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Chapter 3: 26BP_c (page 252)

Summit Record Company is negotiating with two banks for a \(151,000 loan. Fidelity Bank requires a 28 percent compensating balance, discounts the loan, and wants to be paid back in four quarterly payments. Southwest Bank requires a 14 percent compensating balance, does not discount the loan, but wants to be paid back in 12 monthly installments. The stated rate for both banks is 10 percent. Compensating balances will be subtracted from the \)151,000 in determining the available funds in part a.

c. Does your choice of banks change if the assumption in part b is correct?

Short Answer

Expert verified

The decision does not change as the effective interest rate offered by Southwest bank is low in both parts a and b.

Step by step solution

01

Calculation of effective interest rate on the loan taken from Fidelity bank

The effective interest rate is 31.83%.

Effectiveinterestrate=2脳Annualnumberofpayments脳InterestrateTotalnumberofpayments+1脳Principal-Interestpayable=2脳4脳$15,1004+1脳$151,000-$15,100=$120,800$379,500=31.83%

02

Calculation of effective interest rate on the loan taken from Southwest bank

The effective interest rate is 18.46%.

Effectiveinterestrate=2脳Annualnumberofpayments脳InterestrateTotalnumberofpayments+1脳Principal=2脳12脳$15,10012+1脳$151,000=$362,400$1,963,000=18.46%

03

Decision regarding the bank from which the loan should be taken

Fidelity bank offers the loan at an effective interest rate of 31.83% whereas Southwest bank has an effective interest rate of 18.46%. The company should borrow funds from Southwest bank.

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Most popular questions from this chapter

What are three quantitative measures that can be applied to the collection policy of the firm?

Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in the right-hand portion of Table 6-6.

1-year T bill at the beginning of year 1

5%

1-year T bill at the beginning of year 2

8%

1-year T bill at the beginning of year 3

7%

1-year T bill at the beginning of year 4

10%

Tobin Supplies Company expects sales next year to be \(500,000. Inventory and accounts receivable will increase \)90,000 to accommodate this sales level. The company has a steady profit margin of 12 percent with a 40 percent dividend pay-out. How much external financing will Tobin Supplies Company have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing.

A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain.

City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers so the firm鈥檚 checks will take longer to clear the bank. Collection time has been reduced by two days and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yielding 12 percent per annum.

a. If City Farm has \(5 million per day in collections and \)3 million per day in disbursements, how many dollars has the cash management system freed up?
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