Question

Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $153,000 for 6 months. State Bank has offered to lend the funds at an annual rate of 8.6% subject to a 10.4% compensating balance. (Note: Weathers currently maintains $0 on deposit in State Bank.) Frost Finance Co. has offered to lend the funds at an annual rate of 8.6% with discount-loan terms. The principal of both loans would be payable at maturity as a single sum. a. Calculate the effective annual rate of interest on each loan. b. What could Weathers do that would reduce the effective annual rate on the State Bank loan? a. State Bank's semi-annual rate is %. (Round to two decimal places.) State Bank's effective annual rate is (Round to two decimal places.) Frost Finance's semi-annual rate is %. (Round to two decimal places.) Frost Finance's effective annual rate is %. (Round to two decimal places.) b. What could Weathers do that would reduce the effective annual rate on the State Bank loan? "If Weathers became a regular customer of State Bank and kept its normal deposits at the bank, then the additional deposit required for the compensating balance would be reduced and the cost would be lowered." Is the above statement true or false? V (Select from the drop-down menu.)

Answer 1

Answer a)

for state bank : Semiannual rate = (1 + annual rate)^(1/2) – 1

Semiannual rate = (1 + 8.6%)^(1/2) – 1 = 4.2211%

Effective interest rate with Compensating deposit = Interest / Principle - Compensating deposit

=> ER = 4.2211% / (1-10.40%) = 0.047 = 4.7%

Semiannual rate = (1 + annual rate)^(1/2) – 1

Semiannual rate = (1 + 8.6%)^(1/2) – 1 = 4.2211%

Effective interest rate in discounting loan = Interest / Principle - interest deduction

ER = 4.2211% / (1-4.2211%) =0.04397 = 4.397%

Answer b)

The above statement is True

The normal deposit may be used at place of required compensating deposit