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 ​$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.

Answer 1

(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: