security usually consists of liquid assets such as receivables, inventories, or securities. Sometimes the bank will accept a floating charge against these assets.24 This gives it a general claim if the firm defaults, but it does not specify the assets in detail, and it sets few restrictions on what the company can do with the assets.
More commonly, banks will require specific collateral. For example, suppose that there is a significant delay between the time that you ship your goods and when your customers pay you. If you need the money up front, you can borrow using these receivables as collateral. First, you must send the bank a copy of each invoice and provide it with a claim against the money that you receive from your customers. The bank will then lend up to 80 percent of the value of the receivables.
Each day, as you make more sales, your collateral increases and you can borrow more money. Each day also some customers pay their bills. This money is placed in a special collateral account under the bank’s control and is periodically used to reduce the size of the loan. Therefore, as the firm’s business fluctuates, so does the amount of the collateral and the size of the loan.25
You can also use inventories as security for a loan. For example, if your goods are stored in a warehouse, you need to arrange for an independent warehouse company to provide the bank with a receipt showing that the goods are held on the bank’s behalf. When the loan is repaid, the bank returns the warehouse receipt and you are free to remove the goods.26
Banks are naturally choosy about the collateral that they will accept. They want to make sure that they can identify and sell the collateral if you default. For example, they may be happy to lend against a warehouse full of a standard nonperishable commodity, but they would turn up their nose at a warehouse of ripe Camemberts.
Banks also need to ensure that the collateral is kept safe and the borrower doesn’t sell the assets and run off with the money. This is what happened in the great salad oil swindle. Fifty-one banks and companies made loans of nearly $200 million to the Allied Crude Vegetable Oil Refining Corporation. In return the company agreed to provide security in the form of storage tanks full of valuable salad oil. Unfortunately, the cursory inspections of the tanks failed to notice that they simply contained seawater and sludge. When the fraud was discovered, the president of Allied went to jail and the 51 lenders were left out in the cold, looking for their $200 million.27 Lenders have been more careful since then, but Finance in the News shows that even old scams can still work.
Commercial Paper
Banks borrow money from one group of firms or individuals and relend the money to another group. They make their profit by charging the borrower a higher rate of interest than they offer the lender.
24Floating charges are common in other countries.
25In Chapter 32 we will describe how firms sometimes raise money by selling their receivables to a factor. The factor is responsible for collecting the debt and suffers any losses if the customers don’t pay. When you pledge your receivables as collateral for a loan, you remain responsible for collecting the debt and you suffer if a customer is delinquent.
26It is not always practicable to keep inventory in a warehouse. For example, automobile dealers need to display their cars in a showroom. One solution is to enter into a floor-planning arrangement in which the finance company buys the cars and the dealer holds them in trust. When the cars are sold, the proceeds are used to redeem the cars from the finance company.
27See N.C. Miller, The Great Salad Oil Swindle, London, Gollancz, 1966.
F I N A N C E I N T H E N E W S
THE HAZARDS OF SECURED BANK LENDING
The National Safety Council of Australia’s Victoria
ones that the bankers saw when they came to
Division had been a sleepy outfit until John
check that their loans were safe. Sometimes a sus-
Friedrich took over. Under its new management,
picious banker would ask to inspect a particular
NSC members trained like commandos and were
container. Friedrich would then explain that it was
prepared to go anywhere and do anything. They
away on exercise, fly the banker across the country
saved people from drowning, they fought fires,
in a light plane and point to a container well out in
found lost bushwalkers and went down mines.
the bush. The container would of course be empty,
Their lavish equipment included 22 helicopters, 8
but the banker had no way to know that.
aircraft and a mini-submarine. Soon the NSC began
Six years after Friedrich was appointed CEO, his
selling its services internationally.
massive fraud was uncovered. But a few days before
Unfortunately the NSC’s paramilitary outfit cost
a warrant could be issued, Friedrich disappeared. Al-
millions of dollars to run—far more than it earned
though he was eventually caught and arrested, he
in revenue. Friedrich bridged the gap by borrowing
shot himself before he could come to trial. Investiga-
$A236 million of debt. The banks were happy to
tions revealed that Friedrich was operating under an
lend because the NSC’s debt appeared well se-
assumed name, having fled from his native Germany,
cured. At one point the company showed $A107
where he was wanted by the police. Many rumors con-
million of receivables (that is money owed by its
tinued to circulate about Friedrich. He was variously
customers), which it pledged as security for bank
alleged to have been a plant of the CIA and the KGB
loans. Later checks revealed that many of these
and the NSC was said to have been behind an at-
customers did not owe the NSC a cent. In other
tempted counter-coup in Fiji. For the banks there was
cases banks took comfort in the fact that their
only one hard truth. Their loans to the NSC, which had
loans were secured by containers of valuable res-
appeared so well secured, would never be repaid.
