Dr. Ruth is going to borrow $4,000 to help write a book. The loan is for one yea

Question

Dr. Ruth is going to borrow $4,000 to help write a book. The loan is for one year and the money can either be borrowed at the prime rate or the LIBOR rate. Assume the prime rate is 8 percent and LIBOR 1.0 percent less. Also assume there will be a $42 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR). a. What is the effective interest rate on the LIBOR loan?(Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Effective interest rate b. Which loan has the lower effective interest cost? Prime LIBOR

Explanation / Answer

in case of LIBOR we have transaction cost that we deduct from pv i.e =4000-42 = 3958
as libor given is = 8-1 =7%
interest = 4000*0.07 = 280

now we use pv formula to find r
pv = int +fv) / (1+r)^1
3958 = 280+4000)/(1+r)
1+R = 4280/3958
1+R = 1.08135
r= 8.14%approx

effective interest rate = 8.14%

2 .prime has lower effective interest cost of 8%

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