Cost of short-term financing


18-7A (Cost of short-term financing) The R. Morin Construction Company needs to borrow $100,000 to help finance a new $150,000 hydraulic crane used in the firm’s commercial construction business. The crane will pay for itself in one year. The firm is considering the following alternatives for financing its purchase:

Alternative A—
The firm’s bank has agreed to lend the $100,000 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 $25,000 in the bank.

Alternative B—
The equipment dealer has agreed to finance the equipment with a one-year loan. The $100,000 loan would require payment of principal and interest totaling $116,300 at year end.

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?