Introduction to Finance

compensating balance 
requirement that 10 to 20 percent 
of a loan be kept on deposit at the 
bank
discounted loan 
borrower receives 
the principal less the interest at the 
time the loan is made; the principal 
is repaid at maturity
6
This periodic rate can be computed using our Chapter 9 concepts. We know that FV = PV (1 + 
r
)
n
. Since FV equals 
$10,000 (the amount to be repaid), PV equals $9,600 (the usable funds received after discounting), and 
n
is 1 for our 
six-month time frame, we have the following: $10,000 = $9,600 (1 + 
r
)
1
. Solving for 
r
, we see the periodic interest 
rate is 4.17 percent.

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C H A PT E R 1 6 Short-Term Business Financing
to off er the line of credit if the fi rm’s fi nancial condition worsens. Line of credit agreements 
usually allow the bank to reduce or withdraw its credit extension to the fi rm.
A well-established business with an excellent credit rating may be able to obtain a 
revolving credit agreement
.
 
A revolving credit agreement (also called a revolver) is a com-
mitment in the form of a standby agreement
 
for a guaranteed line of credit. Unlike a line of 
credit, a revolving credit agreement is a legal
 
obligation of the bank to provide funds up to the 
agreed-upon borrowing limit during the time
 
the agreement is in eff ect. In addition to paying 
interest on borrowed funds for the loan period, the business must pay a commission, or fee, to 
the bank based on the unused portion of the credit line, or the money it has “on call” during 
the agreement period. This fee is usually between
 
0.25 and 0.50 percent of the unused amount 
of the line.
7
To compute the eff ective cost of a revolver, the joint eff ect of interest on borrowed funds 
and the commitment fee on the un-borrowed portion of the agreement must be considered. 
Suppose Eastnorth has a one-year $1 million revolver with a local bank. The annual interest 
rate on the agreement is 9 percent with a commitment fee of 0.40 percent on the un-borrowed 
portion. Eastnorth expects to have average outstanding borrowings against the revolver of 
$300,000. Over the year, the interest cost on the average amount borrowed is 0.09 × $300,000, 
or $27,000. The commitment fee on the average un-borrowed portion is 0.0040 × $700,000, 
or $2,800. With total interest and fees of $29,800 ($27,000 + $2,800) on average borrowings 
of $300,000, the expected annual cost of the revolver is $29,800/$300,000, or 9.93 percent.
Small Business Administration
The U.S. Small Business Administration (SBA) was established by the federal government to 
provide fi nancial assistance to small fi rms unable to obtain loans through private channels on 
reasonable terms. Created in 1953, the SBA provides a variety of services in addition to loan 
guarantees through its more than 100 fi eld offi
ces.
The reason businesses use SBA loan guarantees is explained by the stated objectives 
of the SBA: to enable deserving small businesses to obtain fi nancial assistance otherwise 
unavailable through private channels on reasonable terms. When the SBA was established, 
it was recognized that the nation’s economic development depended largely on the freedom 
of new business ventures to enter into active operation. Yet, the increased concentration of 
investable funds with large institutional investors, such as life insurance companies, invest-
ment companies, and others, made it increasingly diffi
cult for new and small business ventures 
to attract investment capital. The lack of a track record made loans hard to obtain from tradi-
tional bank sources.
The SBA does not make loans; instead, it guarantees them. Under their 7(a) loan program, 
the SBA will guarantee up to 85 percent of the loan amount for loans of $150,000 or less. For 
loans larger than $150,000 up to $5 million, a small business can obtain a guarantee of up to 
75 percent. The loan guarantee means a bank can lend a sum to a small business owner and 
only have a small portion of the funds at risk. In case of default, the SBA will repay the loan. 
For example, a bank lending $100,000 under the SBA loan guarantee program has 85 percent 
of the loan guaranteed by the SBA. This means that 15 percent, or $15,000, of their funds is 
at risk. In the event that the borrower cannot repay the loan, the SBA will reimburse the bank 
for up to $85,000.
If a fi rm is able to obtain fi nancing elsewhere, its loan application to the SBA is rejected. 
An applicant for a loan must prove that funds needed are unavailable from any bank, that 
no other private lending sources are available, that issuing securities is impracticable, that 
fi nancing cannot be arranged by disposing of business assets, and that the personal credit of 
the owners cannot be used. These loans may not be used for paying existing creditors or for 
speculative purposes.
In addition to its business lending activities, the SBA is responsible for several related fi n-
ancial activities. These include development company loans, disaster loans, lease guarantees,