(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 $100,000 maximum loan with interest set at 1 percent over prime. In addition, the firm has to maintain a 17 percent compensating balance in its demand deposit account throughout the year. The prime rate is currently 13 percent. Note: Interest is not paid in advance (discounted).
a. If Southwest normally maintains a $17,000 to $27,000 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?
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.
(a) Effective cost of capital with compensating balance already in Checking account= 14%
(b) Effective cost with compensating balance taken out of maximum loan available=16.87%
Details of computation as follows:
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