Question

Mandaue Foam (MF) is a leading company in the furniture and fixture industry in the country. It has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six (6) months. MF has a credit line with a bank in case it suddenly needs to obtain funds for a temporary period. It previously purchased Treasury securities that it could sell if it experiences any liquidity problems. If the economy continues to be strong, MF may need to increase its production capacity by about 50% over the next few years to satisfy demand. It is concerned about a possible slowing of the economy because of the potential actions of Bangko Sentral ng Pilipinas (BSP) to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to raise funds in the next year. The prevailing commercial paper rate on paper issued by large publicly traded firms is lower than the rate MF would pay when using a line of credit.

Questions:

1. Do you think that MF could issue commercial paper at the prevailing market rate?
2. Should MF obtain funds to cover payments for supplies by selling its holdings of Treasury securities or by using its credit line? Which alternative has a lower cost? Explain.

Give the reference please. Thanks.

Answer 1

1. Yes, i think given the above scenario it would be optimal for MF to use a commercial paper to cover payments for supplies. This is because if MF uses its existing credit line, there are two unfavorable possibilities

• The company anticipates an economic slowdown which would mean less revenue generation and decreased funds with the firm. In such a situation paying off a higher interest as its debt obligation would be financially tolling on the company. Whereas using a CP would help them secure funding to cover payments while remaining on a smaller debt obligation
• If MF happens to use its credit line at the moment, and there is an economic surge contrary to its anticipation it might be unable to secure funds to boost its production by 50% as the credit line had exhausted and issuing and securing such huge amounts of funds in a shorter time-span might not be feasible through a CP. Also, there can be a potential increase in the interest rates of the CP due to the economic surge which would render MF relatively in a worse condition.

2. In case of an economic slump, where the BSP is trying to cut inflation the banks at such an instance will be reluctant to lend money due to resultant monetary policies. Whereas, treasury bills are no-risk investments and the government will oblige to their debt obligation at all times (unless the economy slips into hyperinflation, which in the current scenario is unlikely).
Conclusively, selling the treasury bills right now will lead to an increased opportunity cost in the future incase of an economic slump ( which is anticipated).
Hence, using the credit line instead of the treasury bills will invite lesser costs in the current situation