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.

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The effective interest rate accounts for the compensating balance requirement. The firm must borrow $130,000 to net $117,000 after setting aside 10% ($13,000) as a compensating balance. The interest on $130,000 at 8% is $10,400. The effective interest rate is $10,400 / $117,000 = 8.89%.