A bank lends a firm $1,000,000 for one year at 12 percent on a discounted basis and requires compensating balances of 10 percent of the face value of the loan. The effective annual interest rate associated with this loan is ________.

Question

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When a loan is issued on a discounted basis, the interest is deducted from the loan amount at the beginning. For a $1,000,000 loan at 12%, the interest is $120,000. Thus, the firm receives $880,000 initially ($1,000,000 - $120,000). However, the firm must also maintain a compensating balance of 10% of the face value, or $100,000, reducing the effective amount available to the firm to $780,000 ($880,000 - $100,000). The effective annual interest rate is the interest paid divided by the effective amount received, or $120,000 / $780,000 = 15.38%, which rounds to 15.4%.

A Bank Lends a Firm $1,000,000 for One Year at 12