ABC Company is a net borrower with a weighted average cost of capital of 11.5%. What kind of bank fee arrangement is it likely to prefer?

A net borrower, by definition, has a need for cash and its cost of funds is a key consideration. The company's weighted average cost of capital (WACC) of 11.5% represents its opportunity cost—the return it could generate by investing cash in its operations or the cost it saves by paying down debt. When choosing how to pay for bank services, the company compares this opportunity cost to the earnings credit rate (ECR) a bank offers on compensating balances. Since the ECR is typically based on short-term interest rates and is almost always significantly lower than a company's WACC, the implicit cost of holding balances (forgone earnings of 11.5%) is much higher than the explicit cost of paying direct fees. Therefore, it is more cost-effective for this company to pay direct fees and deploy its cash elsewhere.

B. Balance compensation: This is economically disadvantageous because the opportunity cost of holding the required balances (11.5%) is significantly higher than the earnings credit the bank would provide.

C. Average balance compensation: This is a method of calculating balance compensation and is incorrect for the same reason as option B; it remains an expensive choice for a net borrower.

D. Average fee compensation: This is not a standard industry term for a bank compensation arrangement and is included as a distractor.

1. Association for Financial Professionals. (2021). Essentials of Treasury Management (6th ed.).

Chapter 7: Bank and Financial Service Provider Relationship Management

Section: Compensation. This section explains the trade-off between fee and balance compensation. It states that a company should compare its opportunity cost (for a net borrower

its borrowing rate or WACC) to the bank's ECR. If the opportunity cost is greater than the ECR

it is more cost-effective to pay for services with direct fees. Given a WACC of 11.5%

this condition is met.

2. Brigham

E. F.

& Daves

P. R. (2019). Intermediate Financial Management (13th ed.). Cengage Learning.

Chapter 22: Working Capital Management. The text discusses compensating balances as a part of bank relationships. It clarifies that the cost of maintaining these balances is the opportunity cost of the funds. For a firm with a high cost of capital

tying up cash in low-yielding compensating balances is an inefficient use of resources compared to paying explicit fees.

3. Gallagher

T. J.

& Andrew

J. D. (2018). Financial Management: Principles and Practice (8th ed.).

Chapter 15: Working Capital Management. This chapter discusses cash management techniques and notes that firms with high borrowing costs (i.e.

net borrowers) prefer to minimize idle cash balances. Paying explicit fees for bank services aligns with this principle

as it frees up cash to be used for reducing debt or funding operations

which provides a return or cost savings closer to the WACC.