Victoria Peaches Corporation (VPC)has a line of credit with Trust Company Bank that allows VPC to borrow up to $300,000 at an annual interest rate of 5.5%.However,VPC must keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company Bank.VPC 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 is the annual interest rate plus the annual cost of the compensating balance. The annual cost of the compensating balance is 20% of the amount borrowed times the annual interest rate. In this case, the annual cost of the compensating balance is 20% x $300,000 x 5.5% = $33,000. The effective annual cost of credit is therefore 5.5% + $33,000/$300,000 = 6.875%.

Victoria Peaches Corporation (VPC)has a Line of Credit with Trust