Summit Record Company is negotiating with two banks for a $168,000 loan. Fidelit

Question

Summit Record Company is negotiating with two banks for a $168,000 loan. Fidelity Bank requires a compensating balance of 18 percent, discounts the loan, and wants to be paid back in four quarterly payments. Southwest Bank requires a compensating balance of 9 percent, does not discount the loan, but wants to be paid back in 12 monthly installments. The stated rate for both banks is 11 percent. Compensating balances will be subtracted from the $168,000 in determining the available funds in part a. a-1. Calculate the effective interest rate for Fidelity Bank and Southwest Bank. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) Effective Rate of Interest Fidelity Bank Southwest Bank a-2. Which loan should Summit accept? Southwest Bank Fidelity Bank b. Recompute the effective cost of interest, assuming that Summit ordinarily maintains $30,240 at each bank in deposits that will serve as compensating balances. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) Effective Rate of Interest Fidelity Bank Southwest Bank c. Does your choice of banks change if the assumption in part b is correct? Yes No

Explanation / Answer

Answer A -1

Fidelity Bank :-

Interest = Interest Rate x Principal

= 0.11 x $ 168000 = $ 18480

Compensating Balance = C x Principal

= 0.18 x $ 168000 = $ 30240

Effective Rate of Interest = (2 x Annual Number of Payments x Interest ) / (Total Number Of payments + 1 ) x Principal

= (2 x 4 x $ 18480) / (4+1 ) x ( $ 168000- 18480 - 30240)

= $ 147840 / $ 596400 = 0.2789 or 24.79 %

Southwest Bank

Interest = Interest Rate x Principal

= 0.11 x $ 168000 = $ 18480

Compensating Balance = C x Principal

= 0.09 x $ 168000 = $ 15120

Effective Rate of Interest = (2 x Annual Number of Payments x Interest ) / (Total Number Of payments + 1 ) x Principal

= (2 x 12 x $ 18480) / (12+1 ) x ( $ 168000 - 15120)

= $ 443520 / $ 1987440= 0.2232 or 22.32 %

Answer A - 2) Summit should select SouthWest Bank Since its loan has the lower effective Interest rate

Answer b) The compensating balance requirements for both banks will be met by the current cash deposits.

Fidelity Bank:-

Effective Rate of Interest = ( 2 x Annual number of payments x interest ) / (Total Number of payments +1 ) x Principal

= (2 x 4 x $ 18480) / (4+1 ) x ( $ 168000-18480)

= 147840 / 747600 = 0.1978 or 19.78 %

SouthWest Bank

Effective Rate of Interest = (2 x Annual Number Of Payments x Interest ) / (Total Number of Payments +1 0 x Principal

= (2 x 12 x $ 18480) / (12 +1 ) x $ 168000

= 443520 / 2184000 =0.2031 or 20.31 %

c) Yes if compensating balance are maintained at both banks in the normal course of business ,then Fidelity Bank should be chosen over SouthWest Bank because Fidelity will have the lower effective Interest Rate.

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