A company recently approached their bank about establishing a credit line facility. These are the terms offered by the bank:
a nominal rate of prime + 1.5% (prime is currently 5%) on the amount borrowed
a commitment fee of 20 basis points on the unused portion of the credit line
a compensating balance of 15% on the amount borrowed.
They decide to establish the line for $70 million. Over the course of a year, they anticipate the average amount borrowed to be $50 million.
The firm will keep no balances at the bank paying fees for all cash management services.
a. Estimate the cost of credit line.
b. Assume that the firm did have cash balances to cover the required compensating balances resulting from the credit line borrowings. Estimate the effective cost of the credit line.