CFA Practice Question
eRetailer.com has a revolving credit agreement with a bank. eRetailer.com can borrow up to $2 million at 10% interest and is required to keep 10% compensating balance on all borrowed funds. If the firm must also pay a .4% (.004) compensating balance and borrows $1.2 million for the entire year, what is the effective cost of borrowing?
B. 11.6%
C. 12.2%
A. 10.4%
B. 11.6%
C. 12.2%
Correct Answer: B
Effective cost = [($1,200,000 x .10) + ($1,200,000 x .004) ] / (1,200,000 x .9) = ($120,000 + $4,800) / $1,080,000 = 11.6%
User Contributed Comments 7
| User | Comment |
|---|---|
| kutta2102 | Keep in mind - include those amounts that are "paid" in the numerator. Take out compensating balances and any 'discount' amounts from borrowed funds and use that as the denominator |
| CFALucille | I thought borrower had to pay the 0.4% on the unborrowed $800,000 - |
| Querdenker | Completely agree, CFALucille. Looks like an AN mistake here. |
| IvanTG | Tricky one...0.4% on COMPENSATING BALANCE...so the answer is correct however it seems odd that the company had to pay two separate interests for the same borrowed amount. |
| ddrmax | it didnt say compensating on the unused fund, so answer is correct |
| epfrndz | As a banker, interest charges on the compensating balance is weird. However based on the question, it does seem that it is asking for the appropriate charges on the compensating balance. |
| MathLoser | You are right. It's weird. Here's what I thought about the question. Compensating balance = 120,000 (10% of 1,200,000 because they have to keep 10% on all borrowed funds) Pay 0.4% compensating balance. Doesn't it mean 0.4% of 120,000 = 480? Effective cost of borrowing = 11.16%? |