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Compensating Balances

Compensating Balances. Suppose that Dynamic Sofa (a subsidiary of Dynamic Mattress) has a line of credit with a stated interest rate of 10 percent and a compensating balance of 25 percent. The compensating balance earns no interest.

a. If the firm needs $10,000, how much will it need to borrow?

b. Suppose that Dynamic`s bank offers to forget about the compensating balance requirement if the firm pays interest at a rate of 12 percent. Should the firm accept this offer?

Why or why not?

c. Redo part (b) if the compensating balance pays interest of 4 percent. Warning: You cannot use the formula in the material for the effective interest rate when the compensating balance pays interest. Think about how to measure the effective interest rate on this loan.

9. Compensating Balances. The stated bank loan rate is 8 percent, but the loan requires a compensating balance of 10 percent on which no interest is earned. What is the effective interest rate on the loan? What happens to the effective rate if the compensating balance is doubled to 20 percent?

10. Factoring. A firm sells its accounts receivables to a factor at a 1.5 percent discount. The average collection period is 1 month. What is the implicit effective annual interest rate on the factoring arrangement? Suppose the average collection period is 1.5 months. How does this affect the implicit effective annual interest rate?

11. Discount Loan. A discount bank loan has a quoted annual rate of 6 percent.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one payment at the end of the year?

b. What is the effective rate of interest if the loan is for 1 month?

12. Compensating Balances. A bank loan has a quoted annual rate of 6 percent. However, the borrower must maintain a balance of 25 percent of the amount of the loan, and the balance does not earn any interest.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one payment at the end of the year?

b. What is the effective rate of interest if the loan is for 1 month?

13. Forecasting Collections. Here is a forecast of sales by National Bromide for the first 4 months of 2001 (figures in thousands of dollars):

On average, 50 percent of credit sales are paid for in the current month, 30 percent in the next month, and the remainder in the month after that. What are expected cash collections in months 3 and 4?

14. Forecasting Payments. If a firm pays its bills with a 30-day delay, what fraction of its purchases will be paid for in the current quarter? In the following quarter? What if its payment delay is 60 days?

15. Short-Term Planning. Paymore Products places orders for goods equal to 75 percent of its sales forecast in the next quarter. What will be orders in each quarter of the year if the sales forecasts for the next five quarters are:

16. Forecasting Payments. Calculate Paymore`s cash payments to its suppliers under the assumption that the firm pays for its goods with a 1- month delay. Therefore, on average, twothirds of purchases are paid for in the quarter that they are purchased and one-third are paid in the following quarter.

17. Forecasting Collections. Now suppose that Paymore`s customers pay their bills with a 2- month delay. What is the forecast for Paymore`s cash receipts in each quarter of the coming year? Assume that sales in the last quarter of the previous year were $336.

18. Forecasting Net Cash Flow. Assuming that Paymore`s labor and administrative expenses are $65 per quarter and that interest on long-term debt is $40 per quarter, work out the net cash inflow for Paymore for the coming year using a table like Table 2.7.

19. Short-Term Financing Requirements. Suppose that Paymore`s cash balance at the start of the first quarter is $40 and its minimum acceptable cash balance is $30. Work out the shortterm financing requirements for the firm in the coming year using a table like Table 2.8. The

firm pays no dividends.

20. Short-Term Financing Plan. Now assume that Paymore can borrow up to $100 from a line of credit at an interest rate of 2 percent per quarter. Prepare a short-term financing plan. Use Table 2.9 to guide your answer.

21. Short-Term Plan. Recalculate Dynamic Mattress`s financing plan (Table 2.9) assuming that the firm wishes to maintain a minimum cash balance of $10 million instead of $5 million. Assume the firm can convince the bank to extend its line of credit to $45 million. 22. Sources and Uses of Cash. The accompanying tables show Dynamic Mattress`s year-end 1998 balance sheet and its income statement for 1999. Use these tables (and Table 2.3) to work out a statement of sources and uses of cash for 1999.