Bonbela Inc.has a line of credit with Trust Company Bank that allows GPC to borrow up to $300,000 at an annual interest rate of 5.5%.However, Bonbela must keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company Bank.Bonbela does not normally have a cash balance account with the Trust Company.What is the effective annual cost of credit?

Question

Quizplus · Accepted Answer

The effective annual cost of credit can be calculated by considering the interest paid and the requirement to keep a compensating balance. If Bonbela borrows $300,000, it must keep 20% of that, or $60,000, as a compensating balance. This means Bonbela effectively has access to only $240,000 ($300,000 - $60,000). However, the interest is paid on the full $300,000. At an annual interest rate of 5.5%, the interest paid is $16,500 ($300,000 * 5.5%). The effective annual cost of credit is then calculated as the interest paid divided by the effective loan amount available for use, which is $16,500 / $240,000 = 6.875%.