[khachik2003]

Wiley Question –

the question asks:

On January 1, Scott Corp received a $300,000 line of credit at an interest rate of 12% and drew down the entire amount on February 1. The LOE agreement requires that an amount equal to 15% of the loan be deposited into a compensating balance account. What is the effective annual cost of credit for this loan agreement?

a. 11%

b. 12%

c. 12.94%

d. 14.12%

I calculated the interest cost for 11 months because the loan was drawn on Feb 1 and got $33,000. Then I divided that by the total amount available for the loan, $255,000 (300,000 x 85%). I got 12.94% but the book says the answer is 14.12% because they used the entire interest cost amount for the whole year.

I understand how to do the problem but what I don’t understand is why we would use the interest cost for the entire year ($36,000) instead of only the interest for 11 months ($33,000), seeing as how the loan was drawn on February 1st.

[kb24]

Interest rates, whether the one stated in the loan or the effective rate, are typically given as an annual rate. It doesn't matter what the length of the loan is. The quickest way to calculate it is to take the stated rate (12%) and divide by the percentage of the loan amount that is available for use (85%) for an answer of 14.12%. If this doesn't make sense try calculating the effective rate for one month and multiplying by 12.

$300000 * 1% = $3000

$3000/$255000 = 1.1765%

1.1765% * 12 = 14.12% effective interest rate

FAR 4/1/11 - 89
AUD 4/15/11 - 85
REG 4/29/11 - 80
BEC 5/13/11 - 85

[khachik2003]

so if I'm understanding this correctly, it is asking us for the entire year's interest cost, even though we only had to pay for 11/12 of it?

What if it didnt say ANNUAL effective interest rate and just asked for the effective interest rate?

thanks

[kb24]

You're appear to be confusing interest expense and interest rate. Interest expense is equal to the amount of interest in dollars accrued during the year. It will vary depending on how many months during the year interest was being accrued. Interest rate is a percentage that is not dependent on the number of months during the year that interest was accrued. You should assume it's annual unless specified as something else e.g. monthly, quarterly. Think about this. When you were doing the calculations, you treated the 12% stated rate as an annual rate i.e. you calculated the interest expense by multiplying the face value of the loan by 12% and then adjusted it for 11 months. There's nothing wrong with what you did, but in order to compare apples to apples, you need to reverse the process when calculating the effective interest rate i.e. once you got the 12.94% you needed to adjust it by multiplying it by 12/11 to get the annual effective interest rate.

Hope this helps.

FAR 4/1/11 - 89
AUD 4/15/11 - 85
REG 4/29/11 - 80
BEC 5/13/11 - 85

[khachik2003]

okay I got it, thank you very much

[Author]

Replies