Certified Treasury Professional Practice Exam

To determine the effective annual borrowing rate when there is a compensating balance requirement, it's important to understand the implications of that compensating balance on the amount of funds available for borrowing. In this case, with a 20% compensating balance, it means that 20% of the credit facility must remain in the account and cannot be used.

The formula for calculating the effective interest rate when a compensating balance is involved can be expressed as follows:

1. Determine the effective loan amount. If, for instance, the total credit available is $100, a 20% compensating balance means that $20 must be kept in the account, leaving only $80 available for actual borrowing.

2. Calculate the annual interest payable on the full credit amount. If the interest rate on the credit facility is, for example, 7.8%, that would mean the borrower pays $7.80 in interest for the full $100, although they are only able to use $80 of it.

3. The effective borrowing cost can then be calculated using the actual amount of funds that can be utilized. The effective annual rate can be determined with the following calculation:

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