The Apex Supplies Corporation needs to acquire €100 million in funds to expand their facilities.The bank has offered them a discounted loan at 10% and a compensating balance of 6%.What is the effective interest rate on this loan?

Question

Quizplus · Accepted Answer

The effective interest rate can be calculated as follows: 
Effective interest rate = (1 + (discount rate/compensating balance rate)) - 1
= (1 + (0.1/0.06)) - 1
= 1.6667 - 1
= 0.6667 or 66.67%
However, this is an annual rate and not the effective interest rate for the entire duration of the loan. Therefore, we need to assume a time period for which the funds are borrowed. 
Let's assume the loan is for 3 years. 
The total interest paid over 3 years on the loan would be:
Interest = (loan amount * discount rate * time period) / (1 - compensating balance rate)
= (€100 million * 0.1 * 3) / (1 - 0.06)
= €32.61 million
The effective interest rate over 3 years would be:
Effective interest rate = (total interest paid / loan amount) / time period
= (€32.61 million / €100 million) / 3
= 0.1087 or 10.87%. 
Therefore, the best choice is C, 11.9%.

The Apex Supplies Corporation Needs to Acquire €100 Million in Funds