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Cost of Borrowing (Short-Term Financial Management)

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The Problem is for a Corporate Finance Course. The author is Ross-Westerfield-Jordan: Essentials of Corporate Finance. Fourth Edition. This problem relates to Short-Term Financial Management.

18. Costs of Borrowing.

A bank offers your firm a revolving credit arrangement for up to $60 million at an interest rate of 1.52 percent per quarter. The bank also requires you to maintain a compensating balance of 6 percent against the unused portion of the credit line, to be deposited in a noninterest-bearing account. Assume you have a shortterm
investment account at the bank that pays 0.75 percent per quarter, and assume
that the bank uses compound interest on its revolving credit loans.

a. What is your effective annual interest rate (an opportunity cost) on the revolving
credit arrangement if your firm does not use it during the year?

b. What is your effective annual interest rate on the lending arrangement if you
borrow $40 million immediately and repay it in one year?

c. What is your effective annual interest rate if you borrow $60 million
immediately and repay it in one year?

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Solution Summary

The solution explains how to calculate the effective interest rate

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For the purpose of the revolving credit arrangement, a compensating non interest bearing deposit of 6% is required.

a. Credit line has not been used, so 6% of 60 million will be the deposit=3,600,000. This deposit is non interest bearing. To make this deposit, the company loses the ...

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