Chapter 8

Discussion Questions
8-1. Under what circumstances would it be advisable to borrow money to take a
cash discount?
It is advisable to borrow in order to take a cash discount when the cost of
borrowing is less than the cost of foregoing the discount. If it cost us
36 ercent to miss a discount! we would be much better off finding an
alternate source of funds for 8 to 1" ercent.
8-#. $iscuss the relative use of credit between large and small firms. %hich grou
is generally in the net creditor osition! and why?
&arger firms tend to be in a net creditor osition because they have the
financial resources to be suliers to credit. 'he smaller firm must look to the
larger manufacturer or wholesaler to hel carry the firm(s financing
re)uirements.
8-3. *ow have new banking laws influenced cometition?
+ew banking laws allowed more cometition and gave banks the right to
e,and across state lines to create larger! more cometitive markets.
'hey also increased bank mergers.
8--. %hat is the rime interest rate? *ow does the average bank customer fare
in regard to the rime interest rate?
'he rime rate is the rate that a bank charges its most creditworthy customers.
'he average customer can e,ect to ay one or two ercent .or more/ above
rime.
8-0. %hat does &I123 mean? Is &I123 normally higher or lower than the
U.4. rime interest rate?
&I123 stands for &ondon Interbank 2ffered 3ate. 5s indicated in
6igure 8-1! it is consistently below the rime rate.
48-1
8-6. %hat advantages do comensating balances have for banks? 5re the
advantages to banks necessarily disadvantages to cororations?
'he use of a comensating balance or minimum re)uired account balance
allows the banker to generate a higher return on a loan because not all funds
are actually made available to the borrower. 5 71#0!""" loan with a 7#0!"""
comensating balance re)uirement means only 71""!""" is being rovided
on a net basis. 'his benefit to the lender need not be a disadvantage to the
borrower. 'he borrower may! in turn! receive a lower )uoted interest rate and
certain gratuitous services because of the comensating balance
re)uirement.
8-8. 5 borrower is often confronted with a stated interest rate and an effective
interest rate. %hat is the difference! and which one should the
financial manager recogni9e as the true cost of borrowing?
'he stated interest rate is the ercentage rate unad:usted for time or method
of reayment. 'he effective interest rate is the true rate and considers all
these variables. 5 0 ercent stated rate for ;" days rovides a #" ercent
effective rate. 'he financial manager should recogni9e the effective rate as
the true cost of borrowing. 'he effective rate is also referred to as the
5<3 .5nnual <ercentage 3ate/.
8-8. =ommercial aer may show u on cororate balance sheets as either
a current asset or a current liability. >,lain this statement.
=ommercial aer can be either urchased or issued by a cororation.
'o the e,tent one cororation urchases another cororation(s commercial
aer as a short-term investment! it is a current asset. =onversely! if a
cororation issues its own commercial aer! it is a current liability.
8-;. %hat are the advantages of commercial aer in comarison with bank
borrowing at the rime rate? %hat is a disadvantage?
In comarison to bank borrowing! commercial aer can generally be issued
at below the rime rate. 6urthermore! there are no comensating balance
re)uirements! though the firm is re)uired to maintain aroved credit lines at
a bank. 6inally! there is a certain degree of restige associated with the
issuance of commercial aer.
'he drawback is that commercial aer may be an uncertain source of funds.
%hen money gets tight or confidence in the commercial aer market
diminishes! funds may not be available. 'here is no loyalty factor such as that
which e,ists between a bank and its best borrowers.
48-#
8-1". %hat is the difference between ledging accounts receivable and factoring
accounts receivable?
<ledging accounts receivable means receivables are used as collateral for a
loan? factoring account receivables means they are sold outright to a finance
comany.
8-11. %hat is an asset-backed ublic offering?
5 ublic offering is backed by an asset .accounts receivable/ as collateral.
>ssentially a firm sells its receivables into the securities markets.
8-1#. 1riefly discuss three tyes of lender control used in inventory financing.
'hree tyes of lender control used in inventory financing are@
a. 1lanket inventory A lien-general claim against inventory or collateral.
+o secific items are marked or designated.
b. 'rust receit A borrower holds the inventory in trust for the lender. >ach
item is marked and has a serial number. %hen the inventory is sold! the trust
receit is canceled and the funds go into the lender(s account.
c. %arehousing A the inventory is hysically identified! segregated! and
stored under the direction of an indeendent warehouse comany that controls
the movement of the goods. If done on the remises of the warehousing firm!
it is termed ublic warehousing. 5n alternate arrangement is field
warehousing whereby the same rocedures are conducted on the borrower(s
roerty.
8-13. %hat is meant by hedging in the financial futures market to offset interest rate
risks?
*edging means to engage in a transaction that artially or fully reduces a rior
risk e,osure. In selling a financial futures contract! if interest rates go u! one
is able to buy back the contract at a rofit. 'his will hel to offset the higher
interest charges to a cororation or other business entity.
48-3
Chapter 8
Problems
1. =omute the cost of not taking the following cash discounts.
a. #B1"! net -".
b. #B10! net 3".
c. #B1"! net -0.
d. 3B1"! net ;".
8-1. Solution:
=ost of not
$iscount C 36"
taking a cashD
1""C $isc.C 6inal due date
discount
$iscount eriod

