A firm needs $45,000 to purchase inventory.The bank requires a 5% compensating balance.With a stated interest rate of 15%,what is the effective interest rate?

Question

Quizplus · Accepted Answer

To find the effective interest rate, we need to take into account the compensating balance. The firm needs $45,000, but they will actually have to borrow $47,368 ($45,000/0.95) in order to satisfy the 5% compensating balance requirement. 
The interest on the loan will be:
$47,368 x 0.15 = $7,105.20 
Thus, the effective interest rate can be found using the following formula:
Effective Interest Rate = Total Interest / Amount Borrowed 
Effective Interest Rate = $7,105.20 / $45,000 
Effective Interest Rate = 0.1579 or 15.79%

Therefore, the best choice is C.

A Firm Needs $45,000 to Purchase Inventory