The Dixon Corporation has an outstanding 1-year bank loan of $300,000 at a stated interest rate of 8%. In addition, Dixon is required to maintain a 20% compensating balance in its checking account. Assuming the company would normally maintain a zero balance in its checking account, the effective interest rate on the loan is

Answer (D) is correct. The requirement to maintain a compensating balance of 20% of the $300,000 loan means that the borrower has effective use of only 80% of the loan, or $240,000. The 8% interest rate applied to a $300,000 loan requires an annual interest expenditure of $24,000. In turn, paying $24,000 for the use of $240,000 indicates an effective interest rate of 10%.