The List Company, which can earn 7 percent on money market instruments, currentl

Question

The List Company, which can earn 7 percent on money market instruments, currently has a lockbox arrangement with a New Orleans bank for its Southern customers. The bank handles $3 million a day in return for a compensating balance of $2 million. a. The List Company has discovered that it could divide the Southern region into a south- western region (with $1 million a day in collections, which could be handled by a Dallas bank for a $1 million compensating balance) and a southeastern region (with $2 mil- lion a day in collections, which could be handled by an Atlanta bank by a $2 million compensating balance). In each case, collections would be one-half day quicker than with the New Orleans arrangement. What would be the annual savings (or cost) of dividing the Southern region? b. In an effort to retain the business, the New Orleans bank has offered to handle the collections strictly on a fee basis (no compensating balance). What would be the maximum fee the New Orleans bank could charge and still retain List's business?

Explanation / Answer

Given Bank handles daily - $3 million and interest rate is 7%

now new arrengements : savings in a day if cash balance =0.5

cash handling per day :3 million additional interest earned on 0.5* 3=1.5 million per day interest saved per year =1.5 *7%= 0.105 million.

Now (l) additional compensation balance to be maintain=3-2=1 million

Interest expense on additional compensation balance = 1*7%=0.07 million

(II) annual net savings =0.105-0.07=$0.035 million

(I)-(II) If new Orleans doesn't ask for compensation balance then the savings on interest would be 2.million

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