Question

Carey Company is borrowing $400,000 for one year at 16.5 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. The principal refers to funds the firm can effectively utilize (Amount borrowed ? Compensating balance). a. What is the effective rate of interest? b. What would the effective rate be if Carey were required to make 12 equal monthly payments to retire the loan?

Answer 1

a). Effective rate of interest with 20% compensating balance

= [Interest / (Principal - Compensating Balance)] x [Days in the year(360) / Days loan is outstanding]

= [$66,000/($400,000 - $80,000)] x [360/360]

= [$66,000/$320,000] x [360/360] = 20.625%

b). Installment loan with compensating balance

= [2 x Annual No. of Payments x Interest] / [(Total no. of payments + 1) x Principal]

= [2 x 12 x $66,000] / [(12 + 1) x ($400,000 - $80,000)]

= $1,584,000 / [13 x $320,000]

= $1,584,000 / $4,160,000 = 38.077%