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Compensating Balance

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Suppose that Dynamic Sofa (a subsidiary of Dynamic Mattress) has a line of credit with a stated interest rate of 10 percent and a compensating balance of 25 percent. The compensating balance earns no interest.

a. If the firm needs $10,000, how much will it need to borrow?
b. Suppose that Dynamic's bank offers to forget about the compensating balance requirement if the firm pays interest at a rate of 12 percent. Should the firm accept this offer? Why or why not?
c. Redo part (b) assuming the compensating balance pays interest of 4 percent.

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Solution Summary

The solution explains various calculations when amount borrowed is subject to compensating balance.

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a. If the firm needs $10,000, how much will it need to borrow?

Since the firm needs a 25% compensating balance, the amount to be borrowed is 10,000/0.75 = 13,333.33. Of this the compensating balance is 13,333.33X.25=3,333.33 and the amount taken on loan is 13,333.33-3,333.33=10,000

b. Suppose that Dynamic's bank offers to ...

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