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Chapter 3: 8BP (page 249)

Dr. Ruth is going to borrow \(5,000 to help write a book. The loan is for one year and the money can either be borrowed at the prime rate or the LIBOR rate. Assume the prime rate is 11 percent and LIBOR 1.5 percent less. Also assume there will be a \)45 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR). Which loan has the lower effective interest cost?

Short Answer

Expert verified

The LIBOR rate is less than the prime rate.

Step by step solution

01

Information provided in the question

Amount of loan = $5,000

Loan term = 1 year

Prime rate = 11%

LIBOR rate = 9.5%

Transaction fee in LIBOR = $45

02

Calculation of interest payable

The interest payable is $520.

Interestpayable=Interestrate脳Principal+Transactionfee=9.5%脳$5,000+$45=$520

03

Calculation of effective interest rate of LIBOR rate loan

The effective interest rate is 10.4%.

Effectiverate=InterestPrincipal脳DaysinyearDaysloanisoutstanding=$520$5,000脳360360=10.4%

04

Comparison between the prime rate and LIBOR interest rate

The prime rate is 11% and the effective LIBOR rate is 10.4%. Therefore, the LIBOR is lower than the prime rate, so this rate should be selected.

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Most popular questions from this chapter

City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers so the firm鈥檚 checks will take longer to clear the bank. Collection time has been reduced by two days and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yielding 12 percent per annum.

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Discuss the relative volatility of short- and long-term interest rates

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