cue gear. There were more than 100 containers
stacked around the NSC’s main base. Only a hand-
Source: Adapted from Chapter 7 of T. Sykes, The Bold Riders, Allen
ful contained any equipment, but these were the
& Unwin, St. Leonards, NSW, Australia, 1994.
Sometimes it is convenient to have a bank in the middle. It saves the lenders the trouble of looking for borrowers and assessing their creditworthiness, and it saves borrowers the trouble of looking for lenders. Depositors do not care whom the bank lends to: They need only satisfy themselves that the bank as a whole is safe.
There are also occasions on which it is not worth paying an intermediary to perform these functions. Large well-known companies can bypass the banking system by issuing their own short-term unsecured notes. These notes are known as commercial paper (CP). Financial institutions, such as bank holding companies and finance companies,28 also issue commercial paper, sometimes in very large quantities. For example, GE Capital Corporation has nearly $70 billion of commercial paper in issue. The major issuers of commercial paper have set up their own marketing departments and sell their paper directly to investors, often
28A bank holding company is a firm that owns both a bank and nonbanking subsidiaries.
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using the Web to do so. Smaller companies sell through dealers who receive a fee for marketing the issue.
Commercial paper in the United States has a maximum maturity of nine months, though most paper is for 60 days or less. Buyers of commercial paper generally hold it to maturity, but the company or dealer that sells the paper is usually prepared to repurchase it earlier.
The majority of commercial paper is issued by high-grade, nationally known companies.29 Companies generally support their issue of commercial paper by arranging a backup line of credit with a bank, which guarantees that they can find the money to repay the paper.30 The risk of default is, therefore, small.
Commercial paper is very popular with major companies. By cutting out the intermediary, they are able to borrow at rates that may be 1 to 1.5 percent below the prime rate charged by banks. Even after allowing for a dealer’s commission and the cost of any backup line of credit, this is still a substantial savings. Banks have felt the competition from commercial paper and have been prepared to reduce their rates to blue-chip customers. As a result, “prime rate” doesn’t mean what it used to. It once meant the rate banks charged their most creditworthy customers. Now the prime customers often pay less than the prime rate.
Medium-Term Notes
New issues of securities do not need to be registered with the SEC as long as they mature within 270 days. So by limiting the maturity of commercial paper issues, companies can avoid the delays and expense of registration. However, large blue-chip companies also make regular issues of unsecured medium-term notes (MTNs).
You can think of MTNs as a hybrid between corporate bonds and commercial paper. Like bonds, they are relatively long-term instruments; their maturity is never less than 270 days and may be as long as 30 years.31 On the other hand, like commercial paper, MTNs are not underwritten but are sold on a regular basis either through dealers or, occasionally, direct to investors. Borrowers, such as finance companies, that are always needing cash, welcome the flexibility of MTNs. For example, a company may tell its dealer the amount of money that it needs to raise that week, the range of maturities that it can offer, and the maximum interest that it is prepared to pay. It is then up to the dealers to find the buyers.
29Moody’s and Standard and Poor’s publish quality ratings for commercial paper. For example, Moody’s provides three ratings, from P-1 (denoting Prime 1, the highest-grade paper) to P-3. Most investors are reluctant to buy low-rated paper. For example, money-market funds are largely limited to holding P-1 paper.
30Banks often reserve the right to cancel this line of credit if there is a material adverse change in the company’s condition. However, lower-rated companies may back their paper with an irrevocable line of credit.
31The Walt Disney Company has even used its MTN shelf registration to issue a 100-year bond.
Short-term financial planning is concerned with the management of the firm’s
SUMMARY
short-term, or current, assets and liabilities. The most important current assets are
cash, marketable securities, inventory, and accounts receivable. The most impor-
tant current liabilities are short-term loans and accounts payable. The difference
between current assets and current liabilities is called (net) working capital.
