Pierce Control Systems

With $10 million in debt coming due, Sam Fenton was considering two options. One was to reborrow the money on a five year basis with Prudential Insurance Company, a major lender to emerging firms. The loan would carry a flat 8 percent rate over the next five years. The principal would be due at the end of the life of the loan.

Sam considered the first option described above as relatively long term in nature. It would ensure that the firm would have adequate financing through 2021. A second option would be to borrow the money from a bank on a short term basis. Although banks normally lend funds for 90 to 180 day periods, he intended to ask for a one-year loan. He then would renew the loan each year over the five-year period. The loan officer at Bank of America told Sam that the bank always floats the interest rate on its loans with the prime interest rate. Right now, the prime interest rate was 6 percent or a full 2 percent less than the rate Sam would have to pay on the longer-term insurance company loan.

Furthermore, If Sam maintained compensating balance on 10 percent of the loan outstanding, the interest rate charge would be reduced to percent below prime, or to 5 percent. Clearly, there appeared to be a financial advantage to borrowing the money short term, but Sam also remembered that the prime interest rate could be quite volatile and had reached 20 percent back in 1981. He would look pretty foolish tom his boss. William Pierce III, if he were being forced to pay that kind of interest at some point in the future.

Sam Fenton was also concerned about the danger of a future credit crunch in the economy, as was witness in 2007 and 2008. At times banks become very hesitant to make loans because of an overabundance of bad loans already on their books and fears of federal regulators criticizing them. This is particularly true when the economy is in a recession and bank loan officers are fearful about future business conditions.

1.Based on the 10 percent compensating balance requirement, how much would Pierce Control Systems have to borrow to acquire $10 million in needed funds?

2.Would the cost of the bank loan with the 10 percent compensating balance requirement and a 5 percent rate applied to the total loan outstanding be more or less than the 6 percent prime rate loan on $10 million? Work this in term of total dollar interest payment and compare the two answers.

3. What if 4 percent interest could be earned on all funds kept in excess of the $10 million under the compensating balance loan arrangement? What would be the net dollar interest cost of the compensating balance loan arrangement? How does this compare to the 6 percent prime interest rate loan total dollar cost?

4. Based on the difference between the 6 percent prime (short-term) interest rate charged by the bank and the 8 percent longer-term interest rate charged by the insurance company, what does this tell you about the likely current shape of the term structure of interest rate? Based on the expectations hypothesis, what might you infer is the next most likely move in interest rates?

5.Assume the following projected interest rates for the prime rate over the next five years, what would be the total interest cost on the $10 million loan over that period? (Disregard the compensating balance alternative for purpose of this question.) How does this compare to the total dollar cost of the five-year, 8 percent insurance company loan?

Projected Prime

Year Interest Rate

2017 6%

2018 8%

2019 9%

2020 9%

2021 4%

6. As a second scenario. assume the prime rate would move more dramatically, as shown below:

Projected Prime

Year Interest Rate

2017 6%

2018 10%

2019 15%

2020 13%

2021 13%

What would be the total dollar cost under the five-year bank loan? How does this compare to the total dollar cost of the five-year insurance company loan?

7. With a probability of 70 percent of the interest rate scenario in question 5 and a 30 percent probability of the interest rate scenario in questions 6, what is the expected value of the dollar interest cost of short-term borrowing? Is this higher or lower than the total dollar interest cost of tge five-year insurance company loan?

8. At what relative probability between the two scenarious would the firm be indifferent between short-term and long-term borrowing?

9. Briefly explain how hedging can help the firm reduce the risk associated with the short-term borrowing arrangement.