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 Topic: Effective Cost of Loan ( Topic Closed)
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cpasam101
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Joined: 12 Jul 2012
Location: United States
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Posts: 5
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| Posted: 16 Jul 2012 at 15:54 | IP Logged
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Hi,
I have a question I was hoping someone could help me with.
Hagar Company's bank requires a compensating balance of 20 percent on a
$100,000 loan. If the stated interest on the loan is 7 percent, what is the
effective cost of the loan?
a. 7.00 percent.
b. 8.18 percent.
c. 8.40 percent.
d. 8.75 percent.
Explanation
Choice "d" is correct. Total interest for the loan is $100,000 × 7% or
$7,000. The effective amount received is $80,000 after the 20%
compensating balance. The effective interest is
$7,000 / $80,000 = 8.75%
I understand the calculation but I thought that the calculation for effective
COST was different from the calculation of EFFECTIVE interest. Like in this
example:
Corbin Inc. can issue three-month commercial paper with a face value of
$1,000,000 for $980,000. Transaction costs would be $1,200. The effective
annualized percentage cost of the financing, based on a 360-day year,
would be:
a. 2.16% b. 8.48% c. 8.65% d. 8.00%
Explanation
Choice "c" is correct. The cost to issue the commercial paper is the $20,000
original issue discount ($1 million - $980,000), plus transaction costs of
$1,200 for a total of $21,200. Therefore, it costs $21,200 to borrow
$980,000 for 3 months. The 3-month interest cost is 2.16% ($21,200 /
$980,000).
The annual interest cost is 8.65%
Are they both asking for the same thing? The first one is calculating
effective interest, so what's the calculation for effective cost then?
Thanks in advance!
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ArcSine
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Joined: 14 Jun 2012
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| Posted: 17 Jul 2012 at 07:46 | IP Logged
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There are usually a number of different costs involved in any financing; the explicit interest is just one of these. In addition to interest there are usually fees of various types---although these non-interest fees are frequently lumped together under the term "transaction costs", as in your Corbin example.
There are no universally-agreed-upon definitions, but "effective interest" in many cases considers only the loan's explicit interest, as in your Hagar example; whereas "effective cost" casts a wider net and considers all costs, both explicit interest and transaction costs.
You can see this in the Corbin explanation: It refers to the "cost" as being the sum of the 20K OID (which is the "interest" for a zero-coupon instrument) and the trans costs.
It's likely that Hagar also incurs certain transaction costs in their arrangement (various bank fees, e.g.) but these are not mentioned since the focus is on "effective interest" and not on the broader concept of "cost".
Unfortunately, the real-world reality is that these two terms are often used interchangeably, and you simply have to examine the context carefully to determine the intended meaning, case by case.
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astone
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Joined: 23 Mar 2011
Location: United States
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Posts: 91
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| Posted: 23 Jul 2012 at 20:00 | IP Logged
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| This formula helped me with many of the calculations in BEC. |
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| GIVE/GET |
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| GIVE = Everything you have to give and do not get back |
| GET = Everything you get or can access |
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| Problem 1 |
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| Give = 100,000 *.07 = 7,000 |
| Get = 100,000 - (100,000 * .2) 20,000 = 80,000 |
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| 7,000 / 80,000 = 8.75% |
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| Problem 2 |
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| Give = 20,000 + 1,200 |
| Get = 980,000 |
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| 21,200/980,000 = 2.16 * 4 = 8.65% |
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cpasam101
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Joined: 12 Jul 2012
Location: United States
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| Posted: 23 Jul 2012 at 23:59 | IP Logged
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That makes a lot of sense! Thanks so much for that! I guess my problem
was that I didn't understand that they were getting $980,000. I thought with
the transaction costs, they were actually getting $1,200 less than that
amount. I guess when they say that they get it at a discount, that's actually
what they receive after the fees.
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