The R. Morin Construction Company needs to borrow $100,000 to help finance the c

Question

The R. Morin Construction Company needs to borrow $100,000 to help finance the cost of a new $150,000 hydraulic crane used in the firm's commercial construction business. The crane will pay for itself in 1 year, and the firm is considering the following alternatives for financing its purchase:

Alternative A) The firm's bank has agreed to lend the $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 R. Morin because the firm 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.

a. Which alternative should R. Morin select?

b. 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

Solution:

a.       Bank Loan Alternative

Since interest on bank loan is discounted, we should determine the amount borrowed by R. Morin. Let B be the amount to be borrowed

B – 0.14B = $100,000

0.86B = $100,000

B = $100,000/0.86

B = $116,279.07

Interest = 0.14 x $116,279.07

Interest = $16,279.07

Hence, the effective rate of interest on loan is calculated as follows:-

APR = $16,279.07/ ($116,279.07 - $16,279.07) x 1/(360/360)

APR = 0.1628 or 16.28%

Dealer financing alternative

APR = $16,300/ $100,000 x 1/(360/360)

APR = 0.163 or 16.3%

R. Morin should select dealer financing because it has greater flexibility in raising funds for future needs.

b. If the bank’s compensating balance were to necessitate idle demand deposits

B – 0.14B – 0.15B = $100,000

0.71B = $100,000

B = $100,000/0.71

B = $140.845.07

Interest = 0.14 x $140,845.07

Interest = $19,718.31

Compensating balance = 0.15 x $140,845.07

Compensating balance = $21,126.76

APR = $21,126.76/ ($140,845.07 - $21,126.76 - $19,718.31) x 1/(360/360)

APR = 0.197 or 19.7%

Hence, the cost of the bank loan rises to 19.7% where the 15% compensation balancing requirement is binding R. Martin.

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