Gibbs, Inc. 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 percent on the loan, and in addition the firm will pay an annual fee of 50 basis points on the unused balance. The firm borrowed $600,000 on the first day the credit line became available. What is the firm's effective interest rate on this line of credit? Round your final percentage answer to 2 decimal places.
A) 8.00%
B) 7.25%
C) 6.58%
D) 8.25%

Question

Quizplus · Accepted Answer

First, we need to find out the annual fee the firm will pay on the unused balance of the credit line.

Annual fee = 0.50% x ($1,000,000 - $600,000) = $2,000

Next, we need to calculate the total interest expense the firm will incur on the $600,000 borrowed.

Total interest expense = $600,000 x 6.25% = $37,500

The effective interest rate on the line of credit can be calculated as follows:

Effective interest rate = (Total interest expense + Annual fee)/Amount borrowed

Effective interest rate = ($37,500 + $2,000)/$600,000 = 6.58%

Therefore, the firm's effective interest rate on this line of credit is 6.58%.