Question

(Cost of​ short-term bank loan​) On July​ 1, 2018, 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 ​$140 comma 000 maximum loan with interest set at 1 percent over prime. In​ addition, the firm has to maintain a 19 percent compensating balance in its demand deposit account throughout the year. The prime rate is currently 14 percent. Note​: Interest is not paid in advance​ (discounted).

a. If Southwest normally maintains a ​$26 comma 600 to ​$40 comma 600 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?

b. 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

• Loan = $140,000
• Prime rate = 14%
• Interest rate = 14%+1% =15%

a.Interest amount = principal*interest rate

=$140,000*15%

=$21,000

Compensating balance =principal amount*compensating balance

=$140,000*19%

=$26,600

it is already in the checking account so it will not be deducted from loan amount

Effective cost =interest/loan amount

=$21,000/$140000

=15%

effective rate of interest is 15%

b)compensating balance is deducted from loan amount

interest == $21,000 (as calculated above)

loan amount = $140,000 -compensating balance

$140,000- ($140,000*19%)

=$140,000-26,600

=$113,400

effective interest rate = $21,000/$113,400

=18.52%