Tangshan Mining borrowed $100,000 for one year under a line of credit with a stated interest rate of 7.5 percent and a 15 percent compensating balance. Normally, the firm keeps almost no money in its checking account. Based on this information, the effective annual interest rate on the loan is ________.
A) 7.5%
B) 8.0%
C) 8.8%
D) 7.2%

Question

Quizplus · Accepted Answer

To calculate the effective annual interest rate, we first need to calculate the amount of funds Tangshan Mining will actually receive. Since there is a 15% compensating balance, the firm will only receive $85,000 ($100,000 - 15%*$100,000).
Next, we need to calculate the interest paid on the loan. At a stated interest rate of 7.5%, the interest paid would be $7,500 ($100,000*7.5%).
Finally, we divide the interest paid by the funds actually received, and multiply by 100 to get the effective annual interest rate.
Effective annual interest rate = ($7,500/$85,000) * 100 = 8.82%
Therefore, the best choice is C, 8.8%.

Tangshan Mining Borrowed $100,000 for One Year Under a Line