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Paymaster Enterprises has arranged to finance its seasonal working-capital needs with a...

Question:

Paymaster Enterprises has arranged to finance its seasonal working-capital needs with a short-term bank loan. The loan will carry a rate of 12 percent per annum with interest paid in advance (discounted). In addition, Paymaster must maintain a minimum demand deposit with the bank of 9 percent of the loan balance throughout the term of the loan. If Paymaster plans to borrow $100,000 for a period of 4 months, what is the effective cost of the bank loan? Assume the Paymaster does not have sufficient funds in the bank to satisfy the compensating balance requirement.

Interest rate:

The rate which is charged by the lender to the borrower on the principal amount is known as the interest rate. The interest can be paid monthly, quarterly, semi-annually, and annually. It is an expense therefore it is recorded in the profit and loss account.

Answer and Explanation:

Calculating the interest for 3 month

{eq}\begin{align*} \rm\text{Interes}t &= \rm\text{ Loan amount } \times \dfrac{\rm\text{Rate}}{ {100}}\times \dfrac{\rm\text{Number of month}}{{12}}\\ &= \$ 100,000 \times \dfrac{{12}}{{100}} \times \dfrac{4}{12}\\ &= \$ 4,000 \end{align*} {/eq}

Calculating the amount of minimum demand deposit

{eq}\begin{align*} \rm\text{ Minimum demand deposit balance} &=\rm\text{ Loan amount } \times \rm\text{ Rate}\\ &= \$ 100,000 \times \dfrac{9}{100}\\ &= \$ 9,000 \end{align*} {/eq}

Calculating the principal amount:

{eq}\begin{align*} \rm\text{Principal} &= \rm\text{Loan amount} - \rm\text{ Interest } -\rm\text{ Minimum demand deposit}\\ &= \$ 100,000 - \$ 4,000 - \$ 9,000\\ &= \$ 87,000 \end{align*} {/eq}

Calculating the effective cost of the bank loan

{eq}\begin{align*} \rm\text{Cost of bank loan} &= \dfrac{\rm\text{Interest}}{\rm\text{Principal}} \times \dfrac{{1}}{\rm\text{Time}}\\ &= \dfrac{{\$ 4,000}}{{\$ 87,000}} \times \dfrac{12}{4}\\ &= 0.1379\\ &= 13.79\% \end{align*} {/eq}


Learn more about this topic:

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How to Calculate Interest Expense: Formula & Example

from Financial Accounting: Help and Review

Chapter 5 / Lesson 18
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