Question

28. If a firm borrows $50M from a commercial bank with interest rate 10%. But the bank requires the firm to put 10% of the total borrowings in the bank as a compensating balance. What’s the real cost of the debt?

		8.8%
		10.5%
		11.1%
		12.3%

Answer 1

Firm will get $ 50 M from bank after depositing $5 M (i.e. $50M*10%) to bank as a compensating balance. It means firm is getting only $ 45 M (50-5) as a loan from bank (Indirectly as a real loan).But, Firm have to pay 10% interest on $50 M instead of $ 45 M to the bank.

So,

Real cost of debt will be =   (Interest / Real loan)*100

Real cost of debt = [($50M*10%)/$45M]*100

Real cost of debt = ($5M / $45M)*100

Real cost of debt = 0.1111 * 100

Real cost of debt = 11.11 % or 11.1% (rounded off)

So,

3rd option is correct i.e. 11.1 %