Question

Pyramid Products Company has a revolving credit agreement with its bank. The company can borrow up to $1 million under the agreement at an annual interest rate of 9 percent. Pyramid is required to maintain a 10 percent compensating balance on any funds borrowed under the agreement and to pay a 0.5 percent commitment fee on the unused portion of the credit line. Assume that Pyramid has no funds in the account at the bank that can be used to meet the compensating balance requirement. Determine the annual financing cost of borrowing each of the following amounts under the credit agreement:
a. $250,000
b. $500,000
c. $1,000,000

Answer 1

Answer:

a. $250,000

if you borrow $250,000, you will only get $225,000, but you will still have to pay interest for the whole amount, so total interest charge = $250,000 x 9% = $22,500. Additionally, you must pay $750,000 x 0.5%  for the unused portion = $3,750.

total interests charged = $26,250 / $250,000 = 10.5%

b. $500,000

if you borrow $500,000, you will only get $450,000, but you will still have to pay interest for the whole amount, so total interest charge = $500,000 x 9% = $45,000. Additionally, you must pay $500,000 x 0.5%  for the unused portion = $2,500.

total interests charged = $47,500 / $450,000 = 10.56%

c. $1,000,000

since you need to have at least 10% in the bank, if you borrow $1,000,000, you will only get $900,000. So you cannot actually borrow $1 million, your net borrowing = $900,000. But you will still have to pay interest for the whole amount, so total interest charge = $1,000,000 x 9% = $90,000.

total interests charged = $90,000 / $900,000 = 10%