(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.

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Dryomys Dryomys · Answer 1 · 2019-11-07T06:05:10+01:00

Answer:

19.12%

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%