Your company needs to borrow $100,000 to purchase equipment. The equipment will

Question

Your company needs to borrow $100,000 to purchase equipment. The equipment will pay for itself in 1 year and the company is considering the following alternatives for financing its purchase:

Which alternative should your company choose?

Alternative A: The firm’s bank has agreed to lend $100,000 at a rate of 14%. Interest would be discounted, and a 15% compensating balance would be required. However, the compensating-balance requirement would not be binding on the company because the company normally maintains a minimum demand deposit (checking account) balance of $25,000 in the bank.

Alternative B: The equipment dealer has agreed to finance the equipment with a 1 year loan. The $100,000 loan would require payment of principal and interest totaling $116,300.

If the bank’s compensating-balance requirement were to necessitate idle demand deposits equal to 15% of the loan, what effect would this have on the cost of the bank loan alternative?

Explanation / Answer

company shoul choose

Alternative A

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