(Cost of short-term financing) You plan to borrow $20,000 from the bank to pay f
ID: 2757747 • Letter: #
Question
(Cost of short-term financing) You plan to borrow $20,000 from the bank to pay for inventories for a gift shop you have just opened. The bank offers to lend you the money at 10 percent annual interest for the 6 months the funds will be needed. Calculate the effective rate of interest on the loan. In addition, the bank requires you to maintain a 15 percent compensating balance in the bank. Because you are just opening your business, you do not have a demand deposit account at the bank that can be used to meet the compensating-balance requirement. This means that you will have to put up 15 percent of the loan amount from your own personal money (which you had planned to use to help finance the business) in a checking account. What is the cost of the loan now? In addition to the compensating-balance requirement in part (b), you are told that interest will be discounted. What is the effective rate of interest on the loan now?Explanation / Answer
a)
EAR = (1+APR÷n)^n-1
n is number of compounding per year
= (1+5%)^2-1
= 10.25%
b)
Net funds received from loan = $20,000×85% = $17,000
Interest paid = $20,000×5% = $1,000
Cost of debt = 5.88% for 6 months or 11.76% per annum
c)
Net funds received from loan = $20,000×85% = $17,000
Interest paid = $20,000×5% = $1,000
Interest earned = $3,000×5% = $150
Cost of debt:
= ($1,000-$150)÷$17,000
= 5% for six months or 10$ per annum
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