Answer (D) is correct. The prime interest rate is the rate charged by commercial banks to their best (the largest and financially strongest) business customers. It is traditionally the lowest rate charged by banks. However, in recent years, banks have been making loans at still lower rates in response to competition from the commercial paper market.
A small retail business would most likely finance its merchandise inventory with
Answer (C) is correct. A small retail store would not have access to major capital markets. In fact, the only options available, outside of owner financing, are bank loans and a line of credit from suppliers. It is this latter alternative that is most often used because it permits the store to finance inventories for 30 to 60 days without incurring interest cost. A line of credit is an arrangement between a bank and a borrower in which the bank commits itself to lend up to a certain maximum amount to the borrower in a given period.
If a firm borrows $500,000 at 10% and is required to maintain $50,000 as a minimum compensating balance at the bank, what is the effective interest rate on the loan?
Answer (B) is correct. At 10%, the interest on a $500,000 loan is $50,000 per year. However, the $500,000 loan is effectively reduced to $450,000 of usable funds by the compensating balance requirement. Thus, the borrower pays $50,000 of interest for a $450,000 loan, an effective rate of 11.1% ($50,000 ÷ $450,000).
The Dixon Corporation has an outstanding 1-year bank loan of $300,000 at a stated interest rate of 8%. In addition, Dixon is required to maintain a 20% compensating balance in its checking account. Assuming the company would normally maintain a zero balance in its checking account, the effective interest rate on the loan is
Answer (D) is correct. The requirement to maintain a compensating balance of 20% of the $300,000 loan means that the borrower has effective use of only 80% of the loan, or $240,000. The 8% interest rate applied to a $300,000 loan requires an annual interest expenditure of $24,000. In turn, paying $24,000 for the use of $240,000 indicates an effective interest rate of 10%.
Elan Corporation is considering borrowing $100,000 from a bank for 1 year at a stated interest rate of 9%. What is the effective interest rate to Elan if this borrowing is in the form of a discounted note?
Answer (D) is correct. The effective interest rate on a discounted loan can be calculated as follows: Effective rate = Stated rate ÷ (1.0 – Stated rate) = 9% ÷ (100% – 9 = 9% ÷ 91% = 9.89 Note that the amount of the loan is not needed to calculate the effective rate.
The Altmane Corporation was recently quoted terms on a commercial bank loan of 7% discounted interest with a 20% compensating balance. The term of the loan is 1 year and interest is due at the beginning of the year. The effective cost of borrowing is (rounded to the nearest hundredth)
Answer (D) is correct. To illustrate, assume a $1,000 loan; the interest at 7% for 1 year is $70. Hence, the
proceeds of the loan are $930 ($1,000 – $70). Also, 20% of the note, or $200, cannot be used by the borrower because of the compensating balance requirement. Consequently, only $730 is available for use by the borrower. Paying $70 interest for the use of $730 gives an interest rate of $9.59% ($70 ÷ $730). The effective interest rate on a discounted loan with a compensating balance requirement can be calculated as follows: Effective rate = Stated rate ÷ (1.0 – Compensating balance %) = 7% ÷ (100% – 7% – 20 = 7% ÷ 73% = 9.59%
The Flesher Corporation was recently quoted terms on a commercial bank loan of 6% discounted interest with a 22% compensating balance. The term of the loan is 1 year. The effective cost of borrowing is (rounded to the nearest hundredth)
Answer (D) is correct. The effective interest rate on a discounted loan with a compensating balance requirement can be calculated as follows: Effective rate = Stated rate ÷ (1.0 – Stated rate – Compensating balance %) = 6% ÷ (100% – 6% – 22 = 6% ÷72% = 8.33%
The Red Company has a revolving line of credit of $300,000 with a 1-year maturity. The terms call for a 6% interest rate and a 1/2% commitment fee on the unused portion of the line of credit. The average loan balance during the year was $100,000. The annual cost of this financing arrangement is
Answer (C) is correct. The annual cost of Red’s financing arrangement can be calculated as follows: Annual cost = Interest expense on average balance + Commitment fee on unused portion = (Average balance × Stated rate) + [(Credit limit – Average balance) × Commitment fee %] = ($100,000 × 6%) + [($300,000 – $100,000) × 0.5%] = $6,000 $1,000 = $7,000
An example of secured short-term financing is
Answer (B) is correct. A warehouse receipt is issued by a person engaged in the business of storing goods for hire. Security for short-term inventory financing can be arranged if the debtor places its inventory under the control of the lender or its agent (e.g., a public warehouse), and the lender holds the warehouse receipts.
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges 1% commission on the amount of receivables. The net proceeds would be further reduced by an annual interest charge of 10% on the monies advanced. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 90 days is turned over to the finance company?
Answer (C) is correct. The first step is to calculate the gross proceeds the firm will receive from the factoring transaction: Amount of receivable $100,000 Less: reserve ($100,000 × 6%) (6,000 Less: factor fee ($100,000 × 1%) (1,000
Gross proceeds $ 93,000
This amount must be reduced by the interest charged on the gross proceeds: Gross proceeds $93,000 Times: annual finance charge × 10
Annualized interest expense $ 9,300 Times: portion of year (90 days ÷ 360 days) × 25
Interest expense $ 2,325
The actual cash the firm will receive from this factoring transaction is thus calculated as follows: Gross proceeds $93,000 Less: interest expense (2,325)
Net proceeds $90,675