Question

Citibank has approved an 8% $1.5 million dollar loan to Delta Airlines. The loan attracts an application fee of $50,000 and requires a compensating balance equivalent to 10% of the loan amount. What is the contractually promised gross return on the loan if the Federal Reserve Bank mandates a reserve requirement of 5%

Answer 1

We know that -

1 + k = 1 + (f + BR + m)/(1 - [b(1-RR)])

Here -

f = application fee

BR = base rate

m = margin

b = compensating balance equivalent

RR = Reserve requirement

k = Contractually promised gross return

Here we assume that the margin is built in the base rate for the loan.

f = 50000/1500000 = 3.33 %

Putting in the values -

1 + k = 1 + (0.033 + 0.08)/(1-[.1*(1-.05)]) = 1+ .1248 = 1.1248

or, k = 12.48 %

Hence contractually promised gross return is 12.48 %