### CFA Practice Question

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### 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?

A. 10.4%
B. 11.6%
C. 12.2%

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 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%?