A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintai... Accounting MCQs | Accounting MCQs

A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its account for transaction purposes. What is the effective interest rate of the loan?

6.44%
7.00%
5.80%
6.66%Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (A) is correct. The $50,000 compensating balance requirement is partially satisfied by the company’s practice of maintaining a $25,000 balance for transaction purposes. Thus, only $25,000 of the loan will not be available for current use, leaving $225,000 of the loan usable. At 6% interest, the $250,000 loan would require an interest payment of $15,000 per year. This is partially offset by the 2% interest earned on the $25,000 incremental balance, or $500. Subtracting the $500 interest earned from the $15,000 of expense results in net interest expense of $14,500 for the use of $225,000 in funds. Dividing $14,500 by $225,000 produces an effective interest rate of 6.44%.