On July 1, 2012, the Southwest Forging Corporation arranged for a line of credit with the First National Bank (FNB) of Dallas. The terms of the agreement call for a $100,000 maximum loan with interest set at 1 percent over prime. In addition, the firm has to maintain a 20 percent compensating balance in its demand deposit account throughout the year. The prime rate is currently 4 percent (assume a 360-day year).
a. If Southwest normally maintains a $20,000 to $30,000 balance in its checking account with FNB of Dallas, what is the annualized cost of credit through the line-of-credit agreement when the maximum loan amount is used for a full year?
b. Recompute the annualized cost of trade to Southwest if the firm borrows the compensating balance and it borrows the maximum possible under the loan agreement. Again, assume the full amount of the loan is outstanding for a whole year.