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PART IX Financial Planning and Short-Term Management
Current assets and liabilities are turned over much more rapidly than the other items on the balance sheet. Short-term financing and investment decisions are more quickly and easily reversed than long-term decisions. Consequently, the financial manager does not need to look so far into the future when making them.
The nature of the firm’s short-term financial planning problem is determined by the amount of long-term capital it raises. A firm that issues large amounts of longterm debt or common stock, or which retains a large part of its earnings, may find that it has permanent excess cash. In such cases there is never any problem paying bills, and short-term financial planning consists of managing the firm’s portfolio of marketable securities. We think that firms with permanent cash surpluses ought to return the excess cash to their stockholders.
Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of current assets with equity and long-term debt. Such firms may invest cash surpluses during part of the year and borrow during the rest of the year.
The starting point for short-term financial planning is an understanding of sources and uses of cash.32 Firms forecast their net cash requirements by forecasting collections on accounts receivable, adding other cash inflows, and subtracting all cash outlays. If the forecasted cash balance is insufficient to cover day-to-day operations and to provide a buffer against contingencies, the company will need to find additional finance. The search for the best short-term financial plan inevitably proceeds by trial and error. The financial manager must explore the consequences of different assumptions about cash requirements, interest rates, sources of finance, and so on. Firms are increasingly using computerized financial models to help in this process. The models range from simple spreadsheet programs that merely help with the arithmetic to linear programming models that help to find the best financial plan.
If you foresee a large and permanent cash deficiency, the financial plan may involve raising long-term finance. If the shortage is temporary, you may be able to finance it by not paying your bills for a while or you can choose from a variety of shortand medium-term loans.
Often firms arrange a revolving line of credit with a bank that allows them to borrow up to an agreed amount whenever they need financing. This is usually intended to tide the firm over a temporary shortage of cash and is therefore repaid in only a few months. However, banks also make term loans that sometimes extend for five years or more. In addition to borrowing from their domestic banks, companies may borrow dollars (or any other currency) from overseas banks or the foreign branches of U.S. banks. These international bank loans often involve huge sums of money and in this case they may be syndicated among a group of major banks.
Many bank loans are unsecured, but less-creditworthy borrowers may be asked to provide security. Sometimes this consists of a floating charge on receivables and inventories, but usually you will be asked to pledge specific assets. When you borrow against receivables, the bank is informed of all sales of goods
32We pointed out in Section 30.3 that sources and uses of funds are often analyzed rather than sources and uses of cash. Anything that contributes to working capital is called a source of funds; anything that diminishes working capital is called a use of funds. Sources and uses of funds statements are relatively simple because many sources and uses of cash are buried in changes in working capital. However, in forecasting, the emphasis is on cash flow. You pay bills with cash, not working capital.
CHAPTER 30 Short-Term Financial Planning
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and the resulting receivables are pledged to the bank. As the customers pay their bills, the money is paid into a special collateral account under the bank’s control. Similarly, when you borrow against stocks of raw materials, the bank may insist that the goods are under the control of an independent warehouse company. As long as the bank holds the warehouse receipt for these goods, they cannot be released without the bank’s permission.
The interest rate on very short-term bank loans is generally fixed for the life of the loan, but in other cases the rate floats with the general level of short-term interest rates. For example, it might be set at 1 percent over LIBOR (the London Interbank Offered Rate).
Of course, the interest rate that the bank charges must be sufficient to cover not only the opportunity cost of capital for the loan but also the costs of running the loan department. As a result, large regular borrowers have found it cheaper to bypass the banking system and issue their own short-term unsecured debt. This is called commercial paper. Longer-term loans that are marketed on a regular basis are known as medium-term notes.
Here are some general textbooks on working-capital management:
G. W. Gallinger and P. B. Healey: Liquidity Analysis and Management, 2nd. ed., AddisonWesley Publishing Company, Inc., Reading, MA, 1991.
N. C. Hill and W. L. Sartoris: Short-Term Financial Management: Text and Cases, 3rd. ed., Prentice-Hall, Inc., Englewood Cliffs, NJ, 1995.
K. V. Smith and G. W. Gallinger: Readings on Short-Term Financial Management, 3rd ed., West Publishing Company, New York, 1988.
