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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Midland

...1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations? Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta figures. In order to properly assess the cost of capital for Midland’s divisions, Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average of these estimates to derive a beta estimate for divisional beta estimates (pg.6). 2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why? Midland’s corporate WACC is 9.17%. Please see exhibit 1 for supporting calculations. The risk-free rate for 2006 came from the Department of Treasury’s......

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