20-3. Hank Scorpio is considering borrowing $20,000 for a year from a bank that

Question

20-3. Hank Scorpio is considering borrowing $20,000 for a year from a bank that has offered the following alternatives: a. An interest payment of $1,800 at the end of the year b. An interest payment of 8 percent of $20,000 at the beginning of the year c. An interest payment of 7.5 percent of $20,000 at the end of the year in addition to a compensating balance requirement of 10 percent (i) Which alternative is best for Ralph from the effective-interest-rate point of view? (ii) If Ralph needs the entire amount of $20,000 at the beginning of the year and chooses the terms under part c , how much should he borrow? How much interest would he have to pay at the end of the year?

Explanation / Answer

Answer:

Given in the problem some datas and hence the Effective annual interest can be calculated by applying = 1,800/20,000 = 9% b) Interest = $20,000 X 0.08 = $1,600 Effective annual interest = 1,600/(20,000-1,600) = 1,600/18,400 = 8.70% c) Interest = $20,000 X 0.075 = $1500 Compensating balance = $20,000 X 0.10 = $2,000 Effective annual interest = $1,500/($20,000 - $2,000) = 1,500/18,000 = 8.33% (i) Which alternative is best for Ralph from minimum effective interest rate point of view? Alternative c is better

(ii) Let B be the amount Ralph should borrow So, X - 0.1 X B = $20,000 Solving, B = $22,222.22 So, Ralph should borrow $22,222.22 and Interest payment = 22,222.22 X .075 = $1,666.67

Thank you.

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