Question

Jumbo Enterprises plans to borrow R1 000 000 for one year. The stated interest rate is 15% per annum.

Required:

Use the information provided above to calculate the effective interest rate if:

4.3.1 The interest is discounted

4.3.2 There is a 25% compensating balance requirement

Answer 1

Required amount to be borrowed = 1,000,000

standard interest rate = 15%

Discounted factor @ 15% for 1 year = 1/ (1 + 15%)^1

= 1/ (1 + 0.15)^1

= 1/ 1.15 = 0.8696 = 0.870

Discounted factor @ 15% for 1 year = 0.870

Case 1: Effective interest rate if the interest is discounted:

Interest to be paid at end of 1 year = 1,000,000 * 15% = 150,000

Discounted interest to be paid for 1 year @ 15% = 150,000 * Discounted factor @ 15% for 1 year

= 150,000 * 0.870 = 130,500

So, Discounted interest to be paid for 1 year @ 15% = 130,500

Effective interest rate = 130,500 / 1,000,000 = 0.1305 = 13.05%

Therefore, Effective interest rate = 13.05%

Case 2: Effective interest rate if there is a 25% compensating balance requirement

A compensating balance is a minimum balance that must be maintained with the bank, used to offset the cost incurred by a bank to set up a loan.

In the current case, compensating balance requirement is 25%. So Jumbo Enterprises should maintain 25% of loan amount with the bank, and hence it receives only 75% of the loan amount.

Interest for 1 year for 75% of loan amount = 1,000,000 * 75% * 15% = 112,500

Effective interest rate for 1 year with 25% compensating balance requirement = 112,500 / 1,000,000 = 0.1125

Effective interest rate for 1 year with 25% compensating balance requirement = 11.25%