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Charles Smith recently was hired as president of Dellvoe Office Equipment Inc., a small manufacturer of...

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, nad assume also that Dellvoe has $100,000 of cash balances that it normally holds for transactions purposes, which can be used as part of the required compensating balance.

A. How does this affect the size of the required loan?

B. and the EAR of the loan?

Dellvoe is considering using secured short-term financing.

C. What is a secured loan?

D.What two types of current assets can be used to secure loans?

Solutions

Expert Solution

Ans A. Clause of compensating balance imposed by bank effectively reduces the available amount for use to the borrower.

Since, in this case bank has a compensating balance of 20% of %800,000 i.e. $160000 it effectively reduces the available loan amount for use to Dellvoe i.e. Dellvoe can utilize only upto 80% of loan amount i.e. $640000 for their requirement.

Ans B. Since, clause of compensating balance reduces the amount available for borrower use, it increases the EAR.

Assumingly, Dellvoe borrows full $800000, interest charged to Dellvoe is 7% * 800000 i.e. $56000

But available finance amount is only $640000

Hence, EAR = $56000 / $640000 = .0875 or 8.75%

So EAR for Dellvoe increases to 8.75% from 7%

Ans C. A Secured Loan is a loan backed by some asset i.e. a loan for which a collateral is provided to lender. For example, a Mortgage loan or a Loan Against Property are secured loans as property is provided to lender as collateral.

Ans D. Current Assets which can be used to secure loans:

  1. Inventory
  2. Account receivables

jeff jeffy answered 2 years ago
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