Crawley,Inc.has a line of credit with HNC Bank that allows the company to borrow up to $800,000 at an interest rate of 12 percent.However,Crawley,Inc.must keep a compensating balance of 18 percent of any amount borrowed on deposit at the bank.Crawley,Inc.does not normally keep a cash balance account with HNC Bank.What is the effective annual cost of credit?
A) 12.40%
B) 12.83%
C) 14.63%
D) 15.47%

Question

Quizplus · Accepted Answer

The effective annual cost of credit can be calculated by considering the interest paid and the requirement to keep a compensating balance. If Crawley, Inc. borrows $800,000, it must keep 18% of that, or $144,000, as a compensating balance. This means the usable funds are $800,000 - $144,000 = $656,000. However, interest is paid on the full $800,000. At a 12% interest rate, the annual interest is $800,000 * 12% = $96,000. The effective annual cost of credit is then $96,000 / $656,000 = 14.63%.