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%.

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

2. 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 supportingcalculations. [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 provideconcise 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 from Commercial Paper

Commercial paper issued = $10,000,000

Rate of Interest = 4%

Time period = 90 days

Interest for 90 days = $10,000,000 * (90/360) * 4%

Interest for 90 days = $100,000

Net amount borrowed from Commercial Paper = $10,000,000 - $100,000

Net amount borrowed from Commercial Paper = $9,900,000

(ii) Amount borrowed = $9,900,000

INterest Rate = 4%

Amount to be repaid after 90 days

Interest amount = $9,900,000 * 4% * (90/360)

Interest amount = $99,000

Principal amount = $9,900,000

Total Amount to be repaid after 90 days = Prinicpal + Interest

Total Amount to be repaid after 90 days = $9,900,000 + $99,000

Total Amount to be repaid after 90 days = $9,999,000

bi) 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 as the rules and regulations on the Eurodollar market are less in comparison to other money market assets.

bii) A financing company ussually sells its Commercial Papers directly to the customers. So, it may prefer borrownig via Commercial papaer market than RP market.

c) A start-up might choose to issue equity instead of debt because there is no pressure of compulsory payments that arise in the debt funding due to the fixed expenditures such as Interest. However, in equity financing the company has discretion whether the company wants to give its shareholders dividend or not.

This fixed expenditure – Interest also reduces the profit of the start-up and at early stage, the start-up need to be able to cover their cost.

Therefore, the start-ups prefer equity financing to debt financing.

In Equity financing, the company sells the shares of the company to the outsiders. The shareholders are technically the owners of the company. They get voting rights and take part in crucial decision making. They also have the privilege of attending Annual General Meetings of the company. The company gives the shareholders - dividend.

d) The statement “The typical IPO is under-priced.” means that the price of the shares at IPO is lower than the actual worth of the company.

The reasons for under-pricing of IPO are

1. IPO are under-priced so as to increase the demand for the new share and entice investors into investing in their company.

2. While issuing IPO, the company appoint underwriters to monitor the demand and collection of the IPO. It may be the case that the underwriters have underestimated the demand of the company’s stock in the market.

3. Some Investment banks also encourage under-pricing of the IPO.