A bank offers your firm a revolving credit arrangement for up to $115 million at

Question

A bank offers your firm a revolving credit arrangement for up to $115 million at an interest rate of 2 percent per quarter. The bank also requires you to maintain a compensating balance of 5 percent against the unusedportion of the credit line, to be deposited in a non-interest-bearing account. Assume you have a short-term investment account at the bank that pays 1.3 percent per quarter, and assume the bank uses compound interest on its revolving credit loans. What is the effective annual interest rate on the revolving credit arrangement if your firm does not borrow any money during the year?

A bank offers your firm a revolving credit arrangement for up to $115 million at an interest rate of 2 percent per quarter. The bank also requires you to maintain a compensating balance of 5 percent against the unusedportion of the credit line, to be deposited in a non-interest-bearing account. Assume you have a short-term investment account at the bank that pays 1.3 percent per quarter, and assume the bank uses compound interest on its revolving credit loans. What is the effective annual interest rate on the revolving credit arrangement if your firm does not borrow any money during the year?

Explanation / Answer

Interest rate on revolving credit =2 % per quarter

Balance required in an investment account=5% against the unused portion of the credit line

Interest rate on the investment account=1.3% per quarter

Since the interest is accrued quarterly ,there will be =4 periods

The firm has not borrowed any money ,hence the effective annual rate will be :

EAR=1.013^4-1

EAR=0.053023

Effective annual rate=5.3 %

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