a.
#C 36"
=ost of
#."-C 1#."" #-.-8C
lost discount
;8C -" 1"
= = =

b.
#C 36"
=ost of
D #."-C #-."" -8.;6C
lost discount
;8C 3" 10
= =

c.
#C 36"
=ost of
D #."-C 1".#; #".;;C
lost discount
;8C -0 1"
= =

d.
3C 36"
=ost of
D 3.";C -.0" 13.;1C
lost discount
;8C ;" 1"
= =

48--
# $elilah(s *aircuts can borrow from its bank at 13 ercent to take a cash discount.
'he terms of the cash discount are #B10! net 00. 4hould the firm borrow the funds?
8.2. Solution:
Delilahs Haircuts
6irst! comute the cost of not taking the cash discount and
comare this figure to the cost of the loan.
=ost of not
$iscountC 36"
taking a cashD
1""C $isc.C final due date discount eriod
discount
#C 36"
;8C 00 10
#."-C ; 18.36C

= =
'he cost of not taking the cash discount is greater than the cost of
the loan .18.36C vs. 13C/. 'he firm should borrow the money
and take the cash discount.
3. Eour bank will lend you 7-!""" for -0 days at a cost of 70" interest. %hat is your effective
rate of interest?
8-3. Solution:
Interest $ays in the year .36"/
>ffective rate D
<rincial $ays loan is outstanding
70" 36"
7-! """ -0
1.#0C 8 1"C

=
= =
48-0
-. Eour bank will lend you 73!""" for 0" days at a cost of 7-0 interest. %hat is your effective
rate of interest?
8-4. Solution:
Interest $ays in the year .36"/
>ffective rate D
<rincial $ays loan is outstanding
7-0 36"
73! """ 0"
1.0C 8.# 1".8"C

=
= =
0. I. F. 1oring borrows 70!""" for one year at 13 ercent interest. %hat is the effective rate
of interest if the loan is discounted?
8-. Solution:
!.". #orin$
Interest $ays er year .36"/
>ffective rate on a
D
discounted loan
<rinc. Int. $ays loan is outstanding
760" 36" 760"
1
70! """ 760" 36" 7-!30"
1-.;-C

= =

=
48-6
6. Ida Gline borrows 78!""" for ;" days and ays 718" interest. %hat is the effective rate of
interest if the loan is discounted?
8-%. Solution:
!&a 'line
Interest $ays er year .36"/
>ffective rate on a
D
discounted loan
<rinc. Int. $ays loan is outstanding
718" 36" 718"
-
78! """ 718" ;" 78!8#"
#.3"C - ;.#"C

= =

= =
8. Fo and =hris(s 4orting Hoods! Inc.! borrows 71-!0"" for #" days at 1# ercent interest.
%hat is the dollar cost of the loan?
Use the formula@
$ollar cost 5mount Interest
$ays loan is outstanding
of loan borrowed rate $ays in the year .36"/
=
8-(. Solution:
"o an& Chris Sportin$ )oo&s
$ollar cost of loan D
$ays loan is outstanding
5mount 1orrowed Interest rate
$ays in the year .36"/

