Question

(Cost of short-term bank loan) On July 1, 2015, the Southwest Forging Corporation arranged for a line of credit with the First National Bank (FNB) of Dallas. The terms of the agreement call for a $100,000 maximum loan with interest set at 1 percent over prime. In addition, the firm has to maintain a 20 percent compensating balance in its demand deposit account throughout the year. The prime rate is currently 4.5 percent.

1. If Southwest normally maintains a $20,000 to $30,000 balance in its checking account with FNB of Dallas, what is the effective cost of credit under the line- of-credit agreement when the maximum loan amount is used for a full year?

2. Compute the effective cost of credit if the firm borrows the compensating balance and the maximum possible amount under the loan agreement. Again, assume the full amount of the loan is outstanding for a whole year.

Answer 1

a	Calculation of the effective rate of interest
	The cost of credit is ($100000,5.5%)
		$5,500
	APR	Interest/Principal *Time
	APR	(.055*100000)/(100000-(0.055*100000)-(20000)
		7.38%
	Cost of Credit when the maximum loan is used is 7.38%
b	Calculate the effective rate of interest
	If all the compensating balances of $20000 is utilized the interest on $20000 at 4.5% is $900
	The maximum loan after utilizing the compensation balance is $80000 the interest is ($80000*5.5%)
	$4400 .The total interest cost is $5300
	The effective cost is as follows
	APR	5300/(100000-(20000)
		5300/80000
		6.63%
	The effective cost of credit when the maximum amount of loan is outstanding is 6.63%