Summit Record Company is negotiating with two banks for a
a. Calculate the effective interest rate for Fidelity Bank and Southwest Bank. Which loan should Summit accept?
b. Recompute the effective cost of interest, assuming that Summit ordinarily maintains
c. Does your choice of banks change if the assumption in part b is correct?
a.
To calculate: The effective rate of interest for Summit Record Company, and determine whether Fidelity Bank or Southwest Bank should be chosen by the company.
Introduction:
Effective interest rate:
Also termed as annual equivalent rate, it is the rate actually charged on an investment or a loan over a specific time period.
Compensating Balance:
Also known as offsetting balance, it is the minimum balance that the borrowing company needs to maintain in its bank account. This benefits the lender by lowering their cost of lending.
Answer to Problem 26P
The effective rate of interest for Fidelity Bank is 25.81% and that for Southwest Bank is 21.47%.
Thus, Southwest Bank should be chosen by the company as it has the lowest effective rate of interest.
Explanation of Solution
Calculation of the effective rate of interest for Fidelity Bank:
Calculation of the effective rate of interest for Southwest Bank:
Working Note:
Calculation of the interest for Fidelity Bank:
Calculation of the compensating balance for Fidelity Bank:
Calculation of the stated compensation balance for Fidelity Bank:
Calculation of the interest for Southwest Bank:
Calculation of the compensating balance for Southwest Bank:
b.
To calculate: The effective cost of interest for Summit Record Company.
Introduction:
Effective interest rate:
Also termed as annual equivalent rate, it is the rate actually charged on an investment or a loan over a specific time period.
Compensating Balance:
Also known as offsetting balance, it is the minimum balance that the borrowing company needs to maintain in its bank account. This benefits the lender by lowering their cost of lending.
Answer to Problem 26P
The effective rate of interest for Fidelity Bank is 17.78% and that for Southwest Bank is 18.46%.
Explanation of Solution
Calculation of the effective rate of interest for Fidelity Bank:
Calculation of the effective rate of interest for Southwest Bank:
c.
To determine: Whether the choice of banks remains the same if the assumption taken in part (b) is correct.
Introduction:
Effective interest rate:
Also termed as annual equivalent rate, it is the rate actually charged on an investment or a loan over a specific time period.
Compensating Balance:
Also known as offsetting balance, it is the minimum balance that the borrowing company needs to maintain in its bank account. This benefits the lender by lowering their cost of lending.
Answer to Problem 26P
Yes, the choice of bank would remain the same if the assumptions in part (b) are taken to be correct.
Explanation of Solution
Since the effective rate of Fidelity Bank is lower than that of Southwest Bank, Fidelity Bank should be chosen over Southwest Bank if compensating balance is to be maintained by both banks. The effective cost of the loan by Fidelity Bank would be lesser.
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Chapter 8 Solutions
EBK FOUNDATIONS OF FINANCIAL MANAGEMENT
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