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 a balance of about $10,000 in its checking account. Based on this information, the effective annual interest rate on the loan is ________.
A) 7.89%
B) 8.05%
C) 8.89%
D) 7.29%

Question

Quizplus · Accepted Answer

The effective annual interest rate is 7.89%.The compensating balance is 15% of $100,000, or $15,000. This means that Tangshan Mining must keep $15,000 in its checking account at all times. However, the firm normally keeps only $10,000 in its checking account. Therefore, the firm must borrow an additional $5,000 to maintain the compensating balance.The interest on the $5,000 loan is $5,000 * 7.5% = $375. The effective annual interest rate on the loan is therefore ($375 + $7,500) / $100,000 = 7.89%.

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