#"
71-! 0"" 1#C
36"
1
71-! 0"" 1#C
18
71-! 0"" .68C 7;8.10
=
=
= =
48-8
8. 4amson 2range Iuice =omany normally takes #" days to ay for its average daily credit
urchases of 76!""". Its average daily sales are 78!"""! and it collects accounts in #8 days.
a. %hat is its net credit osition? 'hat is! comute its accounts receivable and accounts
ayable and subtract the latter from the former.
5ccounts receivable D 5verage daily credit sales J 5verage collection eriod
5ccounts ayable D 5verage daily credit urchases J 5verage ayment eriod
b. If the firm e,tends its average ayment eriod from #" days to 30 days .and all else
remains the same/! what is the firm(s new net credit osition? *as it imroved its
cash flow?
8-8. Solution:
Sampson *ran$e +uice Compan,
a. +et credit osition D accounts receivable A accounts ayable
5verage $aily 5verage
5ccounts rec.D
=redit <urchases <ayment <eriod
71;6! """ 78! """ #8

=
5verage $aily 5verage
5ccounts ayable D
=redit <urchases <ayment <eriod
71#"! """ 76! """ #"

=
+et =redit <osition D 71;6!""" A 71#"!""" D 786!"""
b. 5ccounts 3eceivable will remain at 71;6!"""
5ccounts <ayable D 76!""" J 30 D #1"!"""
+et =redit <osition .7 1-!"""/
'he firm has imroved its cash flow osition. Instead of
e,tending 786!""" more in credit .funds/ than it is receiving!
it has reversed the osition and is the net reciient of
71-!""" in credit.
48-8
;. Fa,im 5ir 6ilters! Inc.! lans to borrow 73""!""" for one year. +ortheast +ational 1ank
will lend the money at 1" ercent interest and re)uires a comensating balance of
#" ercent. %hat is the effective rate of interest?
8--. Solution:
"a.im /ir 0ilters1 !nc.
>ffective rate of interest with #"C comensating balance D
( ) ( )
Interest rate 1"C 1"C
1#.0C
1 = 1 .# .8
= = =

or
Interest $ays of the year .36"/
<rincial =omensating balance $ays loan is outstanding
73"! """ 73"! """
1 1 1#.0C
73""! """ 76"! """ 7#-"! """

= = =

48-;
1". $igital 5ccess! Inc.! needs 7-""!""" in funds for a ro:ect.
a. %ith a comensating balance re)uirement of #" ercent! how much will the firm need
to borrow?
b. Hiven your answer to art a and a stated interest rate of ; ercent on the total amount
borrowed! what is the effective rate on the 7-""!""" actually being used?
8-12. Solution:
Di$ital /ccess1 !nc.
a.
( )
( )
5mount needed
5mount to be borrowed D
1 =
7-""! """ 7-""! """
1 .#" .8"
70""! """

= =

=
b.
70""!""" total amount borrowed
;C Interest rate
7 -0!""" Interest
7-0! """
11.0C
7-""! """
=
48-1"
11. =arey =omany is borrowing 7#""!""" for one year at 1# ercent from 4econd Intrastate
1ank. 'he bank re)uires a #" ercent comensating balance. %hat is the effective rate of
interest? %hat would the effective rate be if =arey were re)uired to make 1# e)ual monthly
ayments to retire the loan? 'he rincial! as used in 6ormula 8A6! refers to funds the firm
can effectively utili9e .5mount borrowed A =omensating balance/.
8-11. Solution:
Care, Compan,
>ffective rate of interest with #"C comensating balance D
Interest $ays in the year .36"/
<rincial =omensating balance $ays loan is outstanding
7#-! """ 36" 7#-! """ 36"
10C
7#""! """ 7-"! """ 36" 716"! """ 36"

= = =

>ffective rate for installment loan with comensating balance

( )
( ) ( )
# 5nnual no. ayments Interest
'otal no. of ayments K 1 <rincial
# 1# 7#-! """
1# 1 7#""! """ 7-"! """
7086! """ 7086! """
#8.6;C
13 716"! """ 7#! "8"! """

