The Stuart Glass Company established a line of credit with a local bank.The maximum amount that can be borrowed under the terms of the agreement is $1,000,000 at an annual rate of 8 percent.A compensating balance averaging 25 percent of the amount borrowed is required.Prior to the agreement,Stuart had no deposit with the bank.Shortly after signing the agreement,Stuart needed $240,000 to pay off a note that was due.Stuart decides to borrow an amount sufficient to pay the $240,000 note and also to cover the compensating balance.What is the effective annual cost of credit if the loan is made on a discount basis?
A) 11.94%
B) 11.00%
C) 10.83%
D) 10.57%

Question

Quizplus · Accepted Answer

To calculate the effective annual cost of credit, we need to calculate the interest paid on the loan and the cost of maintaining the compensating balance.

Amount to be borrowed = $240,000 + 25% of $240,000 = $300,000

Interest on the loan = $240,000 x 8% = $19,200

Net amount received = $300,000 - $75,000 (25% compensating balance) = $225,000

Effective interest rate = ($19,200 / $225,000) x (365 / 360) = 0.1024 or 10.24%

Since the loan is made on a discount basis, the interest is deducted upfront, and the net amount received is $225,000. Therefore, the effective annual cost of credit is:

(Interest paid / Net amount received) x (365 / Days of loan) = ($19,200 / $225,000) x (365 / 360) = 0.1194 or 11.94%

Therefore, the best choice is A, 11.94%.

The Stuart Glass Company Established a Line of Credit with a Local