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?
Answer(s): D
Of the $500,000 borrowed, the debtor has the use of only $450,000. The compensating balance provision requires a minimum balance that is $50,000 greater than the balance that the company usually maintains. At 8% on a $500,000 loan, the annual interest expense is $40,000. However, this amount is reduced by the interest earned on the extra $50,000 in the checking account. At 3%, the extra $50,000 earns $1,500 per year. Thus, the net expense is $38,500. The effective interest rate is 8.56% ($38500 ÷ $450,000)
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?
The calculation of the cash that the company will initially receive from factoring $100,000 in receivables is as follows:
If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year.
If the gross amount of the invoice is $1,000, the buyer will pay $970 [$1,000 x (1 0 - .03)] if (s)he takes the discount. If (s)he does not, (s)he will pay $30 for the use of $970 for up to an additional 35 days. The percentage cost of not taking the discount is the annualized interest rate, that is, the $30 cost divided by the $970 effectively borrowed for 35 days, multiplied by the number of 35-day periods in a 360-dayyear. Thus, the cost of forgoing the discount is 31.81% [($30 ÷ $970) x (360 ÷ 35)].
If a firm borrows $590,000 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(s): B
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).
Which one of the following statements concerning cash discounts is correct?
Payments should be made within the discount periods if the cost of not taking discounts exceeds the firm's cost of capital. For example, failing to take a discount when terms are 2/10, net 30 means that the firm is paying an effective annual interest rate exceeding 36%. Thus, the cost of not taking a discount is usually higher than the cost of a bank loan.
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