=
+
= = =

48-11
1#. =aone =hild =are =enters! Inc.! lans to borrow 7#0"!""" for one year at 1" ercent from
the =hicago 1ank and 'rust =omany. 'here is a #" ercent comensating balance
re)uirement. =aone kees minimum transaction balances of 718!""" in the normal course
of business. 'his idle cash counts toward meeting the comensating balance re)uirement.
%hat is the effective rate of interest?
8-12. Solution:
Capone Chil& Care Centers1 !nc.
>ffective rate of interest D
Interest $ays in the year .36"/
<rincial =omensating balance $ays loan is outstanding
7#0! """ 36" 7#0! """
11.-8C
7#0"! """ 73#! """L 36" 7#18! """

= =

L=omensating 1alance D #"C J #0"!""" D 70"!"""

+ormal 6unds D 18!"""
3estricted =omensating 1alance 73#!"""
48-1#
13. 'he treasurer of +eiman 4uermarkets is seeking a 73"!""" loan for 18" days from
%rigley 1ank and 'rust. 'he stated interest rate is 1" ercent and there is a 10 ercent
comensating balance re)uirement. 'he treasurer always kees a minimum of 7#!0"" in
the firm(s checking account. 'hese funds could count toward meeting any comensating
balance re)uirement. %hat is the effective rate of interest on this loan?
8-13. Solution:
3eiman Supermar4ets
>ffective rate of interest D
InterestL $ays in the year .36"/
<rincial =omensating balance $ays loan is outstanding
71!0"" 36"
0.36C # 1".8#C
73"! """ 7#! """LL 18"

= = =

( )
18"
L 1"C 73"! """ 71! 0""
36"
=
LL=omensating 1alance D 10C J 3"!""" D 7-!0""
+ormal 6unds D #!0""
3estricted =omensating 1alance 7#!"""
48-13
1-. 'ucker $rilling =or. lans to borrow 7#""!""". +orthern +ational 1ank will lend the
money at one-half ercentage oint over the rime rate of 8M ercent .; ercent total/ and
re)uires a comensating balance of #" ercent. <rincial in this case refers to funds that
the firm can effectively use in the business.
%hat is the effective rate of interest? %hat would the effective rate be if 'ucker
$rilling were re)uired to make four )uarterly ayments to retire the loan?
8-14. Solution:
5uc4er Drillin$ Corp.
>ffective rate of interest with #"C comensating balance
D 718!"""B.7#""!""" A 7-"!"""/ D 718!"""B716"!""" D 11.#0C
Installment &oan with comensating balance
( )
# - 718! """
71--! """B 78""! """ 18."C
0 716"! """

= = =

48-1-
10. Eour comany lans to borrow 70 million for 1# months! and your banker gives you a
stated rate of 1- ercent interest. Eou would like to know the effective rate of interest for
the following tyes of loans. .>ach of the following arts stands alone./
a. 4imle 1- ercent interest with a 1" ercent comensating balance.
b. $iscounted interest.
c. 5n installment loan .1# ayments/.
d. $iscounted interest with a 0 ercent comensating balance.
8-1. Solution:
a. 4imle interest with a 1"C comensating balance
78""! """ 78""! """
1 10.06C
70! """! """ 70""! """ 7-! 0""! """
= =

b. $iscounted interest
78""! """ 78""! """
1 16.#8C
70! """! """ 78""! """ 7-! 3""! """
= =

c. 5n installment loan with 1# ayments

# 1# 78""! """ 716! 8""! """
#0.80C
13 70! """! """ 760! """! """

= =

d. $iscounted interest with a 0C comensating balance

78""!"""B.70!"""!""" A 78""!""" A 7#0"!"""/ D 18.#8C
48-10
16. If you borrow 71#!""" at 7;"" interest for one year! what is your effective interest rate for
the following ayment lans?
a. 5nnual ayment.
b. 4emiannual ayments.
c. Nuarterly ayments.
d. Fonthly ayments.
8-1%. Solution:
a. 7;""B71#!""" D 8.0C
Use formula 8-6 for b! c! and d.
3ate on installment loan D
( )
# 5nnual no. of ayments Interest
'otal no. of ayments K 1 <rincial

