(Estimating the cost of bank credit) Paymaster Enterprises has arranged to finan

Question

(Estimating the cost of bank credit) Paymaster Enterprises has arranged to finance its seasonal working-capital needs with a short-term bank loan. The loan will carry a rate of 12 percent per annum with interest paid in advance (discounted). In addition, Paymaster must maintain a minimum demand deposit with the bank of 10 percent of the loan balance throughout the term of the loan. If Paymaster plans to borrow $100,000 for a period of three months, what is the effective cost of the bank loan?

DATA
Annual interest rate 12%
Minimum demand dep 10%
Loan 100,000
Months 3

Interest = 3,000
APR = ?

Explanation / Answer

First, we calculate the interest expense for the 3-month loan as follows: Interest = .12 x $100,000 x 3/12 = $3,000. Assuming that Paymaster has to leave 10% of the loan idle in a compensating balance,the effective cost of credit can be calculated as follows: APR = [$3,000/($100,000 - 10,000 - 3,000)] x (12/3) = 13.79% If the company already has sufficient funds in the bank to satisfy the compensating balance requirement, then the cost of credit drops to 12.37%

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