Question

Calculating the Effective Annual Cost of Short-Term Bank Credit

M&M Beverage Company has a $300,000 line of credit that requires a compensating balance equal to 20 percent of the loan amount. The rate paid on the loan is 7 percent per annum; $200,000 is borrowed for a 6-month period deposit with the lending bank. The dollar cost of the loan includes the interest expense and the opportunity cost of maintaining an idle cash balance equal to the 20 percent compensating balance. To accommodate the cost of the compensating-balance requirement, assume that the added funds will have to be borrowed and simply left idle in the firm’s checking accounts

Answer 1

Effective annual cost of credit= 8.75%

Calculation as below: