Assume that Ningbo Steel borrows $1,000,000 for one year under a line of credit with a stated interest rate of 7.5 percent and a 15 percent compensating balance and that the firm keeps no money on deposit in its checking account. Based on this information, the effective annual interest rate on the loan is

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The effective annual interest rate takes into account the impact of the compensating balance on the actual amount of funds available for use. With a 15% compensating balance, Ningbo Steel must keep $150,000 (15% of $1,000,000) in the account, leaving $850,000 effectively available for use. However, the interest is calculated on the full $1,000,000. Therefore, the effective interest rate is $75,000 (7.5% of $1,000,000) divided by $850,000, which equals approximately 8.8%.

Assume That Ningbo Steel Borrows $1,000,000 for One Year Under