Vitra Glass Company needs to borrow $150,000 to help finance the cost of a new $225,000 kiln to be used in the production of glass bottles. The kiln will pay for itself in one year and the firm is considering the following alternatives for financing its purchase:
Alternative A-The firm's bank has agreed to lend the $150,000 for one year at a rate of 15%. Interest would be discounted, and a 16% compensating balance would be required. However, the compensating balance requirement would not be binding on Vitra, because the firm normally maintains a minimum demand deposit (checking account) balance of $25,000 in the bank.
Alternative B-The kiln dealer has agreed to finance the equipment with a one-year loan. The $150,000 loan would require payment of principal and interest totaling $163,000.
a. Which alternative should Vitra select?
b. If the bank's compensating balance requirement were to necessitate idle demand deposits equal to 16% of the loan, what effect would this have on the cost of the bank loan alternative?