b. .# J # J 7;""/B.3 J 71#!"""/ D 73!6""B736!""" D 1".""C

c. .# J - J 7;""/B.0 J 71#!"""/ D 78!#""B76"!""" D 1#.""C
d. .# J 1# J 7;""/B.13 J 71#!"""/ D 7#1!6""B7106!""" D 13.80C
48-16
18. Oroom Fotorcycle =omany is borrowing 73"!""" from 6irst 4tate 1ank. 'he total interest
is 7;!""". 'he loan will be aid by making e)ual monthly ayments for the ne,t three
years. %hat is the effective rate of interest on this installment loan?
8-1(. Solution:
6room "otorc,cle Compan,
3ate on installment loan D
( )
( )
# 5nnual no. of ayments Interest
'otal no. of ayments K 1 <rincial
# 1# 7;! """ 7#16! """
1;.-6C
36 1 73"! """ 71!11"! """

= = =
+
18. Fr. <aul <romtly is a very cautious businessman. *is sulier offers trade credit terms of
3B1"! net 8". Fr. <romtly never takes the discount offered! but he ays his suliers in
6" days rather than the 8" days allowed so he is sure the ayments are never late. %hat is
Fr. <romtly(s cost of not taking the cash discount?
8-18. Solution:
Paul Promptl,
$iscount C 36"
=ost of not taking
D
a cash discount
1""C $isc.C <ayment date
$iscount eriod
3C 36"
1""C 3C 6" 1"
3.";C 8.# ##.#0C

=

= =
In this roblem! Fr. <romtly has the use of funds for 0" e,tra
days .6"-1"/! instead of 6" e,tra days .8"-1"/. Fr. <romtly(s
suliers are offering terms of 3B1"! net 8". Fr. <romtly is
effectively acceting terms of 3B1"! net 6".
48-18
1;. 'he 2gden 'imber =omany buys from its suliers on terms of #B1"! net 30. 2gden has
not been utili9ing the discount offered and has been taking 0" days to ay its bills. 'he
suliers seem to accet this ayment attern! and 2gden(s credit rating has not been hurt.
Fr. %ood! 2gden 'imber =omany(s vice-resident! has suggested that the comany
begin to take the discount offered. Fr. %ood rooses that the comany borrow from its
bank at a stated rate of 10 ercent. 'he bank re)uires a #0 ercent comensating balance
on these loans. =urrent account balances would not be available to meet any of this
comensating balance re)uirement. $o you agree with Fr. %ood(s roosal?
8-1-. Solution:
5he *$&en 5imber Compan,
$iscount C 36"
=ost of not taking a cash
D
discount
1""C $isc.C 6inal due date
$iscount eriod
#C 36"
#."-C ; 18.36C
;8C 0" 1"

= = =

%e use 0" days instead of 30 days as the final due date because
2gden(s suliers have effectively made this the due date even
though the stated due date is 30 days.
>ffective rate of interest with a #0C comensating balance
re)uirement@
D Interest rateB.1 A =/
D 10CB.1 A .#0/
D 10CB..80/ D #"C
'he effective cost of the loan! #"C! is more than the cost of
assing u the discount! 18.36C. 2gden 'imber =omany should
continue to ay in 0" days and ass u the discount.
48-18
#". In roblem 1;! if the comensating balance re)uirement were 1" ercent instead of
#0 ercent! would you change your answer? $o the aroriate calculation.
8-22. Solution:
5he *$&en 5ime Compan, 7Continue&8
>ffective rate of interest with a 1"C comensating balance
re)uirement@
( ) ( ) ( )
Interest rate 10C 10C
16.68C
1 = 1 .1 .;
= = = =

