5 Chapter 9 Case Study

Case Study Exploring Different Sources of Compound Financing

The Situation

Quentin is the human resources manager for Lightning Wholesale. Recently, he was approached by Katherine, who is one of the employees in the sporting goods department. She enquired about the possibility of getting an advance on her next paycheque. Quentin informed her that Lightning Wholesale’s payroll policy is not to provide advances on paycheques. Katherine indicated that she was having some financial problems, did not have a very good credit rating, and would be forced on her way home to stop in at a payday loan company to take out an advance.

Concerned for his employee, Quentin visited Katherine later in the day and sat down with her to show her the true costs of using a payday loan company. He also wanted to show her a better alternative to get some short-term financing.

The Data

Canadian payday loan companies generally operate under one of three structures:

1. The Traditional Model. These companies incur all operating costs, provide their own capital for any loan, and collect interest and charges or fees for their services. These companies assume all the risk.
2. The Broker Model. These companies incur all operating costs but do not provide the capital for the loan. A third-party partner provides the capital, and the payday loan company charges a brokerage fee for its services. The third-party partner collects all interest and assumes all risk.
3. The Insurance Model. These companies incur all operating costs and recover these costs through fees and insurance premiums on the loan. An insurance company (usually owned by the payday loan company) provides all capital and assumes all risk.

The table below summarizes a sample of charges that could be imposed under each model.

 Observe that under Section 347 of the Criminal Code, any charges related to the borrowing of money are considered interest. This includes any types of fees and charges, although in name they may not be called interest.

• As an alternative to using a payday loan company, Katherine could use a finance company that targets people with poor credit ratings or those in quick need of money. These companies typically charge 28% compounded monthly on loans.
• A second alternative is to take a cash advance on her credit card. Most credit card companies charge around 18% compounded daily.

Important Information

• Like most people who borrow money from payday loan companies, Katherine needs to borrow a small sum of money for a short period of time. Her requirements are to borrow $300 for a period of seven days, or one week.
• Assume exactly 52 weeks in a year.

Your Tasks

1. Show Katherine the true effective rate of interest she is being charged if she borrows the money from any of these payday loan companies. For each model:
   1. Convert the effective rate into a nominal weekly compounded rate.
   2. Calculate the future value of the loan after one week using the weekly periodic rate.
   3. Calculate any cheque cashing, brokerage, or insurance fees on the future value.
   4. Take the interest on the loan and add all fees charged, including any flat fees. This is the total interest amount on the loan.
   5. Convert the interest amount into a percentage of principal. This is the periodic interest rate per week.
   6. Take the periodic interest rate per week and convert it into a nominal weekly compounded rate.
   7. Convert the nominal weekly compounded rate into an effective rate.
2. Now make Katherine aware of what the alternative sources of financing will cost.
   1. Convert both the finance company’s interest rate and the credit card’s interest rate into effective rates and weekly compounded nominal rates.
   2. For each option, calculate the future value of her loan and determine the amount of interest charged.
3. Examine the effective rates for all of the options. Rank them from the best alternative to the worst alternative.
4. Look at the amount of interest paid under the best alternative compared to the worst alternative. Express the worst alternative as a percentage of the best alternative.
5. Summarize your findings for Katherine.