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# c. Assume the proceeds from the loan with the compensating

### Resolved Question:

c. Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about installment payments and use the loan cost from part a.

If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds to take the discount?

d. Assume the firm actually takes 80 days to pay its bills and would continue to do so in the future if it did not take the cash discount. Should it take the cash discount?

e. Because the interest rate on the loans is floating, it can go up as interest rates go up. Assume that the prime rate goes up by 2 percent and the quoted rate on the loan goes up the same amount. What would then be the effective rate on the loan
with compensating balances? Convert the interest to dollars as the first step in your calculation.

f. In order to hedge against the possible rate increase described in part e, Midland decides to hedge its position in the futures market. Assume it sells \$500,000 worth of 12-month futures contracts on Treasury bonds. One year later, interest
rates go up 2 percent across the board and the Treasury bond futures have gone down to \$488,000. Has the firm effectively hedged the 2 percent increase in interest rates on the bank loan as described in part e? Determine the answer in
dollar amounts.
Submitted: 7 years ago.
Category: Finance
Expert:  Milan Vaishnav replied 7 years ago.

Dear Friend,

C. Effective Rate of Cash Discount would be as under:
= [Discount/(100-Discount)]*[360/(Final period-discount period)]
= [1.5/(100-1.5)]*[{360/(50-10)] = 1.52*9 = 13.68%
The cost of not taking the cash discount is greater than the cost of the loan i.e.13.68% vs. 10.31%.

It is advised that the firm should take the cash discount.

D. New effective rate would be as under:

= [1.5/(100-1.5)]*[360/(80-10)] =1.52*5.143 = 7.82%

The cost of not taking the cash discount is less than the cost of the loan i.e. 7.82% vs. 10.31%..

It is thus advised that the firm should not take the cash discount.

E. Interest = \$500,000*10.25% = \$51,250
Effective interest = Interest/Available funds = \$51,250/\$400,000 =12.81%

F. Profit on future contract = Strike price - Exercise price = \$500,000 - \$488,000 = \$12,000
Extra Interest = \$500,000*2% = \$10,000

It is evident that the firm has effective and efficiently managed to hedge the position as the gains on the bonds (treasury) bonds futures was more. Thus it has offsetted the 2% increase in the cost of funds.

I hope the above helps...

Regards,