CFA Level I · CFA Level I Exam · Working Capital and Liquidity
A firm borrows €2,000,000 on a line of credit for one year at a stated rate of 6%. The bank requires a compensating balance of 10% of the loan, which earns no interest, and the firm borrows the full amount. The effective annual cost of borrowing, assuming the firm needs the full €2,000,000 in usable funds and the compensating balance is part of the loan, is closest to:
The effective cost is closest to 6.7%. Interest of €120,000 is paid on the full €2,000,000 loan, but only €1,800,000 is usable after the 10% compensating balance. Dividing 120,000 by 1,800,000 gives about 6.67%, above the stated 6%.
- A6.0%
- B6.7%Correct
- C7.5%
Explanation
The loan is €2,000,000 with €200,000 held back, so usable funds are €1,800,000. Interest is 6% × 2,000,000 = €120,000. Cost = 120,000/1,800,000 = 6.67%, about 6.7%. Using 6.0% ignores the compensating balance.
Did you get it right without looking?
One question tells you little. A timed set on Working Capital and Liquidity shows your real accuracy, how long you take and where you lose marks.
More Working Capital and Liquidity questions
- A company needs short-term funding and is comparing a bank line of credit with commercial paper. Compared with a bank line of credit, commer…
- A company reports annual credit sales of 7,300,000, cost of goods sold of 5,110,000, average receivables of 800,000, average inventory of 70…
- A firm purchases goods on terms of 2/10, net 40. Assuming a 365-day year, the approximate effective annual cost of forgoing the discount and…
- A corporate treasurer is setting the objectives of the firm's short-term investment policy for surplus cash. Which objective should most lik…
- A firm reports annual sales of 3,650 and cost of goods sold of 2,555, all on credit. Average receivables are 300, average inventory is 350, …
- A company's cash conversion cycle lengthens from 35 days to 55 days over two years, driven by slower collection of receivables. The change w…