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# Compensating balances and effective annual rates

Company X has a line of credit at Bank A that requires it to pay 11% interest on its borrowing and to maintain a compensating balance equal to 15% of the amount borrowed. The company has borrowed \$800,000 during the year under the agreement. Calculate the effective annual rate on the company's borrowing in each of the following circumstances:

a) The company normally maintains no deposit balances at Bank A.

b) The company normally maintains \$70,000 in deposit balances at Bank A.

c) The company normally maintains \$150,000 in deposit balances at Bank A.

d) Compare, contrast, and discuss your findings in parts a, b, and c.

#### Solution Preview

In compensating balance, a part of the funds is kept with the bank and only the remaining amount is given out as a loan, while interest is paid on the full loan value. If some deposit is maintained, then compensating balance is adjusted with the deposit.
In this case the loan amount ...

#### Solution Summary

The solution explains how to calculate the effective annual rate with compensating balance

\$2.19