Formal line of credit: Gibbs Ltd has just set up a formal line of credit of $1 million with First National Bank. The line of credit is good for up to five years. The bank will be charging them an interest rate of 6.25 per cent on the loan, and in addition the company will pay an annual fee of 50 basis points on the unused balance. The company borrowed $600,000 on the first day the credit line became available. What is the company's effective interest rate on this line of credit?

Question

Quizplus · Accepted Answer

To calculate the effective interest rate, we need to take into account both the interest rate and the annual fee on the unused balance.

First, let's calculate the interest expense on the $600,000 that Gibbs Ltd borrowed:
Interest expense = $600,000 x 6.25% = $37,500

Next, let's calculate the annual fee on the unused balance: 
Annual fee = 0.5% x ($1,000,000 - $600,000) = $2,000

The total cost of the line of credit is the sum of the interest expense and the annual fee: 
Total cost = $37,500 + $2,000 = $39,500

To calculate the effective interest rate, we need to express the total cost as a percentage of the amount borrowed: 
Effective interest rate = ($39,500 / $600,000) x 100% = 6.58%

Therefore, the answer is (C) 6.58%.

Formal Line of Credit: Gibbs Ltd Has Just Set Up