage &ge o* the
&ccount o+er the 8ast
9ear
5............... 8 0"!""" 30
1............... 8"!""" #0
=............... 1#"!""" -7
$............... 1"!""" 10
>............... #0"!""" 30
6............... 6"!""" 01
I............... -"!""" 18
*............... 18"!""" 6"
I................ 10!""" -3
J................ #0!""" 33
H............... #""!""" -1
&............... 6"!""" #8
J O J 6inancial =ororation will lend ;" ercent against account balances that
have averaged 3" days or less? 8" ercent for account balances between 3" and
-" days? and 7" ercent for account balances between -" and -0 days.
=ustomers that take over -0 days to ay their bills are not considered as
ade)uate accounts for a loan.
'he current rime rate is 1# ercent! and J O J 6inancial =ororation charges 3
ercent over rime to 'e,as 2il 4ulies as its annual loan rate.
a. $etermine the ma,imum loan for which 'e,as 2il 4ulies could )ualify.
b. $etermine how much one month(s interest e,ense would be on the loan
balance determined in art a.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--"
834:. Continued
Solution:
/e%as "il Supplies
a. "-3" days 5mount
1 8 8"!"""
$ 1"!"""
I -"!"""
& 6"!"""
'otal 1;"!"""
loan D ;"D
loan 8171!"""
31--" days 5mount
5 8 0"!"""
> #0"!"""
J #0!"""
'otal 83#0!"""
loan D 8"D
loan 8#6"!"""
-1--0 days 5mount
I 8 10!"""
H #""!"""
'otal 8#10!"""
loan D 7"D
loan 810"!0""
Ga,imum &oan C 8171!""" P 8#6"!""" P 810"!0"" C 8081!0""
b. &oan balances 8 081!0""
Interest! 10D annual .1.#0D/ er month
2ne monthEs interest 87!#68.70
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--1
8-#-. 'he treasurer for 'hornton <ie and 4teel =omany wishes to use financial
futures to hedge her interest rate e,osure. 4he will sell five 'reasury futures
contracts at 81"0!""" er contract. It is July and the contracts must be closed
out in $ecember of this year. &ong-term interest rates are currently 7.- ercent.
If they increase to 8.0 ercent! assume the value of the contracts will go down
by 1" ercent. 5lso if interest rates do increase by 1.1 ercent! assume the firm
will have additional interest e,ense on its business loans and other
commitments of 86"!8"". 'his e,ense! of course! will be searate from the
futures contracts.
a. %hat will be the rofit or loss on the futures contract if interest rates go to
8.0 ercent?
b. >,lain why a rofit or loss took lace on the futures contracts.
c. 5fter considering the hedging in art a! what is the net cost to the firm of
the increased interest e,ense of 86"!8""? %hat ercent of this increased
cost did the treasurer effectively hedge away?
d. Indicate whether there would be a rofit or loss on the futures contracts if
interest rates went down.
Solution:
/hornton Pipe and Steel Compan$
a. 4ales rice! $ecember 'reasury bond contract
.4ale takes lace in July/ 0 , 81"0!""" C 80#0!"""
<urchase rice! $ecember 'reasury bond contract
.1"D rice decline/
.; , 81"0!""" C 8 ;-!0"" +ew <rice of '-1ond
0 , 8;-!""" C 8-7#!0""Nalue of 0 '-1ond =ontracts
4old 0 '-1ond =ontracts in July at 80#0!"""
<urchased 0 '-1ond =ontracts in $ecember at 8-7#!0""
<rofit on futures contracts 8 0#!0""
b. 5 rofit took lace because the value of the bond went down due to
increasing rates. 'his meant the subse)uent rice was less than the
initial sales rice.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--#
834;. Continued
c. Increased interest cost 86"!8""
<rofit from hedging 0#!0""
+et cost 8 8!3""
D 60 . 13
8"" ! 6" 8
3"" ! 8 8
cost interest Increased
=ost +et
= =
'he net cost is 13.60D. 'his means 86.30D of the increased
interest cost was hedged away.
d. If interest rates went down! there would be a loss on the futures
contracts. 'he lower interest rates would lead to higher bond rices
and a urchase rice that e,ceeded the original sales rice.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--3
Comprehensi+e Problem
=< 8-1. &dditional problem not included in the te%t:
Gidland =hemical =o. is negotiating a loan from Ganhattan 1ank and 'rust.
'he small chemical comany needs to borrow 80""!""".
'he bank offers a rate of 8 Q ercent with a #" ercent comensating balance
re)uirement! or as an alternative! ; R ercent with additional fees of 80!0"" to
cover services the bank is roviding. In either case the rate on the loan is
floating .changes as the rime interest rate changes/. 'he loan would be for
one year.
a. %hich loan carries the lower effective rate? =onsider fees to be the
e)uivalent of other interest.
b. If the loan with a #" ercent comensating balance re)uirement were to be
aid off in 1# monthly ayments! what would the effective rate be?
.<rincial e)uals amount borrowed minus the comensating balance./
c. 5ssume the roceeds from the loan with the comensating balance
re)uirement will be used to take cash discounts. $isregard art b about
installment ayments and use the loan cost from art a.
If the terms of the cash discount are 1.0B1"! net 0"! should the firm borrow the
funds to take the discount?
d. 5ssume the firm actually takes 8" days to ay its bills and would continued
to do so in the future if it did not take the cash discount. 4hould the
comany take the cash discount?
e. 1ecause the interest rate on the loans is floating! it can go u as interest
rates go u. 5ssume that the rime rate goes u by # ercent and the )uoted
rate on the loan goes u the same amount. %hat would then be the
effective rate on the loan with comensating balances? =onvert the interest
to dollars as the first ste in your calculation.
f. In order to hedge against the ossible rate increase described in art e! the
Gidland =hemical =o. decides to hedge its osition in the futures market.
5ssume it sells 80""!""" worth of 1#-month futures contracts on 'reasury
bonds. 2ne year later! interest rates go u # ercent across the board and
the 'reasury bond futures have gone down to 8-88!""". *as the firm
effectively hedged the # ercent increase in interest rates on the bank loan
as described in art e? $etermine the answer in dollar amounts.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4---
CP 835. Continued
Solution:
Midland Chemical Co.
a. =omensating 1alance &oan
80""!"""
8.#0D
8 -1!#0" Interest
80""!""" &oan
1""!""" #"D comensating balance re)uirement
8-""!""" 5vailable funds
D 31# . 1"
""" ! -""
#0" ! -1 8
funds 5vailable
Interest
rate >ffective = = =
6ee-added &oan
80""!"""
;.70D
8 -8!70" Interest
Interest lus fees
8-8!70" Interest
0!0"" 6ees
80-!#0"
D 80" . 1"
""" ! 0""
#0" ! 0- 8
&oan
fees lus Interest
rate >ffective = = =
'he loan with the comensating re)uirement has the lower effective
cost .1".31#D vs 1".80"D/.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--0
CP 835. Continued
( )
( )
D "38 . 1;
""" ! #"" ! 0
""" ! ;;" 8
""" ! -"" 8 1 1#
#0" ! -1 8 1# #
rincial 1 ayments of no. total
interest ayments no. annual #
loan t installmen
on rate >ffective
b.
=
=
+

