In 2022, Sam Fenton was extremely pleased to view the online Globe and Mail and see that the prime rate had fallen to 6 percent. As vice-president of finance for Pierce Control Systems, he knew he has to refinance some major long-term debt coming due and he wanted to consider all possible options.

Pierce Control Systems is a manufacturer of material handling, accessory, and control equipment for the printing industry. Pierce’s products are designed to improve the productivity and cost-efficiency of printing presses. Products include automatic cleaning systems, fountain solution and ink control systems, press and web control systems, and web and material handling systems. The business started eleven years ago and over the past decade has grown to a sales volume of $40 million.

Sam Fenton joined the company three years after its startup. After eight years with Pierce Control System, he was promoted to vice president of finance in 2022.

The Financing Decision

With $10 million in debt coming due, Sam is considering two options. One is to reborrow the money on a five-year basis with Empire Life 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 for the next five years. 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 Montreal 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, 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 balances on 10 percent of the loan outstanding, the interest rate charge would be reduced to ½ percent below prime, or to 5 ½ percent. Clearly, there is a financial advantage to borrowing the money short term, but Sam also knows that the prime interest rate could be quite volatile and had reached 20 percent back in 1981. He would look pretty foolish to his boss, if he were being forced to pay that kind of interest at some point in the future.

Sam Fenton is also concerned about the danger of a future credit crunch in the economy, as was witnessed 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 ½ 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 terms of total dollar interest payments for one year and compare the two answers.
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 purposes of this question.) How does this compare to the total dollar cost of the five-year, 8 percent insurance company loan?
Year	Projected Prime Interest Rate
2023	6%
2024	8%
2025	9%
2026	9%
2027	4%
Assume the bank offered a 5 ½% rate and no compensating balance if the interest on the loan was paid at the beginning of the year. Would the rate on this loan be more or less than the 6 percent prime rate loan on $10 million?

Answer rating: 100% (QA)

To determine whether the rate on the loan offered by the bank at 55 would be more or less than the 6 prime rate loan on 10 million we first need to ca... View the full answer