Deep Sea Mining Inc wants to preserve financial flexibility

Deep Sea Mining Inc. wants to preserve financial flexibility by obtaining a line of credit for $10 million. The interest on any money borrowed is 11% (with annual compounding) and there is a 15% compensating balance requirement, i.e., 15% of the money borrowed must be kept in a non-interest bearing account with the bank.

The company wants to borrow $1,200,000 to build a new mine.

1. What is the annual interest rate on the loan if the company borrows $1,200,000 for one year?

Solution

Interest to be paid for loan of $1,200,000= $1,200,000* 11% = $132,000

Money we will actually receive in $1.2 Million loan= $1,200,000*(100-15)%= $1,020,000

Effective interest rate= ($132,000/$1,020,000) * 100 = 12.94%