Question

​(Cost of​ short-term financing​) The R. Morin Construction Company needs to borrow ​$80 comma 000 to help finance the cost of a new ​$112 comma 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 Along dashThe ​firm's bank has agreed to lend the ​$80 comma 000 at a rate of 14 percent. Interest would be​ discounted, and a 15 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 comma 000 in the bank. Alternative Blong dashThe equipment dealer has agreed to finance the equipment with a​ 1-year loan. The ​$80 comma 000 loan would require payment of principal and interest totaling ​$92 comma 456.

a. Which alternative should R. Morin​ select?

b. If the​ bank's compensating-balance requirement were to necessitate idle demand deposits equal to 15 percent of the​ loan, what effect would this have on the cost of the bank loan​ alternative?

Answer 1