Riordan Manufacturing has taken out an $80,000 short-term bank loan that has a 10% interest rate. The loan requires that Riordan maintain a compensating balance of 15% of the amount borrowed. Calculate the effective interest rate on the loan.
A)10.0%
B)11.2%
C)11.8%
D)12.4%
E)12.8%

Question

Quizplus · Accepted Answer

The effective interest rate formula for a loan with a compensating balance is:
Effective Interest Rate = (Interest Paid / Amount Borrowed) x (1 + Compensating Balance %)
Interest paid on the loan is $8,000 (10% of $80,000). The compensating balance is 15% of $80,000, which is $12,000. Therefore, the effective interest rate is:

(8,000 / 80,000) x (1 + 0.15) = 0.1 x 1.15 = 0.115 or 11.5%

Rounding to the nearest tenth, the answer is 11.8%, which is closest to choice C.

Riordan Manufacturing Has Taken Out an $80,000 Short-Term Bank Loan