Ralph Bellamy is considering borrowing $20,000 for a year from a bank that has o

Question

Ralph Bellamy is considering borrowing $20,000 for a year from a bank that has offered the following alternatives: a. An interest payment of $ 1,800 at the end of the year b. An interest payment of 8 percent of $20,000 at the beginning of the year c. An interest payment of 7.5 percent of $20,000 at the end of the year in addition to a compensating balance requirement of 10 percent (i) Which alternative is best for Ralph from the effective-interest-rate point of view? (ii) If Ralph needs the entire amount of $20,000 at the beginning of the year and chooses the terms under (c), how much should he borrow? How much interest would he have to pay at the end of the year?

Explanation / Answer

r=(1+i/n)^n-1 r is effective interest rate I is nominal rate n is number of compounding periods per year a. First we have to calculate nominal rate, which is simply total interest payment divided by total borrowing per year 9% effective interest rate with nominal rate of 9% compounding annualy 9% b. interest payment of 8% at beginning of the year Putting i=8% and n=1 in below formula r=(1+i/n)^n-1 8% c. Total interest payment will be 17.5% Best alternative is alternative B with interest payment of 8% annualy

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