Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves are 6 percent. What is the expected or promised gross return on the loan?

Question

Quizplus · Accepted Answer

To calculate the expected or promised gross return on the loan, we need to add up all the costs associated with the loan and also take into account the compensating balance requirement.

1. Default risk-free borrowing rate: 8%
2. Risk premium: 3%
3. Origination fee: 0.1875%
4. Compensating balance requirement: 9%

So the total cost of the loan is:

8% + 3% + 0.1875% = 11.1875%

But we also need to consider the amount that must be held in required reserves, which is 6% of the loan amount. So we can adjust the interest rate as follows:

11.1875% / (1 - 0.06) = 11.9091%

Therefore, the expected or promised gross return on the loan is 11.9091%, which is closest to option E (12.22 percent)

Confidence Bank Has Made a Loan to Risky Corporation