Cumberland Furniture wishes to establish a prearranged borrowing agreement with its local commercial bank. The bank's terms for a line of credit are 4.30% over the prime rate, and each year the borrowing must be reduced to zero for a 30-day period. For an equivalent revolving credit agreement, the rate is 3.80% over prime with a commitment fee of 0.50% on the average unused balance. With both loans, the required compensating balance is equal to 20% of the amount borrowed. The prime rate is currently 8%. Both agreements have $5 million borrowing limits. The firm expects on average to borrow $2 million during the year no matter which loan agreement it decides to use.

a. What is the effective annual rate under the line of credit?

b. What is the effective annual rate under the revolving credit agreement?

c. If the firm does expect to borrow an average 40% of the amount available which arrangement would you recommend for the borrower? Explain why.

d. What step should be needed to reduce the effective annual rate?