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Working Capital Financing^357

cash balance equal to the 10 per cent compensating balance. To accommodate the cost
of the compensating balance requirement, assume that the added funds will have to be
borrowed and simply left idle in the firmís checking account. Thus, (a) the amount
actually borrowed (b) will be larger than the needed Rs 200,000. In fact, the needed Rs
200,000 will comprise 90 per cent of the total borrowed funds due to the 10 per cent
compensating balance requirement, hence 90B =Rs 200,000, such that B =Rs 222,222.
Thus, interest is paid on a Rs 222,222 loan Rs 222,222 ◊ .12 ◊ Ω = Rs 13,333.32), of
which only Rs 200,000 is available for use by the firm.^2 The effective annual cost of
credit therefore is

13.33 per cent

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Rs 200,000

Rs 13,333.32

RATE = ¥ =

If the firm normally maintains at least Rs 200,000 (or 10 per cent of the needed funds)
in a demand deposit with the leading bank, then the cost of the credit is,

12 per cent

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Rs 200,000

Rs 12,000

RATE = ¥ =

In the M&M Beverage Company example the loan required the payment of principal
Rs 222,222) plus interest Rs 13,333.32) at the end of the six-month loan period.
Frequently, bank loans will be made on a discount basis. That is, the loan interest will be
deducted from the loan amount before the funds are transferred to the borrower,
extending the M&M Beverage company example to consider discounted interest involves
reducing the loan proceeds (Rs 200,000) in the previous example by the amount of
interest for the full six months (Rs 13,333.32). The effective rate of interest on the loan
is now:

.1429, or 14.29 per cent

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Rs 200,000 - Rs 13,333,32

RATE = Rs^ 13,333.32 ¥ =

The effect of discounting interest was to raise the cost of the loan from 13.33 per cent
to 14.29 per cent. This results from the fact that the firm pays interest on the same
amount of funds as before Rs 222,222); however, this time they get the use of Rs
13,333.32 less, or Rs 200,000 ñ Rs 13,333.32 = Rs 186,666.68.^3

3 If M&M needs the use of a full Rs 200,000, then they will have to borrow more than Rs 222,222 to cover

both the compensating balance requirement and the discounted interest. In fact, the firm will have to borrow

some amount B such that

B ñ .10 B ñ (.12 ◊ Ω) B = Rs 200,000

.84 B = Rs 200,000

B= Rs^ 200,000.84 = Rs 238,095

The cost of credit remains the same at 14.29 per cent, as we see below:

.1429, or 14.29 per cent

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Rs 238,095 - Rs 23,810 - Rs 14,285.70

RATE = Rs^ 14,285,70 ¥ =