Question

Question 3 (25 marks / Money Market and Equity Financing)

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

i. Price = Face value/ [1+ Yeild * ( Number of days to maturity/365)]

by putting values in formula = $ 9.9 million.

ii. Pay back after 90 days = 9.9 ( 1+4/100)90/365

= $ 9.996 million

b (i) The euro dollar market is relatively free of regulation so such deposit can pay higher return than commercial market. 2. speculators are shorting the dollar and the euro betting on dollar & the euro to fall in value because they are two widely used currency across the globe.

(ii) RP market use to offer lower intrest rate than commercial paper if the company is able to pay loan next business day then it is profitable to use RP market.

c) because start up don't have their credibility so no one like to buy their debt bonds. in case of equity investor is getting ownership right so they still consider this option as safe avenue. in case of equity we are getting something but in case of debt fund nothing is their in the hand of investors. so it is risky to invest in that.

d. IPO is under price means It's price is at lowerside , it is use to keep under price to increase the demand in market.

when issures information is not there in market then too IPO are underprice.

to discount the risk associate with new issue, this is also areason to keep IPO underprice.