
Concept explainers
a)
To determine: The effective annual interest rate.
Introduction:
Borrowing cost: The aggregate value of debt (inclusive of interest and other payments) is termed as borrowing cost. Compensating balance is the amount kept by the company in a bank with lower interest or as non-bearing accounts. It is a part of a loan agreement.
a)

Answer to Problem 14QP
Explanation of Solution
Given information:
A bank offers a loan to Mr. X’s firm Y. The cost of borrowing on a line of credit agreement is $70 million, interest rate 1.45% per quarter, and the required compensating balance is 5% against the portion which is being unused. The firm Y has a short-term investment account at the bank, which pays 0.85% per quarter.
The interest rate is on a
The formula to calculate the effective interest rate:
Where,
n is the number of months or year and the given number of months is 12
Compute the effective annual interest rate:
Hence, the effective annual rate is 3.44%.
b)
To determine: The effective annual interest rate on the loan for $45 million and if it is repayable within a year.
Introduction:
Borrowing cost: The aggregate value of debt (inclusive of interest and other payments) is termed as borrowing cost. Compensating balance is the amount kept by the company in a bank with lower interest or as non-bearing accounts. It is a part of a loan agreement.
b)

Answer to Problem 14QP
Explanation of Solution
Given information:
Firm Y borrows $45 million and repays it within a year; the required compensating balance is 5% against the unused portion of the credit line, firm Y has a short-term investment account at the bank, which pays 0.85% per quarter.
To calculate the effective annual interest rate, the loan’s interest is divided by the total loan value. The interest amount is a part of
Formulae:
The formula to calculate the opportunity cost:
The formula to calculate the effective interest rate:
Compute the opportunity cost:
Hence, the opportunity cost is $43,044.95.
Compute the interest paid to the bank:
Hence, interest cost is $2,667,318.24.
Compute the effective rate of interest:
Hence, the effective annual interest rate is 6.02%.
c)
To determine: The effective annual interest rate on the loan for $70 million
c)

Answer to Problem 14QP
Explanation of Solution
Given information:
Firm Y borrows $70 million and repays it within one year
Note: The compensating balance is applied only to the portion of credit line, which is unused. Therefore, the effective annual rate of the loan on the full credit line is calculated.
The formula to calculate the effective interest rate:
Where,
n is number of months or year and the given number of months is 12
Compute the effective annual interest rate:
Hence, the effective annual rate is 5.93%.
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Chapter 18 Solutions
Fundamentals of Corporate Finance with Connect Access Card
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