Question

What is the cost of capital for bank overdraft (k_bo). The overdraft rate is 5.1 % pa compounded 12 times a year? Answer as a percentage to two decimal places (2.12% should be entered as 2.14)

Answer 1

Solution :

As per the information given in the question

The bank overdraft rate per annum is 5.1 %.

This implies that the monthly rate is = 5.1 % / 12 = 0.425 % = 0.00425

Further we know that the bank overdraft rate has been compounded monthly.

The formula for calculating the annual overdraft rate after the effect of compounding is

= [ ( 1 + Monthly rate ) n – 1 ]

Where n = no. of compounding periods

As per the information available we have

Monthly rate = 0.00425   ; n = 12 months   ; ( since compounding is monthly and there are 12 months in a year )

Applying the above information in the formula we have

= [ ( 1 + 0.00425 ) 12 - 1 ]

= [ ( 1.00425 ) 12 – 1 ]

= 1.052209 – 1

= 0.052209

= 5.2209 %

= 5.22 % ( when rounded off to two decimal places )

Thus the cost of capital for bank overdraft is = 5.22 %

Note : The value of ( 1.00425 ) 12   has been calculated using the excel function =POWER(Number,Power). Thus =POWER(1.00425,12) = 1.052209