"8-24. Solution:Thornton Pipe and Steel Companya. Sales price, December Treasury bond contract(Sale takes place in July) 5 × $105,000 =$525,000Purchase price, December Treasury bond contract(10% price decline).9 × $105,000 = $ 94,500 New Price of T-Bond5 × $94,000 = $472,500Value of 5 T-Bond ContractsSold 5 T-Bond Contracts in July at $525,000Purchased 5 T-Bond Contracts in December at $472,500Profit on futures contracts $52,500b. A profit took place because the value of the bond went downdue to increasing rates. This meant the subsequent price wasless than the initial sales price.c. Increased interest cost $60,800Profit from hedging 52,500Net cost $8,300Net Cost $8,300 = =13.65% Increased interest cost $60,800 The net cost is 13.65%. This means 86.35% of the increasedinterest cost was hedged away.d. If interest rates went down, there would be a loss on thefutures contracts. The lower interest rates would lead tohigher bond prices and a purchase price that exceeded theoriginal sales price.S8-26 COMPREHENSIVE PROBLEMComprehensive Problem 8-1.Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The small chemicalcompany needs to borrow $500,000.The bank offers a rate of 8 ¼percent with a 20 percent compensating balance requirement, or asan alternative, 9¾ percent with additional fees of $5,500 to cover services the bank is providing.In either case the rate on the loan is floating (changes as the prime interest rate changes). The loan would be for one year.a. Which loan carries the lower effective rate? Consider fees to be the equivalent of otherinterest.b. If the loan with a 20 percent compensating balance requirement were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowedminus the compensating balance.)c. Assume the proceeds from the loan with the compensating balance requirement will be usedto take cash discounts. Disregard part b about installment payments and use the loan costfrom part a.If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds to take thediscount?d. Assume the firm actually takes 80 days to pay its bills and would continue to do so in thefuture if it did not take the cash discount. Should the company take the cash discount?e. Because the interest rate on the loans is floating, it can go up as interest rates go up. Assumethat the prime rate goes up by 2 percent and the quoted rate on the loan goes up the sameamount. 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, the Midland ChemicalCo. decides to hedge its position in the futures market. Assume it sells $500,000 worth of12-month futures contracts on Treasury bonds. One year later, interest rates go up 2 percentacross the board and the Treasury bond futures have gone down to $488,000. Has the firmeffectively hedged the 2 percent increase in interest rates on the bank loan as described inpart e? Determine the answer in dollar amounts.S8-27 CP 8-1. Solution:Midland Chemical Co.a. Compensating Balance Loan$500,0008.25% $41,250 Interest $500,000 Loan100,000 20% compensating balance requirement$400,000 Available fundsInterest $41,250 Effective rate = = =10.312%Available funds 400,000 Fee-added Loan$500,000 9.75% $ 48,750 InterestInterest plus fees$48,750 Interest 5,500 Fees$ 54,250 Interest plus fees $54,250 Effective rate = = =10.850%Loan 500,000 The loan with the compensating requirement has the lowereffective cost (10.312% vs 10.850%).S8-28 CP 8-1. (Continued)b.2× annual no. payments×interest Effective rate on = installment loan total no. of payments + 1 × principal ( ) 2×× 12 $41,250 $990,000 = =12+× 1 $400,000 5,200,000 ( ) = 19.038% Discount Percent Cost of failing to c.= take a cash discount100 percent - Discount percent 360 ×Final due date - Discount Period 1.5% 360 = × 98.5% 50 -10 =1.52%×= 9 13.680% The cost of not taking the cash discount is greater than thecost of the loan (13.680% vs. 10.312%) so the firm shouldtake the cash discount.d. If the firm is going to take 80 days to pay if it does takethe cash discount, then it is keeping the money for an extra 70 days.The cost of not taking the cash discount and keeping themoney for 70 more days is:1.5% 360 = ×=1.52%×5.14= 7.813%98.5% 70 The cost of not taking the cash discount is less than thecost of the loan (7.183% vs. 10.312%) so the firm shouldnot take the cash discount.S8-29 CP 8-1. (Continued)e. 500,00010.25%$51,250 InterestInterest $51,250 Effective rate = = =12.813%Available funds 400,000 f. Profit on Treasury BondsSale price, Treasury bonds $500,000Price price, Treasury bonds 488,000Profit on futures contract $12,000Extra interest cost$500,000 × 2% = $ 10,000The firm effectively hedged its position as the gain on theTreasury bond futures contract has more than offset thetwo percent increase in the cost of the loan.(Note a simplifying assumption in this example is thatTreasury bond rates and the prime rate are moving by themagnitude. This is necessary to keep the problemreasonably workable.)S8-30 "