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Abstract

Compensating balances are deposits the borrowing firm keeps with the lending bank in non-interest bearing accounts on loans. It is well known that, when there is no compensating balance imposed, the effective cost of debt remains the same in the two different payment methods, full amortization method and bullet loan (bond) method. It has been experimentally shown that when a compensating balance is imposed, however, the respective effective costs of debt under the two payment methods become different and that the true cost of a fully-amortized loan is always greater than that of a bullet loan. This paper provides a mathematical proof that this is always true. It concludes that, whenever a bank imposes a compensating balance, the borrowing firm should prefer a bullet loan to a fully-amortized one if it wishes to avoid an ambush posed by such a compensating balance.

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