Cumberland Furniture wishes to establish a prearranged borrowing agreement with a local commercial bank. The bank’s terms for a line of credit are 3.30% over the prime rate, and each year the borrowing must be reduced to zero for a 30-day period. For an equivalent revolving credit agreement, the rate is 2.80% over prime with a commitment fee of 0.50% on the average
unused balance. With both loans, the required compensating balance is equal to 20% of the amount borrowed. (Note: Cumberland currently maintains $0 on deposit at the bank.) The prime rate is currently 8%. Both agreements have $4 million borrowing limits. The firm expects on average to borrow $2 million during the year
no matter which loan agreement it decides to use.
a. What is the effective annual rate under the line of credit?
b. What is the effective annual rate under the revolving credit agreement? (Hint:
Compute the ratio of the dollars that the firm will pay in interest and commitment
fees to the dollars that the firm will effectively have use of.)
c. If the firm does expect to borrow an average of half the amount available, which
arrangement would you recommend for the borrower? Explain why.