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Q: Compensating balances and effective annual rates ( Answered,   0 Comments )
Question  
Subject: Compensating balances and effective annual rates
Category: Business and Money > Finance
Asked by: help123-ga
List Price: $10.00
Posted: 06 Apr 2005 10:18 PDT
Expires: 06 May 2005 10:18 PDT
Question ID: 505816
I have a line of credit at my bank that requires me to pay 11%
interest on my borrowings and I must maintain a compensating balance
equal to 15% of the amount borrowed. I have borrowed $800,000 during
the year uder this agreement, but I am having difficulty calculating
the annual rate of the borrowing in the following situations:
- If I maintain no deposite at the bank
- If I maintain $70,000 in deposite at the bank
- If I maintain $150,000 in deposite at the bank

Thanks!

Clarification of Question by help123-ga on 06 Apr 2005 10:36 PDT
I need this answer by Thursday.
Answer  
Subject: Re: Compensating balances and effective annual rates
Answered By: elmarto-ga on 06 Apr 2005 11:24 PDT
 
Hi help123!
If you borrow $800,000, then you'll have to pay 0.11*800000 = $88,000
every year because of interest charges.

When the bank asks you to mantain a compensating balance, this is
equivalent to actually lending you less than the full $800,000,
because you won't be able to use all of it. For example, if they
require you to mantain 15%, then 15% of $800,000 is $120,000, so the
actual amount you borrow is $800,000-$120,000=$680,000. Still, you'll
have to pay $88,000 yearly. So here's how to calculate the "effective"
annual rate in each case:

- No deposit
In this case you keep the full $800,000, and pay $88,000 a year.
Therefore, the annual rate is clearly 11%.

- Mantain $70,000
The actual amount you borrow here is $730,000, on which you pay
$88,000 a year. Therefore, the interest rate is 88000/730000=0.1205.
You're paying an effective annual rate of 12.05%.

- Mantain $150,000
The actual amount you borrow here is $650,000, on which you pay
$88,000 a year. Therefore, since 88000/650000=0.1353, you're paying an
annual rate of 13.53%.


I hope this helps!
Best wishes,
elmarto
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