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Chapter 3: 14BP (page 250)

Carey Company is borrowing $200,000 for one year at 12 percent from Second Intrastate Bank. The bank requires a 20 percent compensating balance. What is the effective rate of interest? What would the effective rate be if Carey were required to make 12 equal monthly payments to retire the loan? The principal, as used in Formula 8-6, refers to funds the firm can effectively utilize (Amount borrowed - Compensating balance).

Short Answer

Expert verified

The effective interest rate is 15% and the effective interest rate on an instalment loan is 22.15%.

Step by step solution

01

Information provided in the question

Loan amount = $200,000

Loan term = 1 year

Interest rate = 12%

Compensating balance = 20%

02

Calculation of interest payable

The interest payable is $24,000.

Interestpayable=Interest×Principal=12%×$200,000=$24,000

03

Calculation of compensating balance in monetary terms

The compensating balance is $40,000.

Compensatingbalance=Compensatingbalancerate×Principal=20%×$200,000=$40,000

04

Calculation of effective interest rate on the loan

The effective interest rate with a 20% compensating rate is 15%.

Effectiverate=InterestPrincipal-Compensatingbalance×DaysinyearDaysloanisoutstanding=$24,000$200,000-$40,000×360360=15%

05

Calculation of effective interest rate when equal instalments have to be made

The effective interest rate is 22.15%.

Effectiverateoninstalmentloan=2×Annualnumberofpayment×InterestTotalnumberofpayments+1×Principal=2×12×$24,00012+1×$200,000=$576,000$2,600,000=22.15%

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Most popular questions from this chapter

Sharpe Knife Company expects sales next year to be \(1,550,000 if the economy is strong, \)825,000 if the economy is steady, and $550,000 if the economy is weak. Mr. Sharpe believes there is a 30 percent probability the economy will be strong, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for the next year?

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