4. An assistant treasurer is currently reevaluating their firm\'s banking relati

Question

4. An assistant treasurer is currently reevaluating their firm's banking relationship. The firm's current lender charges an effective borrowing cost of 4.25%. A competing lender provides the following quote for a $20,000,000 committed credit line: interest rate of 3.50% and a commitment fee of 0.25% on the unused portion of the line. After reviewing the firm's account analysis statement, the assistant treasurer notes that the average daily borrowings on last year's credit line were S6,500,000. a. Assuming that the firm will borrow the same amount as last year, calculate the effective cost on the competitor's credit line b. Based on your answer in a., do you recommend that the assistant treasurer make a change? c. Suppose that the assistant treasurer is considering negotiating a lower interest rate (say to 3.25%) in exchange for a higher commitment fee (0.50%), would you recommend that the assistant treasurer pursue this change? d. Suppose that the assistant treasurer is considering negotiating a higher interest rate (say to 3.75%) in exchange for no commitment fee. Would you recommend that the assistant treasurer pursue this change? Go back to the original assumptions used for a. Now, assume that credit market conditions have suddenly tightened and lender provides the same original quote with the addition of a 10% compensating balance. Should the assistant treasurer switch to the competing bank? e.

Explanation / Answer

a) Interest cost = 6500000*3.5% = $           227,500 Commitment fee = (20000000-6500000)*0.25% = $             33,750 Total cost of the facility $           261,250 Effective cost of the facility = 261250/6500000 = 4.02% b) The assistant treasurer can make the change as the effective cost of the competitor's credit line is lower than the existing facility. c) Interest cost = 6500000*3.25% = $           211,250 Commitment fee = (20000000-6500000)*0.5% = $             67,500 Total cost of the facility $           278,750 Effective cost of the facility = 278750/6500000 = 4.29% No, the change is not recommended as the effective cost of the competitor's line of credit is higher. d) Yes; 3.75% is less than the existing cost. e) Assumption: Assumed that the compensating balance is required on the total amount of $20,000,000, which becomes $2,000,000. This would make the average borrowings 6500000+2000000 = $8,500,000 as the firm will have to borrow extra to keep the compensating balance. The costs would then be: Interest cost = 8500000*3.5% = $           297,500 Commitment fee = (20000000-8500000)*0.25% = $             28,750 Total cost of the facility $           326,250 Effective cost of the facility = 326250/6500000 = 5.02% If the compensating balance is on the amount availed of then the cost would be: Interest cost = 6500000*110%*3.5% = $           227,500 Commitment fee = (20000000-6500000*110%)*0.25% = $             32,125 Total cost of the facility $           259,625 Effective cost of the facility = 259625/(6500000*110%) = 3.63% IF THE COMPENSATING BALANCE IS REQUIRED ON THE TOTAL AMOUNT OF THE CREDIT LINE OF $20,000,000, THEN THE SWITCHING IS NOT RECOMMENDED. BUT IF THE COMPENSATING BALANCE IS ON THE AMOUNT OF CREDIT AVAILED OF, THEN THE SWITCHING IS RECOMMENDED.

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