The R. Morin Construction Company needs to borrow ?$80,000 to help finance the c
ID: 2617714 • Letter: T
Question
The R. Morin Construction Company needs to borrow ?$80,000 to help finance the cost of a new ?$120,000 hydraulic crane used in the? firm's commercial construction business. The crane will pay for itself in one? year, and the firm is considering the following alternatives for financing its? purchase: Alternative A.???The? firm's bank has agreed to lend the ?$80,000 at a rate of 14 percent. Interest would be? discounted, and a 16 percent compensating balance would be required.? However, the? compensating-balance requirement is not binding on the firm because it normally maintains a minimum demand deposit? (checking account) balance of ?$20,000 in the bank. Alternative B.???The equipment dealer has agreed to finance the equipment with a? 1-year loan. The ?$80,000 loan requires payment of principal and interest totaling ?$93,640.
a. Which alternative should Morin? select?
b. If the? bank's compensating-balance requirement had necessitated idle demand deposits equal to 16 percent of the? loan, what effect would this have had on the cost of the bank loan? alternative?
Explanation / Answer
Answer (a)
Alternative (A) Loan From Firm Bank
Interest charged by bank on Loan @ 14%
therefore interest = 80000*14% = 11200$
And the minimum amount of compensating balance required to maintain is 16% = 80000*16% = 12800$
The cost of interest on compensating balance is 12800*14% = 1792$ But it is not needed to do
Thereform total cost of loan or total amount required to be paid after 1 year to firm bank is =
= 80000 +12800 = 92800$
Alternative (B) In case of loan from the dealer
the total amount of interest and principal is to be paid after 1 year is 93640$
So the alternative A is best that is taking loan from the Firm Bank
Answer (b)
The cost of alternative A would be
if in case it is required to maintain balance then the cost is
= 12800 + 1792 = 14592$
cost % = 14592/80000 = 18.24%
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