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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.

## SOLUTION This solution is FREE courtesy of BrainMass!

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 is 800,000 and the compensating balance is 800,000X15% = 120,000. Total interest to be paid is 800,000X11% = 88,000

a) If no deposit is maintained, the amount of loan would be 800,000-120,000=680,000
Effective annual rate = 88,000 interest paid/680,000 funds used = 12.94%

b) If the 70,000 deposit is maintained, then remaining compensating balance is 50,000. The loan amount is 750,000
Effective annual rate = 88,000/750,000 = 11.73%

c) With the 150,000 deposit, no compensating balance is needed and so loan amount is 800,000
Effective annual rate = 88,000/800,000 = 11%

d) What the calculations suggest is that as the compensating balance amount increases the effective annual rate increases since less funds are used. A company which maintains deposit with a bank is in a better situation as compared to a company with no deposit with the bank.

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