'he answer now changes. 'he effective cost of the loan! 16.68C!
is less than the cost of assing u the discount. 2gden 'imber
=omany should borrow the funds and take the discount.
#1. 1osworth <etroleum needs 70""!""" to take a cash discount of #B1"! net 8". 5 banker will
loan the money for 6" days at an interest cost of 78!1"".
a. %hat is the effective rate on the bank loan?
b. *ow much would it cost .in ercentage terms/ if 1osworth did not take the cash
discount! but aid the bill in 8" days instead of 1" days?
c. 4hould 1osworth borrow the money to take the discount?
d. If the banker re)uires a #" ercent comensating balance! how much must 1osworth
borrow to end u with the 70""!"""?
e. %hat would be the effective interest rate in art d if the interest charge for 6" days
were 713!"""? 4hould 1osworth borrow with the #" ercent comensating balance?
.'here are no funds to count against the comensating balance re)uirement./
48-1;
8-21. Solution:
#os9orth Petroleum
a.
78!1"" 36"
>ffective rate of interest D
70""! """ 6"
1.6#C 6 ;.8#C

= =
b.
( )
#C 36"
=ost of lost discount D
;8C 8" 1"
#."-C 6 1#.#-C

= =
c. Ees! because the cost of borrowing is less than the cost of
losing the discount.
d.
( ) ( )
5mount
70""! """ 70""! """ 70""! """
76#0! """ needed to be
1 = 1 .#" .8"
borrowed
= = =

e.
713!""" 36"
>ffective interest rate D
76#0! """ 1#0! """ 6"
713! """
6 #.6C 6 10.6C
70""! """

= = =
+o! do not borrow with a comensating balance of #" ercent
since the effective rate is greater than the savings from taking
the trade discount.
48-#"
##. =olumbus 4hiing =omany is negotiating with two banks for a 71""!""" loan. 1ankcor
of 2hio re)uires a #" ercent comensating balance! discounts the loan! and wants to be
aid back in four )uarterly ayments. =leveland 1ank re)uires a 1" ercent comensating
balance! does not discount the loan! but wants to be aid back in 1# monthly installments.
'he stated rate for both banks is 1" ercent. =omensating balances and any discounts will
be subtracted from the 71""!""" in determining the available funds in art a.
a. %hich loan should =olumbus accet?
b. 3ecomute the effective cost of interest! assuming =olumbus ordinarily maintains
7#"!""" at each bank in deosits that will serve as comensating balances.
c. *ow much did the comensating balances inflate the ercentage interest costs? $oes
your choice of banks change if the assumtion in art b is correct?
8-22. Solution:
Columbus Shippin$ Compan,
a. 1ankcor of 2hio@
( ) ( )
>ffective interest rate
# - 71"! """
D
71""! """ 7#"! """ 71"! """ - 1
78"! """B 730"! """ ##.86C

+
= =
=leveland 1ank@
( ) ( )
>ffective interest rate
# 1# 71"! """
D
71""! """ 71"! """ 1# 1
7#-"! """ B 71!18"! """ #".01C

