Come and Go Bank offers your firm a discount interest loan with an interest rate
ID: 2646731 • Letter: C
Question
Come and Go Bank offers your firm a discount interest loan with an interest rate of 8 percent for up to $24 million, and in addition requires you to maintain a 1 percent compensating balance against the face amount borrowed.
What is the effective annual interest rate on this lending arrangement? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
Required:What is the effective annual interest rate on this lending arrangement? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
Explanation / Answer
Solution -
Note 1 - Discount interest loan - In Discounted loans, interest is reduced from the total amount of the loan & the balance amount is extended as loan and therefore the difference between the face amount of the loan and the interest represents Net Proceeds . Discounted loans are mostly short-term loans. Here Effective Interest rate is thus Interest / Net Proceed
Note 2 - Maintainance of compensating balance against the face amount borrowed - Compensating balances are the the portion of Loan amount bank requires borrower to leave in the bank, thus reducing the funds available for use but borrower pays Interest on entire Loan amount -Here also Effective Interest rate is thus Interest / Net Proceed
In the above question both the condition need to be applied and Effective Interest has to be calculated - Thus we need to reduce both Interest and Compensating balance to arrive at Net Proceed
Thus 8.79% is the effective annual interest rate on this lending arrangement
A Face amount borrowed 24000000 B Interest Rate 8.00% C Interest ( A X B) 1920000 D Compensating balance Rate 1.00% E Compensating balance (A X D) 240000 F Net Proceeds ( A - C - E ) 21840000 I Effective Interest Rate ( C / F ) 8.79%