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$800,000. The compensating balance requirement on outstanding loans is 14 percent, and 8

percent on the unused credit line. The company borrows $500,000at a 20 percent interest rate.

( a ) What is the required compensating balance? ( 6 )What is the effective interest rate?

[CHAP. 5

SHORT-TERM FINANCING

144

SOLUTION

The required compensating balance is:

(a)

$70,000

Loan 0.14 X $500,000

24000

Unused credit 0.08 X $300,000

$94,000

- $500,000- $94,000- $lOO,OOO

0.20 x $500,OOO --=

interest 24.6yo

Effective interest rate =

=

$406,000

proceeds

Average Loan Balance. Wise Corporation borrows $70,000 payable in 12 monthly installments.

5.10

The interest rate is 15 percent. ( a )What is the average loan balance? (6) What is the effective

interest rate?

SOLUTION

- $35,000

$709000=

Average loan balance 2

=

0.15X $70,000- $ O

WO

--= 3oyo

Effective interest rate =

$35,000 $35,000

Average Loan Balance. Assume the same information as in Problem 5.10, except that the loan

5.11

is on a discount basis. ( a ) What is the average loan balance? (6) What is the effective interest

rate?

SOLUTION

Proceeds = $70,000- $10,500 = $59,500

(4

- $29,750

= $59

Average loan balance =

2

$10 500

- 35.3%

Effective interest rate =

=

$29,750

51

.2 Commercial Paper. Boston Corporationâ€™s balance sheet follows:

ASSETS

$ 700,000

Current assets

1.600.000

Fixed assets

$2,300,000

Total assets

LIABILITIES AND

STOCKHOLDERSâ€™ EQUITY

Current liabilities

$ 500,000

Bank loans payable

Commercial paper 100,000

$ 600,000

Total current liabilities

Long-term liabilities 300,000

$ 900,000

Total liabilities

Stockholdersâ€™ equity 1,400,000

Total liabilities and

stockholdersâ€™ equity $2,300,000

145

SHORT-TERM FINANCING

CHAP. 51

The company has an excellent credit rating and can issue additional commercial paper if it

wishes. Should Boston Corporation issue additional commercial paper?

SOLUTl0N

Yes. Commercial paper is a low percentage of current liabilities, 16.7 percent ($100,000/$600,0o0), and

of total liabilities, 11.1percent ($1OO,OOO/$9OO,OOO).Since the cost of commercial paper is less than a bank

loan and since the percentage of commercial paper to total debt financing is low, additional commercial

paper should be issued.

51

.3 Cost of Commercial Paper. Nelson Corporation issues $800,000 of commercial paper every 3

months at a 16 percent rate. Each issuance involves a placement cost of $2,000. What is the annual

percentage cost of the commercial paper?

SOLUTION

Interest ($8OO,OOO X 0.16) $WOO0

Placement cost ($2,000 X 4) 8,OOo

Total cost $136,000

$136,000

- 17.0%

Cost of commercial paper = =

$800,000

Cost of Commercial Paper. Cho Corporation issues $500,000, percent, 120-day commercial

20

5.14

paper. However, the funds are needed for only 90 days. The excess funds can be invested in

securities earning 19 percent. The brokerage fee for the marketable security transaction is 1.0

percent. What is the net cost to the company for issuing the commercial paper?

SOLUTION

Interest [0.20X $500,0oO X (120/360)] $33,333

Brokerage fee (0.01 X $500,000) 5,000

Total cost $38,333

Less: Return on marketable securities

[0.19 x $500,000x (30/360)] 7,917

Net cost $30,416

Financing Strategy. Johnson Company expects that it will need $600,000 cash for March 19x2.

5.15

Possible means of financing are: ( a )Establish a 1-year credit line for $600,000.The bank requires

a 2 percent commitment fee. The interest rate is 21 percent. Funds are needed for 30 days. (6)

Fail to take a 2/10, net140 discount on a $600,O00 credit purchase. (c) Issue $600,000,20 percent

commercial paper for 30 days. Which financing strategy should be selected?

SOLUTION

(a) The credit line cost is:

Commitment fee [0.02X $600,000X (11/12)] $11,O00

Interest [0.21 X $600,000 X (1/12)] 10,500

Total cost

The cost of not taking discount is:

(b)

0.02 x $6oo,oO0 = $12,000

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