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Determination of an Optimal Revolving Credit Agreement

Published online by Cambridge University Press:  19 October 2009

Paul D. Berger  and
William K. Harper
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Extract

Most large companies develop formal or informal agreements with banks to cover anticipated seasonal or temporary cash needs and/or to provide assurance of the availability of funds against unanticipated cash requirements. We address the problem of determining the optimal limits of available funds a company should maintain under a revolving credit agreement. Typically a company will negotiate a legal commitment with a bank or group of banks for a specified period of time, usually one to three years, in which the bank agrees to extend credit up to a specified maximum amount. During the duration of the commitment, the bank must lend money to the company whenever the company wishes to borrow, provided the amount of money borrowed does not exceed the maximum amount noted in the agreement. The company must not be in default of any of the restrictive covenants of the agreement, such as working capital limits, compensating balances, limits on other indebtedness, etc. Although the agreement itself provides for intermediate-term financing, the agreement often takes the form of short-term (30-60-90 days) renewable notes.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 8 , Issue 3 , June 1973 , pp. 491 - 497
Copyright
Copyright © School of Business Administration, University of Washington 1973

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References

1 If the rate on the credit line is tied to a floating prime rate, it is possible during a period of declining interest rates that this rate may not be higher than the borrowing rate on the credit agreement. However, for the balance of the paper we assume that, if the company is forced to go elsewhere for funds, it does obtain these funds at a higher rate.

2 Raiffa, H. and Schlaifer, R., Applied Statistical Decision Theory (Cambridge, Mass.: M. I. T. Press, 1961).Google Scholar

3 Van Home, James C., Financial Management and Policy (Englewood Cliffs, N. J.: Prentice Hall, Inc., 1968), p. 420.Google Scholar

4 See footnote 3 and: Baumol, W. J., “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly Journal of Economics (November 1952)Google Scholar; Miller, M. H. and Orr, D., “A Model of the Demand for Money by Firms,” Quarterly Journal of Economics (August 1966)Google Scholar; Frost, P. A., “Banking Services, Minimum Cash Balances, and The Firm's Demand for Money,” Journal of Finance (December 1970).Google Scholar