A company obtained a short-term bank loan of $500,000 at an annual interest rate of 8%. 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 $500,000 at an annual interest rate of 8%. As a condition of the loan, the company is required to maintain a compensating balance of $100,000 in its checking account. The checking account earns interest at an annual rate of 3%. Ordinarily, the company maintains a balance of $50,000 in its account for transaction purposes. What is the effective interest rate of the loan?

7.77%
8.22%
9.25%
8.56%Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (D) is correct. The $100,000 compensating balance requirement is partially satisfied by the company’s practice of maintaining a $50,000 balance for transaction purposes. Thus, only $50,000 of the loan will not be available for current use, leaving $450,000 of the loan usable. At 8% interest, the $500,000 loan would require an interest payment of $40,000 per year. This is partially offset by the 3% interest earned on the $50,000 incremental balance, or $1,500. Subtracting the $1,500 interest earned from the $40,000 of expense results in net interest expense of $38,500 for the use of $450,000 in funds. Dividing $38,500 by $450,000 produces an effective interest rate of 8.56%.