+
= =
=hoose =leveland 1ank since it has the lowest effective cost.
48-#1
8-22. 7Continue&8
b. 'he numerators stay the same as in art .a/ but the
denominator increases to reflect the use of more money
because balances are already maintained at both banks.
1ankcor of 2hio@
>ffective rateD78"!"""B.71""!""" 71"!"""/ 0D18.88C
=leveland 1ank@
>ffective rate D 7#-"!"""B.71""!""" 13/ D 18.-6C
c. The compensating balance assumption changed interest rates as
follows:
#an4corp Cle:elan&
Interest =ost with =omB1al. ##.86C #".01C
%ithout =omB1al. 18.88C 18.-6C
$ifference in cost 0."8C #."0C
If comensating balances are maintained at both banks in the
normal course of business! then 1ankcor of 2hio(s loan
becomes cheaer than =leveland 1ank(s loan.
48-##
#3. 'e,as 2il 4ulies sells to the 1# accounts listed below.
/:era$e /$e o;
<ecei:able #alance the /ccount o:er
/ccount *utstan&in$ the =ast >ear
5 ................ 7 0"!""" .................... 30 days
1 ................ 8"!""" .................... #0
= ................ 1#"!""" .................... -8
$ ................ 1"!""" .................... 10
> ................ #0"!""" .................... 30
6 ................ 6"!""" .................... 01
H ................ -"!""" .................... 18
* ................ 18"!""" .................... 6"
I ................ 10!""" .................... -3
I ................ #0!""" .................... 33
G ................ #""!""" .................... -1
& ................ 6"!""" .................... #8
IPI 6inancial =ororation will lend ;" ercent against account balances that have
averaged 3" days or less? 8" ercent for account balances between 3" and -" days? and
8" ercent for account balances between -" and -0 days. =ustomers that take over -0 days
to ay their bills are not considered as ade)uate accounts for a loan.
'he current rime rate is 8 ercent! and IPI 6inancial =ororation charges # ercent
over rime to 'e,as 2il 4ulies as its annual loan rate.
a. $etermine the ma,imum loan for which 'e,as 2il 4ulies could )ualify.
b. $etermine how much one month(s interest e,ense would be on the loan balance
determined in art a.
48-#3
8-23. Solution:
5e.as *il Supplies
a. 3-3" days 5mount
1 7 8"!"""
$ 1"!"""
H -"!"""
& 6"!"""
'otal 1;"!"""
loan C ;"C
loan 7181!"""
31--" days 5mount
5 7 0"!"""
> #0"!"""
I #0!"""
'otal 73#0!"""
loanC 8"C
loan 7#6"!"""
-1--0 days 5mount
I 7 10!"""
G #""!"""
'otal 7#10!"""
loan C 8"C
loan 710"!0""
Fa,imum &oan D 7181!""" K 7#6"!""" K 710"!0"" D 7081!0""
b. &oan balances 7 081!0""
Interest! ;C annual ".80C er month
2ne month(s interest 7-!361.#0
48-#-
#-. 'he treasurer for 'hornton <ie and 4teel =omany wishes to use financial futures to
hedge her interest rate e,osure. 4he will sell five 'reasury futures contracts at 71"0!"""
er contract. It is Iuly and the contracts must be closed out in $ecember of this year.
&ong-term interest rates are currently 8.- ercent. If they increase to 8.0 ercent! assume
the value of the contracts will go down by 1" ercent. 5lso if interest rates do increase by
1.1 ercent! assume the firm will have additional interest e,ense on its business loans and
other commitments of 76"!8"". 'his e,ense! of course! will be searate from the futures
contracts.
a. %hat will be the rofit or loss on the futures contract if interest rates go to 8.0
ercent?
b. >,lain why a rofit or loss took lace on the futures contracts.
c. 5fter considering the hedging in art a! what is the net cost to the firm of the
increased interest e,ense of 76"!8""? %hat ercent of this increased cost did the
treasurer effectively hedge away?
d. Indicate whether there would be a rofit or loss on the futures contracts if interest
rates went down.
48-#0
8-24. Solution:
5hornton Pipe an& Steel Compan,
a. 4ales rice! $ecember 'reasury bond contract
.4ale takes lace in Iuly/ 0 J 71"0!""" D 70#0!"""
<urchase rice! $ecember 'reasury bond contract
.1"C rice decline/
.; J 71"0!""" D 7 ;-!0"" +ew <rice of '-1ond
0 J 7;-!""" D 7-8#!0"" Oalue of 0 '-1ond =ontracts
4old 0 '-1ond =ontracts in Iuly at 70#0!"""
<urchased 0 '-1ond =ontracts in $ecember at 7-8#!0""
<rofit on futures contracts 7 0#!0""
b. 5 rofit took lace because the value of the bond went down
due to increasing rates. 'his meant the subse)uent rice was
less than the initial sales rice.
c. Increased interest cost 76"!8""
<rofit from hedging 0#!0""
+et cost 7 8!3""
+et =ost 78! 3""
13.60C
Increased interest cost 76"!8""
= =
'he net cost is 13.60C. 'his means 86.30C of the increased
interest cost was hedged away.
d. If interest rates went down! there would be a loss on the
futures contracts. 'he lower interest rates would lead to
higher bond rices and a urchase rice that e,ceeded the
original sales rice.
48-#6
C*"P<?H?3S!6? P<*#=?"
Comprehensi:e Problem 8-1.
Fidland =hemical =o. is negotiating a loan from Fanhattan 1ank and 'rust. 'he small chemical
comany needs to borrow 70""!""".
'he bank offers a rate of 8 Q ercent with a #" ercent comensating balance re)uirement! or as
an alternative! ;R ercent with additional fees of 70!0"" to cover services the bank is roviding.
In either case the rate on the loan is floating .changes as the rime interest rate changes/.
'he loan would be for one year.
a. %hich loan carries the lower effective rate? =onsider fees to be the e)uivalent of other
interest.
b. If the loan with a #" ercent comensating balance re)uirement were to be aid off in
1# monthly ayments! what would the effective rate be? .<rincial e)uals amount borrowed
minus the comensating balance./
c. 5ssume the roceeds from the loan with the comensating balance re)uirement will be used
to take cash discounts. $isregard art b about installment ayments and use the loan cost
from art a.
If the terms of the cash discount are 1.0B1"! net 0"! should the firm borrow the funds to take the
discount?
d. 5ssume the firm actually takes 8" days to ay its bills and would continue to do so in the
future if it did not take the cash discount. 4hould the comany take the cash discount?
e. 1ecause the interest rate on the loans is floating! it can go u as interest rates go u. 5ssume
that the rime rate goes u by # ercent and the )uoted rate on the loan goes u the same
amount. %hat would then be the effective rate on the loan with comensating balances?
=onvert the interest to dollars as the first ste in your calculation.
f. In order to hedge against the ossible rate increase described in art e! the Fidland =hemical
=o. decides to hedge its osition in the futures market. 5ssume it sells 70""!""" worth of 1#-
month futures contracts on 'reasury bonds. 2ne year later! interest rates go u # ercent
across the board and the 'reasury bond futures have gone down to 7-88!""". *as the firm
effectively hedged the # ercent increase in interest rates on the bank loan as described in
art e? $etermine the answer in dollar amounts.
48-#8
CP 8-1. Solution:
"i&lan& Chemical Co.
a. =omensating 1alance &oan
70""!"""
8.#0C
7 -1!#0" Interest
70""!""" &oan
1""!""" #"C comensating balance re)uirement
7-""!""" 5vailable funds
Interest 7-1! #0"
>ffective rate D 1".31#C
5vailable funds -""! """
= =
6ee-added &oan
70""!"""
;.80C
7 -8!80" Interest
Interest lus fees
7-8!80" Interest
0!0"" 6ees
7 0-!#0"
Interest lus fees 70-! #0"
>ffective rate D 1".80"C
&oan 0""! """
= =
'he loan with the comensating re)uirement has the lower
effective cost .1".31#C vs 1".80"C/.
48-#8
CP 8-1. 7Continue&8
b.
( )
( )
# annual no. ayments interest
>ffective rate on
D
installment loan
total no. of ayments K 1 rincial
# 1# 7-1! #0" 7;;"! """
1# 1 7-""! """ 0! #""! """
1;."38C

