A large manufacturer needs a $100,000 loan to finance inventory. It can open a line of credit with a local bank at a 13 percent interest rate. However, it must also maintain a 10 percent minimum compensating balance. The effective interest rate on the loan is:
A)13 percent.
B)13.13 percent.
C)14.44 percent.
D)23 percent.

Question

Quizplus · Accepted Answer

The effective interest rate takes into account both the interest rate and the impact of the compensating balance requirement. To calculate the effective interest rate, we need to determine the amount of funds that the manufacturer must keep on deposit to satisfy the compensating balance requirement.

Compensating balance = 10% of $100,000 = $10,000

This means that the manufacturer will only have access to $90,000 of the $100,000 line of credit.

Interest expense = (0.13 x $90,000) = $11,700

Effective interest rate = (Interest expense / Amount of funds available) x 100

Effective interest rate = ($11,700 / $90,000) x 100 = 13.00%

Therefore, the effective interest rate on the loan is 14.44 percent.

A Large Manufacturer Needs a $100,000 Loan to Finance Inventory