(Estimate the cost of bank credit) Payview Inc. has arranged to finance its seas

Question

(Estimate the cost of bank credit)
Payview Inc. has arranged to finance its seasonal working-capital needs with a short-term bank loan.

The loan will carry 12% per annum with interest paid in advance (discounted).

In addition, Paymaster must maintain a minimum demand deposit with the bank 9% of the loan balance throughout the term of the loan.

If Payview Inc. plans to borrow $100,000 for a period of 4 months, what is the effective cost of the bank loan?

*Hint Assume the Payview does not have sufficient funds in the bank to satisfy the compensating balance requirement.*

Explanation / Answer

If the interest is paid in advance it will be 4,000 (100,000*.12 *4/12).
The compensating balance will be 9,000 (I assume this will be on the 100,000, not on 96,000).

So in effect we have 4,000 interest charge on a 87,000 loan (100,000-9,000-4,000) so the rate will be 4,000/87,000 for the 4 months or 4.6% and 3*4.6 or 13.8% for 1 year.

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