Choice "B" is correct. 11.1% effective interest rate on loan.
Annual interest | = | $500,000 × 10% | = | $50,000 | = | 11.1% |
Net cash available | $500,000 ($50,000 min) | $450,000 |
This question pertains to the computation of the effective rate of interest on a $500,000 note with a 10% stated rate that requires a $50,000 compensating balance. The answer computes the effective rate at 11.1% by taking the ratio of the amount paid $50,000 to the funds available $450,000 ($500,000 − $50,000). Why would the $50,000 in interest payments not also be deducted in arriving at the effective rate? The simple answer is that the note is not discounted by the interest. It is only subject to the compensating balance. The borrower receives $500,000 in proceeds but must hold out $50,000 and pay back $550,000, principal + interest, to the lender. At the conclusion of the loan, the compensating balance requirement is removed.
