considering Commercial Paper as a potential investment vehicle for excess cash.

Commercial Paper

We talked earlier about Commercial Paper (CP) as a component of Cash Equivalents or Marketable Securities. Then we were

considering Commercial Paper as a potential investment vehicle for excess cash. Here, we’re talking about the firm issuing

(selling) CP as a short-term source of funds.

CP is a type of unsecured note issued by the borrower and purchased by an investor looking for ashort-term, high-quality

investment. CP is unsecured, that is, there is no collateral associated with it, just the firm’s good name and promise to pay.

CP is not just short-term, it must have a maturity of less than 270 days. That limitation exempts it from Securities and

Exchange Commission (SEC) registration and oversight, and that gives the issuing company quick, direct access to the

capital market.

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It’s also sold in very large denominations of $100,000 or more. The market for Commercial Paper is enormous with over $100 billion issued every day. With no collateral or other security to back it and no SEC oversight, the market for CP is only for large firms with very high credit ratings. High-quality and low-risk mean that the interest rate associated with CP is quite low, often below prime. That and the quick access makes CP an attractive source of ST funding for those firms able to sell it.

Short-Term Bank Loans

A large portion of bank lending is short-term (less than one year) often with terms allowing the notes to be renewed, or rolled over. Longer duration loans are often called Term Loans.

Just like any debt arrangement, short-term loans need to have a controlling document that sets forth the terms and conditions. The loan document is often called a promissory note and will usually describe the following details:

• Principal amount being borrowed • Length of the loan or time to maturity • Interest rate • Repayment method • Collateral, if any • Other terms &conditions

Short-term loans have some advantages over longer term loans or corporate bonds:

• Available in lower dollar amounts — if we need to borrow $100,000, it wouldn’t make sense to go to the trouble of registering and issuing a corporate bond (we’ll cover Bonds in a later week).

• Speed —because we’re borrowing directly from our bank, without the complication of registering a security with the SEC, bank loans can be arranged very quickly.

• Lower rate —primarily because of the shorter term, the rate on these loans will be lower. Consider how many of the factors affecting interest rates are a function of time (default, inflation, etc.).

• One, known lender —we’re borrowing from our bank, with whom we ought to have cultivated a cordial business relationship. This allows flexibility in negotiating terms and conditions and coping with special circumstances.

Cost of Bank Loans

The terms and conditions of the loan will always address the rate of interest to be paid and the method and timing of repayment. We’ll look at this separately.

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Costof ShortTerm Financing

Cost of Bank Loans

• For each example:

• Principal = $10,000

• Maturity = 1. year

• Nominal interest rate = 7.0%

Srrnple Interest

Borrowergets the whole principal amount

Pays principal + interest at maturity

Effective rate interest paid

proceeds

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10% Simple Intet•est

Effective rate -interest paid

.._proceeds i

5io,o~~iose = sl.000;- Sio,000 = iow

Effective rate =nominal rate!!

Simple interest is the only lending arrangement where this is so.

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10%Discounted Interest

• Interest is deducted from proceeds

• Proceeds = 10,000 -1,000 = 9,000

Effective rate =interest paid proceeds

$1,000 = $9,000 = 11.1’Yo

Efifective rate> nominal rate

Calculating Face Value

Face = required proceeds _ 10.000 _ 71,111 (1 -interest %} 0.9

Proof:

So actual prxecvl5= $lO.OW

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Compensating Balance Requirement (CBR)

• 10°.6 Simple Interest with a 20% CBR

• Step 1. Face value if funds needed = S70,000

face =funds needed = 10,000 = $12,500

Compensating Balance Requirement (CBR) C~ont~

• 10%Simple Interest with a 20°,G CBR

Step 2. Calculate the effective interest rate

effective = interest paid = 1 52 D = 12.5%

interest proceeds 10,000

10%Discounted Interest with 20% CBR. • Step 1. face value if Funds needed =$10,000

face = funds needed = 10,000 = $14,285

(1 – i%- CBR9L) 1-10%-20%

v~xvum componsanng Interest 6alanee

…….. rate requirement

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10~/o Discou~lted Interestwith 20n/o CBR • Step 2: Calculate the effective interest rate

effective = interest paid = ~i 29 = 14.3%

interest proceeds 10,000

1 1