Dee%u2019s Christmas Trees, Inc., is evaluating options for financing its season

Question

Dee%u2019s Christmas Trees, Inc., is evaluating options for financing its seasonal working-capital needs. A short-term loan from Liberty Bank would carry a 14% annual interest rate, with interest paid in advance (discounted). If this option is chosen, Dee%u2019s would also have to maintain a minimum demand deposit equal to 10 percent of the loan balance, throughout the term of the loan. If Dee%u2019s needs to borrow $125,000 for the upcoming three months before Christmas, what is the effective cost of the loan?

Explanation / Answer

interest expense for the three-month loan as follows: Interest = .14 x $125,000 x 3/12 = $4,375.

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Assuming that Dee has to leave 10% of the loan idle in a compensating balance, the effective cost of credit can be calculated as follows: APR = [$4,375/($125,000 - 12,500 - 4,375)] x (12/3) = 16.18%

================================================================================================================================================= If the company already has sufficient funds in the bank to satisfy the compensating balance requirement, then the cost of credit drops to 14.51%.

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