Charles Smith recently was hired as president of Dellvoe Office Equipment Inc., a small manufacturer of metal office equipment. As his assistant, you have been asked to review the company’s short-term financing policies and to prepare a report for Smith and the board of directors. To help you get started, Smith has prepared some questions that, when answered, will give him a better idea of the company’s short-term financing policies. In discussing a possible loan with the firm’s banker, Smith found that the bank is willing to lend Dellvoe up to $800,000 for one year at a 9% simple, or quoted, rate. However, he forgot to ask what the specific terms would be.
Now assume that the bank charges simple interest, but it requires the firm to maintain a 20% compensating balance.
A. How much must Dellvoe borrow to obtain its needed $800,000 and to meet the compensating balance requirement?
B. What is the EAR on the loan?
Now assume that the bank charges discount interest of 9% and also requires a compensating balance of 20%.
C. How much must Dellvoe borrow, and
D. What is the EAR under these terms?