Introduction to Finance

discounted loan
is one in which the borrower 
receives the principal less the interest at the time the loan is made. The principal is repaid 
at maturity. Discounting has the eff ect of reducing the available funds received by the bor-
rower while raising the eff ective interest rate. If Eastnorth’s loan is discounted, Eastnorth will 
receive $9,600 ($10,000 less $400) and will repay $10,000; in essence, paying $400 interest 
on the $9,600 funds received. This is a periodic rate of $400/$9,600, or 4.17 percent.
6
The 
eff ective annual rate is (1 + 0.0417)
2
– 1, or 8.51 percent, an increase of 0.35 percentage points 
over the undiscounted loan.
When a loan is discounted, a fi rm has to borrow more money than the amount it needs. To 
counteract the eff ect of discounting when acquiring $10,000 in usable funds, they will have to 
borrow $10,000/(1 – 0.04), or $10,416.67. When a loan of $10,416.67 is discounted at a six-
month rate of 4 percent, the net proceeds to Eastnorth will be $10,000 (that is, $10,416.67 – 
[0.04][10,416.67] = $10,000). In general, to receive the desired usable funds, the loan request 
must equal the following:
Loan request = Desired usable funds/(1 – discount)
(16-2)
A loan with a compensating balance is similar to a discounted loan in terms of its eff ect on 
the eff ective interest rate and usable funds. Compensating balances are equivalent to discount-
ing when the fi rm currently has no money on deposit at the bank. The fi rm’s loan request should 
be large enough so that after funds are placed in the compensating balance it will have the 
usable funds it desires. For compensating balance loans, equation 16-2 becomes the following:
Loan 
request =
Desired usable funds
(1 − Compensating balance requirement)
(16-3)
This is identical to equation 16-2, except the discount percent is replaced by the compensating 
balance percentage.
Revolving Credit Agreements 
The offi
cers of a business may feel certain that an agreed-upon line of credit will provide the 
necessary capital requirements for the coming year, but the bank is not obligated to continue