Question

​(Cost of​ short-term financing​) The R. Morin Construction Company needs to borrow $80,000 to help finance the cost of a new $112,000 hydraulic crane used in the​ firm's commercial construction business. The crane will pay for itself in 1​ year, and the firm is considering the following alternatives for financing its​ purchase:

Alternative A—The ​firm's bank has agreed to lend the $80,000 at a rate of 13 percent. Interest would be​ discounted, and a 16 percent compensating balance would be required.​ However, the​ compensating-balance requirement would not be binding on R. Morin because the firm normally maintains a minimum demand deposit​ (checking account) balance of $20,000 in the bank.

Alternative B—The equipment dealer has agreed to finance the equipment with a​ 1-year loan. The $80,000 loan would require payment of principal and interest totaling $93,824.

a. Which alternative should R. Morin​ select? What would the cost of Alternative A be? What would the cost of Alternative B be?

b. If the​ bank's compensating-balance requirement were to necessitate idle demand deposits equal to 16 percent of the​ loan, what effect would this have on the cost of the bank loan​ alternative?

Answer 1