Exploring Financing Options for R. Morin Construction Company

a. Which alternative should R. Morin select?

Should R. Morin go with Alternative A or Alternative B for financing the hydraulic crane?

Answer:

R. Morin should select Alternative B, as it offers a lower total cost for financing the hydraulic crane.

Alternative A involves borrowing $120,000 from the bank at a 13% interest rate, with a compensating-balance requirement of 16%. However, since R. Morin normally maintains a minimum demand deposit balance of $30,000 in the bank, the compensating-balance requirement would not be binding. The interest on the loan would be discounted, but the total cost of the loan needs to be calculated by considering the forgone interest on the idle demand deposits.

Alternative B entails financing the equipment directly with a 1-year loan from the equipment dealer. The loan amount of $120,000 would require total payments of $140,688, inclusive of principal and interest.

To determine the better alternative, the total cost of each option needs to be compared. Considering the information provided, Alternative B has a lower total cost compared to Alternative A. Even if the compensating-balance requirement in Alternative A necessitates idle demand deposits, it would not affect the selection of Alternative B as the more favorable choice.

By selecting Alternative B, R. Morin Construction Company can finance the hydraulic crane with a 1-year loan from the equipment dealer, minimizing the overall cost of financing.