Pierce Control Systems Case 9
Bank Financing
Purpose: The case allows the student to compare the cost of floating rate bank financing with longer-term
fixed rate financing. The relative cost of each under different economic scenarios is considered and
expected values are computed. There is also a brief consideration of the term structure of interest rates
and the expectations hypothesis. Another feature is that the student considers the trade-off between
compensating balance requirements and lower quoted interest rates.
Relation to Text: The case draws on material from both Chapter 6 and Chapter 8 and should follow
Chapter 8.
Complexity: This case is reasonably straightforward and requires 30-45 minutes to solve.
Pierce Control Systems
Solutions
Amount needed
1. Amount to be borrowed (1 )
$10,000,000
(1 .1)
$10,000,000 $11,111,111
.9
C
=–
=–
= =
2. $11,111,111 Loan requirement with compensating balance
.055 (prime rate minus 1/2%)
$ 611,111 Interest cost on loan with compensating balance
OR
3. $11,111,111 Compensating balance loan
–10,000,000 Actual funds needed
$ 1,111,111 Compensating balances
4% Interest rate earned
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4. The term structure of interest rate curve is upward sloping. Under the expectations hypothesis, this
would indicate that the next major move in interest rates is likely to be upward.
Long-term rates reflect the average of expected short-term rates.
5. Total interest cost with borrowing at prime over the next five years.
Short-Term Projected
Year Amount Interest Rate Interest Cost
2017 $10,000,000 6% $ 600,000
$3,600,000
Total interest cost of the five year, 8% insurance company loan.
6. Total interest cost with borrowing at prime over the next five years (Second Scenario).
Short-Term Projected
Year Amount Interest Rate Interest Cost
2017 $10,000,000 6% $ 600,000
$5,700,000
7. Expected Value of Scenarios
Outcome Probability
Expected
Value
$4,230,000
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of McGraw-Hill Education.
8. Probability of the scenarios that produces an indifference point between short-term and long-term
borrowing. Scenario 1 outcome (X) + Scenario 2 outcome (1 – X) = Interest cost under long-term
borrowing.
Note: X represents the probability of the outcome.
Thus