Question

Mr. Fernandez has applied for a revolving credit line of $ 6 million to assist in marketing a new product line. The terms of the loan will be as follows:

(a) The loan will not be a discount loan.

(b) A commitment fee of 0.2 percent on the unused portion of the loan will be charged.

(c) The compensatory balance requirements will be 10 percent on the total credit line and 8 percent on the outstanding loans.

(d) The bank will pay 0 percent interest on demand deposits.

(e) The rate of interest to be charged will be the prime rate plus 3 percent.

(f) The bank will use the "actual/360" accrual method to compute interest payments.

(g) The credit line will be extended for a period of three years.

The loan officer estimates that Mr. Fernandez will use about 60 percent of the credit line on average. If the prime rate is 10 percent and the required reserve rate on demand deposits is 20 percent, what is the effective cost to Mr. Fernandez?

• 18.87 %

• 18.47 %

• 17.67 %

• 18.07 %

Answer 1

The answer is point d) - 18.07%

Refer to the table for calculation

	Amount outstanding
Interest	6million*60%	rate	days in a month	Interest cost
	3.6 million	13%	30	3.6*13%*30/360
				0.039
	Unused balance	rate	days in a month	Commitment fee
Commitment fee	6-3.6	0.20%	30	2.4*.2%*30/360
				0.0004
	minimum balance	rate	days in a month	demand deposit cost
demand deposit	0.888	20%	30	.888*20%*30/360
				0.0148
	TOTAL COST per month			0.0542
	TOTAL COST per year		0.0542*12	0.6504
	EFFECTIVE INTEREST RATE		0.6504/3.6	18.07%

Summary - About revolving credit loan:-

The credit of $6mn is maximum limit available to be utilized during the period of 3 years. The unused portion of the loan keeps getting carried forward every month subject to the repayments made by you. For example, you can utilize 1mn on Jan 1st, repay 0.5mn on Jan 10th, repay 0.5mn on Jan 20th, utilize 0.5mn more on Jan 25th. Your average utilization hence will be as follows:-

(1mn*10 days+0.5mn*10 days+0.5mn*6days)/31 days = 0.4839mn

This figure is given in the question as 60% of $6mn = $3.6 mn

Hence, interest cost = 3.6*13%*30/360 = 0.039 mn

Commitment fee is paid on unused balance as a compensation to the lender for making this facility available to you and blocking amount to give you as and when you need up to your credit limit.

Hence, commitment fee cost is = 2.4*0.2%*30/360 = 0.0004mn

Now, the bank asks you to maintain a minimum portion of the loan facility in the form of demand deposits. This acts as a security/collateral to bank in case you are unable to pay. This is quite similar to margin requirements in a stock market trading account. In actuality, the demand deposits can be up to the unused balance of credit.

In the question, such minimum balance = 10%*6mn + 8%*3.6 mn = $0.888 mn

i.e. 10% of total credit and 8% of loan availed

and bank also charges a reserve rate on such deposits as a measure of security, i.e. 20% in the question

Hence, demand deposit cost = 0.888*20%*30/360 = 0.148mn

and the bank in return is not paying you any return on such deposits