D is corrent. The effective interest rate on a borrowing is the net annual interest cost divided by the net available proceeds from the borrowing. Cody’s gross annual interest cost is $240,000 ($2,000,000 x 12%). Cody is required to maintain a compensating balance of $400,000, which is $200,000 more than their normal balance of $200,000. Therefore, Cody earns incremental annual interest revenue of $12,000 ($200,000 x 6%) on the excess compensating balance. The net annual interest cost is $228,000 ($240,000 - $12,000). The net available proceeds from the borrowing is $1,800,000 ($2,000,000 loan less $200,000 excess compensating balance). Therefore, the effective annual interest rate is 12.67% ($228,000 ?? $1,800,000).
A is incorrect because interest revenue should only be recognized on the incremental compensating balance ($200,000) and the funds available should only be reduced by the incremental compensating balance, not the entire compensating balance.
B is incorrect because it fails to consider the additional information.
C is incorrect because it fails to consider the interest revenue earned on the incremental $200,000.
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