The Babco Co.has a £200,000 line of credit with an 8% interest rate and a 10% compensating balance requirement which is based on the total amount borrowed.What is the effective interest
Rate if the ﬁrm uses this source of funding to purchase a £117,000 piece of equipment? The company
Plans on repaying the loan in a lump sum at the end of one year.

Question

Quizplus · Accepted Answer

The effective interest rate accounts for the compensating balance. The firm borrows £117,000 but must maintain a 10% compensating balance, meaning they effectively have access to £105,300 (£117,000 - £11,700). The interest paid is £9,360 (8% of £117,000). The effective interest rate is £9,360 / £105,300 = 8.89%.