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    Compensating balances and effective annual rates

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    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.

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    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.