Effective interest rate: Serengeti Travels has borrowed $50,000 at a stated APR of 8.5 per cent. The loan calls for a compensating balance of 8 per cent. What is the effective interest rate for this company? (Please refer to section 14.7 'Short term bank loan')

Question

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To calculate the effective interest rate, we need to first calculate the amount of compensating balance required.

Compensating balance = 8% of $50,000 = $4,000

Since the company has to keep $4,000 as a compensating balance, they will only receive $46,000 in cash ($50,000 - $4,000).

The interest paid on the loan will be 8.5% of $50,000 = $4,250

Effective interest rate = (interest paid / amount received in cash) x (365 / loan period)

Loan period is not given, let's assume it to be 1 year.

Effective interest rate = (4,250 / 46,000) x (365 / 1) = 9.24%

Therefore, the effective interest rate for this company is 9.24%.

Effective Interest Rate: Serengeti Travels Has Borrowed $50,000 at a Stated