A bank offers your firm a revolving credit arrangement for up to $74 million at

Question

A bank offers your firm a revolving credit arrangement for up to $74 million at an interest rate of 1.35 percent per quarter. The bank also requires you to maintain a compensating balance of 6 percent against the unused portion of the credit line, to be deposited in a noninterest-bearing account. Assume you have a short-term investment account at the bank that pays .76 percent per quarter, and assume that the bank uses compound interest on its revolving credit loans.

What is your effective annual interest rate (an opportunity cost) on the revolving credit arrangement if your firm does not use it during the year? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

What is your effective annual interest rate on the lending arrangement if you borrow $41 million immediately and repay it in one year? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

What is your effective annual interest rate if you borrow $74 million immediately and repay it in one year? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

A bank offers your firm a revolving credit arrangement for up to $74 million at an interest rate of 1.35 percent per quarter. The bank also requires you to maintain a compensating balance of 6 percent against the unused portion of the credit line, to be deposited in a noninterest-bearing account. Assume you have a short-term investment account at the bank that pays .76 percent per quarter, and assume that the bank uses compound interest on its revolving credit loans.

Explanation / Answer

Solution :

(a) 1.35% is quarterly compounded rate therefore annual rate would be 5.51% and firm also has its investment account in bank which pays 0.76% (assumed to be simple rate) :. annual rate of it would be 0.76 * 4 = 3.04%

Now calculate amount on which interest is to be bear Therefore Interest Expense on $74 Mn * 5.51% = $4.08 Mn Less by Interest Income on deposit 69.56 (74 - 6%) * 3.04% = $2.12 Mn

Thererfore Effectvie Cost = 4.08 - 2.12 = $1.96 Mn.

And So Effective Annual rate would be = 1.96 / 74 = 2.65 %

(b) As in the problem nothing is given we will assume that whole $41 Mn as unused portion ;. 6% of it would be $2.46

Interest cost would be 41 * 5.51% = $2.26 Mn AND Interest Income would be 38.54 (41 - 2.46) * 3.04% = $1.17 Mn

Effective cost = 2.26 - 1.17 = $1.09 Mn

Effective Annual rate would be = 1.09 / 41 = 2.66%

(c) All the calculations and assumptions would be same as above and Effective Annual rate would be 2.65 % only.

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