Question

 Penn Inc. needs to borrow $250,000 for the next 6 months. The company has a line of credit with a bank that allows the company to borrow funds with an 7% interest rate subject to a 20% of loan compensating balance. Currently, Penn Inc. has no funds on deposit with the bank and will need the loan to cover the compensating balance as well as their other financing needs. What will be the total interest amount for this financing?

•  $11,250

•  $10,000

•  $12,500

•  $8,750

Answer 1

A compensating balance is a minimum balance that must be maintained in a bank account, used to offset the cost incurred by a bank to set up a loan.

Here the company borrow $ 250,000 at 7%. The Bank requires that you maintain a 20% compensating balance. The effective interest rate is:

$ 17,500 / ($ 250,000 - $ 50,000) = 8.75%. pa.

Hence the company should pay the interest of $8,750 ($2,00,000*8.75%/2).