The Boyles Ceramics, Inc. established a line of credit with a local bank. The ma

Question

The Boyles Ceramics, Inc. established a line of credit with a local bank. The maximum amount that can be borrowed under the terms of the agreement is $1,000,000 at an annual rate of 8 percent. A compensating balance averaging 25 percent of the amount borrowed is required. Prior to the agreement, Boyles had no deposit with the bank. Shortly after signing the agreement, Boyles needed $240,000 to pay off a note that was due. Boyles decides to borrow an amount sufficient to pay the $240,000 note and also to cover the compensating balance. What is the effective annual cost of credit if the loan is made on a discount basis?

Explanation / Answer

1 Amount to be borrowed = Amount needed / (1-C)

                                         = $1,000,000 / (1 - 0.25)

                                        = $1,333,333.33

2) Effective annual cost of credit on the loan:

Effective annual cost is computed by dividing the intereset expense by the amount borrowed.

Effective annual cost = ($1,333,333 X 8%) / ($1,000,000 - $250,000 - $240,000)

                                  = $106,666.67 / $510,000

                                 = 0.209 or 20.9%

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