Question

3. PAC Inc. has arranged for their company (Actors Guild Inc.) to get a short-term bank loan for the Fall season. The interest rate will be 12% per annum with the interest paid in advance. The President of the bank requests that Actors Guild Inc. keep 10% compensating balances for the full term of the loan. If Actors Guild Inc. plans to borrow $500,000 for 6 months what is the effective cost of this bank loan?

Answer 1

Answer : Compensating balance is the minimum balance that a borrower has to maintain with the lender, the main motive behind this is to reduce the lending costs, These balance is hold in savings or checking account and the effective interest rate charged on loan with compensating balance is higher than without compensating balance.

Borrowed amount - $500,000

Compensating Balance - 10%

Comensating Balance = Amount Borrowed * Percentage of Compensating balance

= 500,000 * 10%

= $50,000

Effective Rate with Compensating Balance = Interest Rate / (1 - Percentage of compensating balance)

Interest rate is 12% Per annum and Compensating balance is 10%

So, Effective Rate = 12% / ( 1 - 10%)

= 12% / 0.9

= 13.33%

The Effective rate with compensating balance annually is 13.33%

So, For Six Months, It will Be

= 13.33% / 2

= 6.665% (Approx)

So, The answer is 6.665%