A firm borrows $100,000 from the bank, but has to maintain a compensating balance of $20,000 with the bank.The annual interest rate for the loan is 12%.What is the effective annual rate if the interest is compounded monthly?

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Quizplus · Accepted Answer

The effective annual rate (EAR) is calculated by considering the actual amount available for use, which is $80,000 ($100,000 - $20,000). The nominal interest rate is 12%, but since the compensating balance reduces the usable funds, the effective rate is higher. The formula for EAR with monthly compounding is: EAR = (1 + (0.12/12))^12 - 1, adjusted for the compensating balance, leading to an EAR of approximately 16.08%.

A Firm Borrows $100,000 from the Bank, but Has to Maintain