Compensating balance versus discount loan Weathers Catering Supply, Inc., needs

Question

Compensating balance versus discount loan Weathers Catering Supply, Inc., needs to borrow $147,000 for 6 months. State Bank has offered to lend the funds at an annual rate of 8.6 % subject to a 10.1 % 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. (This part should have four answers)

b.What could Weathers do that would reduce the effective annual rate on the State Bank loan?

Round answers to two decimal places

Explanation / Answer

A

Loan with compensating balance

Interest = 147000*8.6% = 12642

Proceeds = 147000*(100%- 10.1%) = 132153

EAR = Interest/ Proceeds = 12642/ 132153 = 9.57%

Loan with discount terms

Interest = 147000*8.6%= 12642

EAR = Interest/ Principal-Interest

= 12642/ (147000-12642)

= 9.41%

B. For reducing the EAR on the state bank loan, Weathers can consider becoming a regular customer of State Bank. By doing so, he will maintain regular deposit with the bank and reduce the requirement of maintaining compensating balance. Also, he can negotiate with the bank to charge fees instead of compensating balance.

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