Answer to Part 2 Practice Questions Answer: Question 2.1-FSL Industries 1. Since FSL requires the use of $9 million, it will have to borrow $10 million ($9 million / (1-10%)). This will result in 10% of the loan principle ($1 million) being used to satisfy the compensating balance. Annual interest would be 5% of the total loan of $10 million or $500,000. 2. a. The semi-annual interest cost of the term loan would be $9million*(7%/2)=$315,000. The annual interest cost would then be $315,000*2=$630,000. b. Advantages of this loan over the short term loan include: • The loan would be outstanding for 10 years and would not have to be renegotiated each year. Since the need for these funds is quite long due to the need to carry the spare parts inventory, this is an advantage • The interest rate is fixed for 10 years, eliminating interest rate risk which is inherent in the short term loan Disadvantages of such a loan include: • FSL would not be able to take advantage of falling interest rates in the future. The short term loan would allow the interest rate to adjust each year. • The interest cost of this loan in the first year is $130,000 greater than the cost of the short term loan. 3. a. If the bank loan was used to finance the new inventory, net working capital would decrease since current assets (inventory) and long-term assets (equipment) would increase by a combined $9 million, and current liabilities (short term loan) would increase by $10 million. b. If the term loan was used to finance the inventory, there would be an increase in net working capital since current assets would increase, and there would be no impact on current liabilities since the term loan is classified as long term. 4. Other costs related to this inventory would include carrying costs such as: • Storage • Security • Losses due to theft • Obsolescence
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