Question

To help ease a contginuing need for financing, the CFO of E.I. DuPont de Nemours & Company is considered borrowing from insurance companies (private placement). in addition to the public debt markets. She must choose between transactions suggested by two different insurance companies. In both transactions, DePont would receive $10,000,000 upfront in edxchange for a note promosing a single (larger) maturity payment from DEPont in 15 years at a promised interest rte. The 2 options open to DuPont are:

1.) A note to Pru-Johntower Life insurance company, promosing an anuual rate of interest of 10%;

2.) a note to Tom Paine Mutual Life Insurance Company, promising a rate of interest of 9.72% per year, compounded monthly

Compare the effective annual rtes of the two notes; also compare the future required payment that DuPont will make in 15 years under each option.

Answer 1

In case 1 the effective annual rate is 10% as it is compounded annually. in Case 2 the effective annual rate is caluculated as =(1+ nominal annual rate /12)¹² -1 = (1+ 9.72%/12)¹² - 1 = 10.165%

Hence in case 2 the company will be paying 0.165% higher annualy.

Both the cases can be compared as per below table:

	Case 1	Case 2
Nominal Annual rate	10%	9.72%
Monthly rate	0.833%	0.810%
Compounded	Yearly	Monthly
Effective annual interest rate	10.00%	10.165%
Total effective interest in 15 years	317.7%	327.2%
Total Payment after 15years	41772481.69	42721909.3

Hence if company opts for case 2, company E.I. DuPont will have to pay $949,427 more after 15 years which is around 2.27% higher than option 1. Hence it is advisable to go with option1.