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