As treasurer of your firm, you wish to establish a credit line facility to cover
ID: 2723684 • Letter: A
Question
As treasurer of your firm, you wish to establish a credit line facility to cover an expected average annual borrowing of $65 million. You hav e asked two banks to submit proposals for a credit line of $80 million. Based on the credit line of $55 million, Bank of the West proposes a nominal rate of 6%, a commitment fee of .25% on the unused portion of the credit line, and a 20% compensating balance on the amount borrowed. Bank of the East offers a rate of 5.75% if the size of the credit line is $95 million. In addition, the commitment fee on the unused portion of the credit line is 20 basis points, and compensating balances of 25% will be required on the amount borrowed. Calculate the effective cost of both proposals, and indicate which proposal should be accepted.
Explanation / Answer
Bank of the West
ASSUMPTIONS:
Prime =
6.00%
Increment over prime=
0.00%
Commitment fee =
0.25%
on the unused portion of the credit line
Compensating balance =
20.00%
on the amount borrowed
Size of credit line =
$80,000,000
Amount borrowed =
$65,000,000
Days of borrowing =
365
Assume no balances are kept at the bank.
Interest paid =
$3,900,000
Commitment fee =
$37,500
Out of pocket costs =
$3,937,500
Usable funds =
$52,000,000
Effective rate =
7.57%
Bank of the East
ASSUMPTIONS:
Prime =
5.75%
Increment over prime=
0.00%
Commitment fee =
0.20%
on the unused portion of the credit line
Compensating balance =
25.00%
on the amount borrowed
Size of credit line =
$95,000,000
Amount borrowed =
$65,000,000
Days of borrowing =
365
No balances are kept at the bank.
Interest paid =
$3,737,500
Commitment fee =
$60,000
Out of pocket costs =
$3,797,500
Usable funds =
$48,750,000
Effective rate =
7.79%
Bank of the West offers a lower effective cost even though its nominal rate is higher.
Bank of the West
ASSUMPTIONS:
Prime =
6.00%
Increment over prime=
0.00%
Commitment fee =
0.25%
on the unused portion of the credit line
Compensating balance =
20.00%
on the amount borrowed
Size of credit line =
$80,000,000
Amount borrowed =
$65,000,000
Days of borrowing =
365
Assume no balances are kept at the bank.
Interest paid =
$3,900,000
Commitment fee =
$37,500
Out of pocket costs =
$3,937,500
Usable funds =
$52,000,000
Effective rate =
7.57%
Bank of the East
ASSUMPTIONS:
Prime =
5.75%
Increment over prime=
0.00%
Commitment fee =
0.20%
on the unused portion of the credit line
Compensating balance =
25.00%
on the amount borrowed
Size of credit line =
$95,000,000
Amount borrowed =
$65,000,000
Days of borrowing =
365
No balances are kept at the bank.
Interest paid =
$3,737,500
Commitment fee =
$60,000
Out of pocket costs =
$3,797,500
Usable funds =
$48,750,000
Effective rate =
7.79%
Bank of the West offers a lower effective cost even though its nominal rate is higher.
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