Question

The Gunnison Village Inn (GVI) borrowed short-term funds of $80,000 from the Western Colorado Bank. The annual interest rate is 10 percent. The bank requires GVI to have a compensating balance of $10,000 in its checking account.

Required:
1. Assuming GVI historically has a zero cash bank balance, what is the effective interest

Answer 1

The effective interest rate can be calculated by dividing the total interest expense by the net borrowed amount, which is the principal minus the compensating balance. In this case, the effective interest rate for GVI's short-term funds borrowed from Western Colorado Bank is 11.43%.

Step-by-step explanation:

The effective interest rate is the annual interest rate adjusted for any fees or requirements imposed by the lender. In this case, the bank requires GVI to maintain a compensating balance of $10,000 in the checking account. To calculate the effective interest rate, divide the total interest expense by the net borrowed amount, which is the principal minus the compensating balance.

Net borrowed amount = Principal - Compensating balance

Net borrowed amount = $80,000 - $10,000 = $70,000

Total interest expense = Principal x Annual interest rate = $80,000 x 10% = $8,000

Effective interest rate = Total interest expense / Net borrowed amount

Effective interest rate = $8,000 / $70,000 = 0.1143 or 11.43%