Question: Lola's Ice Cream recently arranged for a line of credit with the Longhorn State Bank of Dallas. The terms of the agreement called for a $100,000 maximum loan with interest set at 2.0 percent over prime. In addition, Lola's must maintain a 15 percent compensating balance in its demand deposit throughout the year. The prime rate is currently 12 percent.
a. If Lola's normally maintains a $15,000 to $25,000 balance in its checking account with LSB of Dallas, what is the effective cost of credit through the line-of-credit agreement where the maximum loan amount is used for a full year?
b. Recompute the effective cost of credit to Lola's Ice Cream if the firm has to borrow 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.