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Compensating Balances

Compensating Balances. 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. Warning: You cannot use the formula in the chapter for the effective interest rate when the compensating balance pays interest. Think about how to measure the effective interest rate on this loan.

Solution Preview

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

The compensating balance requirement is 25%; this implies 25% of the amount borrowed would be kept as compensating balance. Since the firm needs $10,000, it would have to borrow 10,000/ (1-0.25) = 13,333.33 to get $10,000 after the compensating balance.

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

Solution Summary

The solution explains the calculations relating to amount to borrow and the effective interest rate when there are compensating balances to be maintained.

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