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.

Required

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

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.

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?

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?