Question

Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $154,000 for 6 months. State Bank has offered to lend the funds at an annual rate of 9.5% subject to a 9.8% 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 9.5% 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 L %. (Round to two decimal places.)

Answer 1

a)	State Bank:
	Loan required to cover compensating balance = 154000/(1-9.8%) =	$ 1,70,731.71
	Interest for 6 months = 170731.71*9.5%/2 =	$       8,109.76
	Total amount repayable = 170731.71-170731.71*9.8%+8109.76 =	$ 1,62,109.76
	Bank's semi-annual rate = 162109.76/154000-1 =	5.27%
	Effective annual rate of interest on the bank loan = ((1+162109.76/154000-1))^2-1	10.81%
	Frost Finance Co:
	Amount raised as a discount loan = 154000/(1-4.75%) =	$ 1,61,679.79
	Frost semi-annual rate = 161679.79/154000 =	4.99%
	Frost effective annual rate of interest = ((1+(161679.79/154000-1))^2-1 =	10.22%
b)	Weathers could negotiate with the Bank to reduce the
	interest rate as there is a 9.8% compensating balance
	or in the alternative reduce the compensating balance.