WEB APPENDIX 16B

Short-Term Loans and Bank Financing

Chapter 16 discussed two common methods of calculating bank interest charges:
regular, or simple, interest and add-on interest. However, depending on the
nature of the lender and the borrower’s creditworthiness, other loan interest
arrangements may be used. This Web Appendix outlines two such loan interest
structures: discount interest and compensating balances.

Discount Interest
In a discount interest loan, the bank deducts the interest in advance (discounts the Discount Interest
loan). Thus, the borrower receives less than the face value of the loan. On a 1-year Interest that is calculated
$10,000 loan with a 12% (nominal) rate, discount basis, the interest is $10,000(0.12) ¼ on the face amount
$1,200. Therefore, the borrower obtains the use of only $10,000
$1,200 ¼ $8,800. If of a loan but is paid
in advance.
the loan was for less than a year, the interest charge (the discount) would be lower.
In our example, it would be $600 if the loan was for 6 months; hence, the amount
received would be $9,400.
The effective rate on a discount loan is always higher than the rate on an oth-
erwise similar simple interest loan. To illustrate, consider the situation for a 1-year
$10,000 loan with a 12% nominal annual rate, discount basis.
Discount interest, paid annually:
With a financial calculator, enter N ¼ 1, PV ¼ 8800, PMT ¼ 0, and FV ¼
10000; then
press I/YR to get the effective cost of the loan, 13.64%.1
Now consider the situation for a 3-month $10,000 loan with a 12% nominal
annual rate, discount basis.
Discount interest, one quarter:
Enter N ¼ 1, PV ¼ 9700, PMT ¼ 0, and FV ¼
10000; then press I/YR to find the
periodic rate, 3.092784% per quarter, which corresponds to an effective annual rate of
12.96%. Thus, shortening the period of a discount loan lowers the effective rate of
interest. This occurs because there is a delay in paying interest relative to the longer-
term discount loan ($300 paid each quarter rather than $1,200 paid up front).

1
Note that the firm actually receives less than the face amount of the loan.

Funds received ¼ Face amount of loanð1:0
Nominal interest rateÞ

We can solve for the face amount by using the following equation:

Funds received
Face amount of loan ¼
1:0
Nominal rate ðDecimalÞ

Therefore, if the borrowing firm actually requires $10,000 of cash, it must borrow $11,363.64.

$10,000 $10,000
Face value ¼ ¼ ¼ $11,363:64
1:0
0:12 0:88

Now the borrower will receive $11,363.64
0.12($11,363.64) ¼ $10,000. Increasing the face value of the loan does
not change the effective rate of 13.64% on the $10,000 of usable funds.

16B-1
16B-2 Web Appendix 16B

Compensating Balances
If the bank requires a compensating balance and if the amount of the required
balance exceeds the amount the firm would normally hold on deposit, the excess
must be deducted at t ¼ 0 and added back when the loan matures. This has the
effect of raising the effective rate on the loan. To illustrate, the setup for a 1-year
$10,000, 12% nominal annual rate, discount-basis loan with a 20% compensating
balance (that the firm would not otherwise hold on deposit) is shown here:
Discount interest, paid annually, with 20% compensating balance:

0 1

þ10,000
10,000

1,200 (Discount interest) + 2,000 (Compensating balance)
–2,000 (Compensating balance) – 8,000 (Loan payment)
6,800 (Funds available)

Note that the bank initially gives (and the borrower receives) $10,000 at time 0.
However, the bank takes out the $1,200 of interest in advance, and the company
must leave $2,000 in the bank as a compensating balance; hence, the borrower’s
effective net cash flow at t ¼ 0 is $6,800. At t ¼ 1, the borrower must repay the
$10,000, but $2,000 is already in the bank (the compensating balance); so the
borrower must repay a net amount of $8,000. Thus, the funds available from the
loan can be found with the following equation:
     
Funds Face Face Interest Face Compensating
available ¼


value value rate value balance%
 
Face Interest Compensating
16B-1 ¼ 1


value rate balance%

With a financial calculator, enter N ¼ 1, PV ¼ 6800, PMT ¼ 0, and FV ¼
8000;

then press I/YR to get the effective cost of the discount loan with a compensating
balance, 17.65%.

Effects of Compensating Balances

The previous example demonstrates that if a loan is subject to discount interest
and a compensating balance, the borrower actually receives much less than the
face value of the loan. However, what if the firm needs $10,000 in funds today?
How large must the face value of the loan be to ensure that the borrower has his or
her required funds?
From Equation 16B-1, we can determine the required loan face value amount
as follows:
Face Funds available
16B-1a value ¼ 1
Interest rate
Compensating balance%

So to receive $10,000 today, the firm must take out a 20% compensating balance,
12% discount-interest loan with a face value of $14,705.88. Using a financial cal-
culator, the effective rate of the loan is still 17.65%, which indicates that the
effective rate of the loan depends on the terms of the loan (interest rate and
compensating balance) and not on the size of the loan.
 Web Appendix 16B 16B-3

QUESTIONS

16B-1 What are some different ways banks can calculate interest on loans?
16B-2 What is a compensating balance? What effect does a compensating balance requirement
have on the effective interest rate on a loan?

PROBLEMS

16B-1 DISCOUNT INTEREST FACE VALUE Picard Orchards requires a $100,000 annual loan
to pay laborers to tend and harvest its fruit crop. Picard borrows on a discount-interest
basis at a nominal annual rate of 11%. If Picard must receive $100,000 net proceeds
to finance its crop, what must be the face value of the note?
16B-2 DISCOUNT INTEREST FACE VALUE Viking Farms harvests crops in roughly 90-day cycles
based on a 360-day year. The firm receives payment from its harvests sometime after
shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its
harvests using 90-day bank notes on which the firm pays a 12% nominal annual rate,
discount interest. If the firm requires $60,000 in proceeds from each note, what must be
the face value of each note?
16B-3 EAR DISCOUNT LOAN Coverall Carpets Inc. is planning to borrow $12,000 from the
bank for 1 year at a 12% nominal annual rate, discount basis. What is the loan’s effective
interest rate?
16B-4 EAR DISCOUNT/COMPENSATING BALANCE LOAN Suppose you borrow $2,000 from a
bank for 1 year at a stated annual interest rate of 14%, with interest prepaid (a discounted
loan). Also assume that the bank requires you to maintain a compensating balance equal to
20% of the initial loan value. What effective annual interest rate are you being charged?
How much must you actually borrow from the bank to have $2,000 of usable funds?
16B-5 EAR DISCOUNT/COMPENSATING BALANCE LOAN Wentworth Greenery harvests its crop
four times annually and receives payment 90 days after it is picked and shipped. However,
the firm must plant, irrigate, and harvest on a near continual schedule. The firm uses
90-day bank notes to finance its operations. The firm arranges an 11% stated annual rate,
discount-interest loan with a 20% compensating balance four times annually. What is the
effective annual interest rate of these discount loans?
16B-6 EAR DISCOUNT/COMPENSATING BALANCE LOAN Cathcart Systems needs $20,000 in
cash immediately and has gone to its bank for a loan. The bank has set loan terms of 14%
discount interest and a 15% compensating balance. How much must the firm actually
borrow from the bank to have $20,000 of usable funds?