Can you help me with this problem? Thanks Midland Chemical Co. is negotiating a

Question

Can you help me with this problem? Thanks

Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust.
The small chemical company will need to borrow $600,000 .

The bank offers the following:

Interest Rate 6.75%
Compensating balance requirement 22%

or as an alternative…

Interest Rate 9.00%
Additional bank fees $8,500

In either case the rate on the loan is floating (changes as the prime
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 the 22% compensating balance were to be paid off
in 12 monthly payments, what would the effective rate be?
(Principal equals amount borrowed minus compensating balance.)

c. 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%
and the quoted rate on the loan goes up by the same amount.
What would then be the effective rate on the loan with
compensating balances? Convert the interest rate to dollars
as the first step in your calculation.

Explanation / Answer

a. Compensating Balance Loan

Interest = $600,000 * 0.0675 = $40,500

Available Fund = $600,000 - 22% of $600,000 = $468,000

Effective rate = Interest / Available funds = $40,500/ $468,000
Effective rate = 8.65%

Fee-added Loan

Interest = $600,000 * 0.09 = $54,000

Interest plus fees = $54000 + $8500 = $62,500

Effective rate = Interest plus fees / loan

Effective rate = $62,500/$600,000 = 10.42%

The loan with the compensating requirement has the lower
effective cost (8.65 % vs 10.42 %).

b. Effective interest rate on installment loan

Effective rate = (2 x annual no. payment x interest )/
((total no. of payments + 1) x principal)

= 2 x 12 x 40,500/(12+1) x 468,000

= 15.98 %

c. Effective interest rate on installment loan with 2 % increase

Interest increased by 2% = $600,000 * (.0675 + .02) =$52,500

Effective Interest Rate = $52,500/$468,000 = 11.22%

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