A bank lends a firm $500,000 for one year at 8 percent and requires compensating balances of 10 percent of the face value of the loan. The effective annual interest rate associated with this loan is ________.

Question

Quizplus · Accepted Answer

The effective annual interest rate considers both the stated interest rate and any other costs associated with the loan. In this case, the compensating balance requirement adds to the cost of the loan. To calculate the effective annual interest rate, use the following formula: 
Effective annual interest rate = (1 + (stated interest rate/n)) x (1 - compensating balance percentage) - 1
Where n = number of compounding periods per year 
Plugging in the numbers, we get: 
Effective annual interest rate = (1 + (0.08/1)) x (1 - 0.10) - 1 
Effective annual interest rate = 0.089 or 8.9% 
Therefore, the answer is choice A.

A Bank Lends a Firm $500,000 for One Year at 8