Question

Your company has arranged a revolving credit agreement for up to $68 million at an interest rate of 1.37 percent per quarter. The agreement also requires your company to maintain a compensating balance of 6 percent of the unused portion of the credit line, to be deposited in a non-interest bearing account. Your company's short-term investment account at the same bank pays an interest rate of .51 per quarter. What is the effective annual interest rate if your company borrows $33 million for one year?

Answer 1

Given

Company’s revolving credit $68 million

Interest rate of 1.37 percent per quarter

Company to maintain a compensating balance of 6 percent of the unused portion of the credit line, to be deposited in a non-interest bearing account

Company's short-term investment account at the same bank pays an interest rate of .51 per quarter

Company borrows $33 million for one year

Unused portion of the credit line = Total credit line – Credit line utilised

                                                            = $68 million - $33 million = $35 million

Compensating balance to be deposited in non- interest bearing account = 6x35/100 = $2.1 million

Interest foregone on compensating balance in a year = 0.51x2.1/100x4 = $0.04284 million

Interests paid on used credit line in a year =1.37x33/100x4 = $1,8084 million

Effective interest paid on the used credit line = $1,8084 million + $0.04284 million = $1.85124 million

Effective annual interest rate if the company borrows $33 million for one year = Effective interest paid/Used credit linex100 = 5.6098 percent per year