=
+

=
D 68" . 13 ; D 0# . 1
1" 0"
36"
D 0 . ;8
D 0 . 1
<eriod $iscount date due 6inal
36"
ercent $iscount ercent 1""
<ercent $iscount
discount cash a take
to failing of =ost
c.
= =

=
'he cost of not taking the cash discount is greater than the cost of the
loan .13.68"D vs. 1".31#D/ so the firm should take the cash discount.
d. If the firm is going to take 8" days to ay if it does take the cash
discount! then it is keeing the money for an e,tra 7" days.
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--6
CP 835. Continued
'he cost of not taking the cash discount and keeing the money for 7"
more days is@
D 813 . 7 1- . 0 D 0# . 1
7"
36"
D 0 . ;8
D 0 . 1
= = =
'he cost of not taking the cash discount is less than the cost of the
loan .7.183D vs. 1".31#D/ so the firm should not take the cash
discount.
e. 0""!"""
1".#0D
801!#0" Interest
D 813 . 1#
""" ! -""
#0" ! 01 8
funds 5vailable
Interest
rate >ffective = = =
f. <rofit on 'reasury 1onds
4ale rice! 'reasury bonds 80""!"""
<rice rice! 'reasury bonds -88!"""
<rofit on futures contract 8 1#!"""
>,tra interest cost
80""!""" , #D 8 1"!"""
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--7
CP 835. Continued
'he firm effectively hedged its osition as the gain on the 'reasury
bond futures contract has more than offset the two ercent increase in
the cost of the loan.
.+ote a simlifying assumtion in this e,amle is that 'reasury bond
rates and the rime rate are moving by the magnitude. 'his is
necessary to kee the roblem reasonably workable./
Copyright 2005 by The McGraw-Hill Companies, Inc.
4--8