646 PART 5 Short-Term Financial Decisions
commitment fee
The fee that is normally charged
on a revolving credit agreement;
it often applies to the average
unused balance of the borrower’s
credit line.
commercial paper
A form of financing consisting of
short-term, unsecured promis-
sory notes issued by firms with a
high credit standing.
- Many authors classify the revolving credit agreement as a form of intermediate-term financing,defined as having
a maturity of 1 to 7 years. In this text, we do not use the intermediate-term financing classification; only short-term
and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can
be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-
credit agreements. - Some banks not only require payment of the commitment fee but also require the borrower to maintain, in addi-
tion to a compensating balance against actual borrowings, a compensating balance of 10% or so against the unused
portion of the commitment.
revolving credit agreement
A line of credit guaranteedto a
borrower by a commercial bank
regardless of the scarcity of
money.
prospective borrower should attempt to negotiate a line of credit with the most
favorable interest rate, for an optimal amount of funds, and with a minimum of
restrictions. Borrowers today frequently pay fees to lenders instead of maintain-
ing deposit balances as compensation for loans and other services. The lender
attempts to get a good return with maximum safety. Negotiations should pro-
duce a line of credit that is suitable to both borrower and lender.Revolving Credit Agreements
Arevolving credit agreementis nothing more than aguaranteed line of credit.It is
guaranteed in the sense that the commercial bank assures the borrower that a
specified amount of funds will be made available regardless of the scarcity of
money. The interest rate and other requirements are similar to those for a line of
credit. It is not uncommon for a revolving credit agreement to be for a period
greater than 1 year.^7 Because the bank guarantees the availability of funds, acom-
mitment feeis normally charged on a revolving credit agreement.^8 This fee often
applies to the average unused balance of the borrower’s credit line. It is normally
about 0.5 percent of theaverage unused portionof the line.EXAMPLE REH Company, a major real estate developer, has a $2 million revolving credit
agreement with its bank. Its average borrowing under the agreement for the past
year was $1.5 million. The bank charges a commitment fee of 0.5%. Because the
average unused portion of the committed funds was $500,000 ($2 million$1.5
million), the commitment fee for the year was $2,500 (0.005$500,000). Of
course, REH also had to pay interest on the actual $1.5 million borrowed under
the agreement. Assuming that $160,000 interest was paid on the $1.5 million
borrowed, the effective cost of the agreement was 10.83% [($160,000
$2,500)/$1,500,000]. Although more expensive than a line of credit, a revolving
credit agreement can be less risky from the borrower’s viewpoint, because the
availability of funds is guaranteed.Commercial Paper
Commercial paperis a form of financing that consists of short-term, unsecured
promissory notes issued by firms with a high credit standing. Generally, only
quite large firms of unquestionable financial soundness are able to issue commer-
cial paper. Most commercial paper has maturities ranging from 3 to 270 days.
Although there is no set denomination, it is generally issued in multiples of
$100,000 or more. A large portion of the commercial paper today is issued by
finance companies; manufacturing firms account for a smaller portion of this
type of financing. Businesses often purchase commercial paper, which they hold
as marketable securities, to provide an interest-earning reserve of liquidity.