A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the ... Accounting MCQs | Accounting MCQs

A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate but the terms of the loans vary. Which of the following combinations of loan terms will be most attractive for the borrowing firm?

Simple interest, no compensating balance.
Discount interest, no compensating balance.
Simple interest, 20% compensating balance required.
Discount interest, 20% compensating balance required.Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (A) is correct. The most desirable set of terms are those that result in the lowest cost of borrowing. Discount interest results in a higher effective borrowing cost than simple interest because the bank deducts interest in advance so the borrower receives less than the face value of the loan. A compensating balance results in a higher effective borrowing cost because the compensating balance is an amount of cash that the firm is unable to use. The cheapest terms, given that all options have the same nominal interest rate, will be simple interest with no compensating balance.