Question:

E16–4 Jackson Industries has borrowed $125,000 under a line-of-credit agreement. While the
company normally maintains a checking account balance of $15,000 in the lending bank, this
credit line requires a 20% compensating balance. The stated interest rate on the borrowed funds
is 10%. What is the effective annual rate of interest on the line of credit?

Solution:

If you borrow $125,000, then you'll have to pay 0.10*125000 = $12,500 every year because of
interest charges.

When the bank asks you to maintain a compensating balance, this is Equivalent to actually
lending you less than the full $800,000 because you won't be able to use all of it. For example, if
they require you to maintain 20%, then 20% of $125,000 is $25,000, so the Actual amount you
borrow is $125,000-$25,000=$100,000. Still, you'll have to pay $12,500 yearly. So here's how to
calculate the "effective" Annual rate in each case:

- But you are maintaining $15,000

The actual amount you borrow here is $110,000(125,000-15,000), on which you pay $88,000 a
year. Therefore, the effective interest rate is 12,500/110,000=0.1136.

So, the effective annual rate of interest on the line of credit is 11.36%.