A XYZ bank lends a firm $5,000,000 for one year at 12 percent on a discounted basis and requires compensating balances of 10 percent of the face value of the loan

Answer )

Please Note that

Discounted loans are loans that have the interest payment subtracted from the principal before the loan is disbursed .

Also in some loans you may be required to keep a deposit of funds at the bank to qualify for the loan. This deposit is known as a compensating balance and If you fail to repay the loan, the bank can seize the compensating balance.

So For Calculating effective annual interest rate We have to Divide interest by the available principal

Interest Paid = $5,000,000 * 12% = $6Lakh

Compensating Balance Kept by bank = $5,000,000 * 10% = $500000

Amount Received (i.e. Principal Available) = $5,000,000 - $600000 - $500000 = $3900000

Amount Received = $39 Lakh

Effective Interest Rate = $6 Lakh / $3900000

= 15.38%