644 PART 5 Short-Term Financial Decisions
line of credit
An agreement between a
commercial bank and a business
specifying the amount of
unsecured short-term borrowing
the bank will make available to
the firm over a given period of
time.
Assuming that the loan from bank A is rolled over each 90 days throughout
the year under the same terms and circumstances, its effective annualinterest rate
is found by using Equation 4.23. Because the loan costs 2.625% for 90 days, it is
necessary to compound (10.02625) for four periods in the year (that is,
360/90) and then subtract 1:
Effective annual rate(10.02625)^4 1
1.1092 1 0.1092 1
0
.
9
2
%
The effective annual rate of interest on the fixed-rate, 90-day note is 10.92%.
Bank B set the interest rate at 1% above the prime rate on its floating-rate
note.The rate charged over the 90 days will vary directly with the prime rate. Ini-
tially, the rate will be 10% (9%1%), but when the prime rate changes, so will
the rate of interest on the note. For instance, if after 30 days the prime rate rises
to 9.5%, and after another 30 days it drops to 9.25%, the firm will be paying
0.833% for the first 30 days (10%30/360), 0.875% for the next 30 days
(10.5%30/360), and 0.854% for the last 30 days (10.25%30/360). Its total
interest cost will be $2,562 [$100,000(0.833%0.875%0.854%)], result-
ing in an effective 90-day rate of 2.562% ($2,562/$100,000).
Again, assuming the loan is rolled over each 90 days throughout the year
under the same terms and circumstances, its effective annualrate is 10.65%:
Effective annual rate(10.02562)^4 1
1.1065 1 0.1065 1
0
.
6
5
%
Clearly, in this case the floating-rate loan would have been less expensive than
the fixed-rate loan because of its generally lower effective annual rate.Lines of Credit
A line of creditis an agreement between a commercial bank and a business speci-
fying the amount of unsecured short-term borrowing the bank will make avail-
able to the firm over a given period of time. It is similar to the agreement under
which issuers of bank credit cards, such as MasterCard, Visa, and Discover,
extend preapproved credit to cardholders. A line-of-credit agreement is typically
made for a period of 1 year and often places certain constraints on the borrower.
It is not a guaranteed loanbut indicates that if the bank has sufficient funds avail-
able, it will allow the borrower to owe it up toa certain amount of money. The
amount of a line of credit is the maximum amount the firm can owe the bankat
any point in time.
When applying for a line of credit, the borrower may be required to submit
such documents as its cash budget, its pro forma income statement, its pro forma
balance sheet, and its recent financial statements. If the bank finds the customer
acceptable, the line of credit will be extended. The major attraction of a line of
credit from the bank’s point of view is that it eliminates the need to examine the
creditworthiness of a customer each time it borrows money.Interest Rates The interest rate on a line of credit is normally stated as a
floating rate—the prime rate plus a premium.If the prime rate changes, the inter-
est rate charged on new as well as outstandingborrowing automatically changes.