Topka, Inc., needs to borrow $500,000 to meet its working capital requirements for next year. The Merchant Bank has offered the company a 9.5% simple interest loan that has a 16% compensating balance requirement. Determine the effective interest rate for the loan.
Answer (B) is correct. The effective interest rate is equal to the net interest expense over the usable funds. Topka’s net interest expense is equal to $47,500 ($500,000 × 9.5%). Because the bank is requiring a compensating balance of 16 , Topka’s usable funds are equal to $420,000 [$500,000 – ($500,000 × 16%)]. Thus, the effective interest rate is 11.31% ($47,500 ÷ $420,000 .
Buckeye Lawn Maintenance is a seasonal business and has decided to finance seasonal variations in current assets with short-term debt while financing the permanent component of current assets and all fixed assets with long-term debt or equity. Which one of the following best describes this type of financing?
Answer (B) is correct. The hedging approach to financing involves matching maturities of debt with specific financing needs.
Which one of the following is not a form of short-term credit?
Answer (D) is correct. Corporate bonds are not a form of short-term credit.