Question

​(Estimating the cost of bank credit​) Paymaster Enterprises has arranged to finance its seasonal​ working-capital needs with a​ short-term bank loan. The loan will carry a rate of 1616 percent per annum with interest paid in advance​ (discounted). In​ addition, Paymaster must maintain a minimum demand deposit with the bank of 1111 percent of the loan balance throughout the term of the loan. If Paymaster plans to borrow ​$120 comma 000120,000 for a period of 44 ​months, what is the effective cost of the bank​ loan? Hint​: Assume the Paymaster does not have sufficient funds in the bank to satisfy the compensating balance requirement.

Answer 1

19.12%

Step-by-step explanation:

Annual interest rate = 16%

Minimum demand deposit = 11%

Loan = 120,000

Months = 4

First, we calculate the interest expense for the 4-month loan as follows:

Interest = 0.16 × $120,000 × 4 ÷ 12

= $6,400

Assuming that Paymaster has to leave 11% of the loan idle in a compensating balance,the effective cost of credit can be calculated as follows:

APR = [$6,400 ÷ ($120,000 - 13,200 - 6,400)] × (12÷4)

= 19.12%