Georgia Peaches Corporation (GPC) has a line of credit with Trust Company Bank that allows GPC to borrow up to $300,000 at an annual interest rate of 5.5%. However, GPC must keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company Bank. GPC does not normally have a cash balance account with the Trust Company. What is the effective annual cost of credit?
A) 6.875%
B) 6.975%
C) 7.075%
D) 7.775%

Question

Quizplus · Accepted Answer

The effective annual cost of credit is the annual interest rate plus the cost of the compensating balance. The cost of the compensating balance is the annual interest rate times the compensating balance percentage. In this case, the annual interest rate is 5.5% and the compensating balance percentage is 20%. Therefore, the cost of the compensating balance is 5.5% * 20% = 1.1%. The effective annual cost of credit is therefore 5.5% + 1.1% = 6.6%.

Georgia Peaches Corporation (GPC) Has a Line of Credit with Trust