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%**

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