Question

a) Assume the rate of interest quoted in the 90-day commercial paper market is 4.0%. You issued $10 million (face value) of 90-day commercial paper, with an interest rate of 4.0%.

i) How much did you borrow? Show the supporting calculations.

ii) If you borrowed the same amount in the Eurodollar deposit market and paid 4% interest in that market, how much would you pay back in 90 days? Show the supporting calculations. [Note: If you couldn’t figure out the answer to part (i), just assume you borrowed an amount X.]

The following parts are independent of each other. [Note: You are strongly advised to provide concise answers and presenting your answers in point form).

(bi) Give TWO reasons why the interest rate for a given maturity in the commercial paper market is typically lower than the interest rate for the same maturity in the Eurodollar market.

(bii) A finance company wishes to raise money so that it can make (potentially) profitable loans. Is it more likely to use the RP market (rolling over overnight borrowing) or the commercial paper market (rolling over 90-day borrowing) to do so? Explain.

c) Explain why a startup might choose to issue equity instead of debt. Describe the nature of the equity. [Hint: When you supply financing (debt or equity) to a firm, what make it pay you back?]

d) Define what is meant by the statement that “the typical IPO is underpriced.” Provide THREE possible explanations for IPO underpricing.

Answer 1

(a)

i. Amount borrowed is equal to the price at which commercial papers were issued.

FV = $10 million

Yield = 4%

Maturity period = 90 days

Price = $10 million / (1+4%*90/360) = $9.901 million

ii. Eurodollar time deposits are quoted using annualized simple interest assuming a 30/360 day count. This means that a 3-month (90 day) $9.901 million Eurodollar time deposit made at 4% will pay

$9.901 million*4/100*90/360 = $0.099 million = $99,010

(bii) The finance company is more likely to issue commercial paper to raise money than to borrow from banks at prime lending rate because of the following reasons:

- CP can be issued at below the prime rate.

- There is no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank.

- There is a certain degree of prestige associated with the issuance of commercial paper.

(c) In case of debt, a startup will have to make regular payments as interest to its debt holders. This can be a big burden for young startups, since most of them run in significant losses in their initial stages. At the same time, startups don't have any proven business idea or significant assets that they can use as a collateral to get cheaper interest rates for their debt payments.

On the other hand, equity investors don't need to be paid dividends any time sooner. The start ups may take many years before getting listed and start distributing dividends to their investors. hence, there is no annual payment burden on startups. Equity investors usually look for capital gains in a business, and if the startup performs well and grows at an exponential pace in its initial years, the start up valuation goes significantly up,which increases the value of stake of equity holders (capital appreciation).

(d) IPOs are generally underpriced because:

1) It raises demand for the specific stock (quantity over quality) and ensures that the underwriter gets back at least his initial investment,

2) the company wants to leave a “good taste in the mouth” for all investors so they come back and buy again,

3) underpricing has fewer tax implications for the company as well as its investors.

Lastly,

A theory is that if institutional investors are attracted to a certain stock, amateurs will follow, however, the major difference is that institutional investors understand the intrinsic value of the stock, while amateurs will stay in and propel the market (missing the entry and exit points to make a decent profit). Since the stock market is a zero-sum game, it's essentially a great opportunity to exploit the herd mentality of buying the trending stock.