= =
+
=
c.
$iscount <ercent
=ost of failing to
D
take a cash discount
1"" ercent $iscount ercent
36"
6inal due date $iscount <eriod
1.0C 36"
;8.0C 0" 1"
1.0#C ; 13.68"C

= =
'he cost of not taking the cash discount is greater than the
cost of the loan .13.68"C vs. 1".31#C/ so the firm should
take the cash discount.
d. If the firm is going to take 8" days to ay if it does take
the cash discount! then it is keeing the money for an
e,tra 8" days.
'he cost of not taking the cash discount and keeing the
money for 8" more days is@
1.0C 36"
1.0#C 0.1- 8.813C
;8.0C 8"
= = =
'he cost of not taking the cash discount is less than the
cost of the loan .8.183C vs. 1".31#C/ so the firm should
not take the cash discount.
48-#;
CP 8-1. 7Continue&8
e. 0""!"""
1".#0C
701!#0" Interest
Interest 701! #0"
>ffective rate D 1#.813C
5vailable funds -""! """
= =
f. <rofit on 'reasury 1onds
4ale rice! 'reasury bonds 70""!"""
<rice rice! 'reasury bonds -88!"""
<rofit on futures contract 7 1#!"""
>,tra interest cost
70""!""" J #C D 7 1"!"""
'he firm effectively hedged its osition as the gain on the
'reasury bond futures contract has more than offset the
two ercent increase in the cost of the loan.
.+ote a simlifying assumtion in this e,amle is that
'reasury bond rates and the rime rate are moving by the
magnitude. 'his is necessary to kee the roblem
reasonably workable./
48-3"