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Midland Financial

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Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The | | small chemical company needs to borrow $500,000. | | | | | The bank offers a rate of 8¼ percent with a 20 percent compensating balance | | requirement, or as an alternative, 9¾ percent with additional fees of $5,500 to cover | services the bank is providing. In either case the rate on the loan is floating (changes as | the prime interest 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. | | | | | | | | | | | | | | | | | | | | | | | | | | 1st choice: | | | | | | | | Loan amount: $500,000 | | | | | | | Compensating balance: $500,000x20%=$100,000 | | | | | Available amount of funds: $500,000-$100,000=$400,000 | | | | Interest: $500,000x8.25%=$41,250 | | | | | | Effective interest: Interest/Available funds: $41,250/$400,000=10.312% | | | 2nd choice: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Interest: $500,000x9.75%=$48,750 | | | | | | | Borrowing cost: Interest + fees: $48,750 + $5,500= $54,250 | | | | | Effective interest: Borrowing cost/Loan Amount: $54,250/$500,000=10.850% | | | | | | | | | | | | | The loan with the compensating requirement has the lower effective cost: (10.312% vs 10.850%) | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | b. If the loan with a 20 percent compensating balance requirement were to be paid | | off in 12 monthly payments, what would the effective rate be? (Principal equals | | | amount borrowed minus the compensating balance.) | | | | | | | | | | | | | | | | | | | | | |…...

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