Question

Part of Virginia purchase will be financed with a conventional, interest-only debt. CEO got quotes from couple banks: First National Bank offers 4.25 percent loans with monthly compounding. State Bank offers loans at 4.35 percent compounded semi-annually. Based on this information only, which bank is offering a better deal for Carolina? Why?

Answer 1

In order to compare the offerings of two banks, we need to calculate the effective annual rate of both these offerings. One with the lower effective annual rate offers a better rate.

For First National Bank, assume $1 is invested at 4.25%, with monthly compounding.

FV = PV * (1 + r)ⁿ

FV = $1 * (1 + 4.25%/12)¹²

FV = $1 * (1.043338)

FV = $1.043338

Hence, effective rate = 4.3338%

For State Bank, assume $1 is invested at 4.35%, with semi-annually compounding.

FV = PV * (1 + r)ⁿ

FV = $1 * (1 + 4.35%/2)²

FV = $1 * (1.043973)

FV = $1.043973

Hence, effective rate = 4.3973%

Now that effective annual rate for First National Bank is lower, that offers a better deal.