estrada graphics a graphic design firm has borrowed 1 million under a line of credit 681676

Estrada Graphics, a graphic design firm, has borrowed $1 million under a line of credit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 x $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 ÷ $800,000), 2.5% more than the stated rate of 10%. If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 ÷ $900,000). Thus a compensating balance raises the cost of borrowing only if it is larger than the firm’s normal cash balance.