J.H. Vander Weide and S. F. Maier: Managing Corporate Liquidity: An Introduction to Working Capital Management, John Wiley & Sons, Inc., New York, 1985.
F.C. Scherr: Modern Working Capital Management: Text and Cases, Prentice-Hall, Inc., Englewood Cliffs, NJ, 1989.
Pogue and Bussard present a linear programming model for short-term financial planning:
G. A. Pogue and R. N. Bussard: “A Linear Programming Model for Short-Term Financial Planning under Uncertainty,” Sloan Management Review, 13:69–99 (Spring 1972).
FURTHER READING
1. Fill in the blanks in the following statements:
QUIZ
a.A firm has a cash surplus when its ______ exceeds its ______. The surplus is normally invested in ______.
b.In developing the short-term financial plan, the financial manager starts with a budget for the next year. This budget shows the ______ generated or absorbed by the firm’s operations and also the minimum ______ needed to support these operations. The financial manager may also wish to invest in ______ as a reserve for unexpected cash requirements.
c.Short-term financing plans are developed by ______ and ______, often aided by computerized ______.
2.Listed below are six transactions that Dynamic Mattress might make. Indicate how each transaction would affect (a) cash and (b) working capital.
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PART IX Financial Planning and Short-Term Management
The transactions are
i.Pay out $2 million cash dividend.
ii.Receive $2,500 from a customer who pays a bill resulting from a previous sale.
iii.Pay $5,000 previously owed to one of its suppliers.
iv.Borrow $1 million long term and invest the proceeds in inventory.
v.Borrow $1 million short term and invest the proceeds in inventory.
vi.Sell $5 million of marketable securities for cash.
3.State how each of the following events would affect the firm’s balance sheet. State whether each change is a source or use of cash.
a.An automobile manufacturer increases production in response to a forecasted increase in demand. Unfortunately, the demand does not increase.
b.Competition forces the firm to give customers more time to pay for their purchases.
c.Inflation increases the value of raw material inventories by 20 percent.
d.The firm sells a parcel of land for $100,000. The land was purchased five years earlier for $200,000.
e.The firm repurchases its own common stock.
f.The firm doubles its quarterly dividend.
g.The firm issues $1 million of long-term debt and uses the proceeds to repay a short-term bank loan.
4.Here is a forecast of sales by National Bromide for the first four months of 2003 (figures in $ thousands):
Month 1
Month 2
Month 3
Month 4
Cash sales
15
24
18
14
Sales on credit
100
120
90
70
On the average 50 percent of credit sales are paid for in the current month, 30 percent are paid in the next month, and the remainder are paid in the month after that. What is the expected cash inflow from operations in months 3 and 4?
5. Dynamic Futon forecasts the following purchases from suppliers:
Jan.
Feb.
Mar.
Apr.
May
Jun.
Value of goods ($ millions)
32
28
25
22
20
20
a.Forty percent of goods are supplied cash on delivery. The remainder are paid with an average delay of one month. If Dynamic Futon starts the year with payables of $22 million, what is the forecasted level of payables for each month?
b.Suppose that from the start of the year the company stretches payables by paying 40 percent after one month and 20 percent after two months. (The remainder continue to be paid cash on delivery.) Recalculate payables for each month assuming that there are no cash penalties for late payment.
6.Each of the following events affects one or more tables in the chapter. Show the effects of each event by adjusting the tables listed in parentheses:
a.Dynamic repays only $2 million of short-term debt in 2001. (Tables 30.2, 30.4–30.6)
b.Dynamic issues an additional $10 million of long-term debt in 2001 and invests $12 million in a new warehouse. (Tables 30.2, 30.4–30.6)
c.In 2001 Dynamic reduces the quantity of stuffing in each mattress. Customers don’t notice, but operating costs fall by 10 percent. (Tables 30.2–30.6)
CHAPTER 30 Short-Term Financial Planning
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d.Starting in the third quarter of 2002, Dynamic employs new staff members who will prove very effective in persuading customers to pay more promptly. As a result, 90 percent of sales are paid for immediately, and 10 percent are paid in the following quarter. (Tables 30.7 and 30.8)
e.Starting in the first quarter of 2002, Dynamic cuts wages by $4 million a quarter. (Table 30.8)
f.In the second quarter of 2002 a disused warehouse mysteriously catches fire. Dynamic receives a $10 million check from the insurance company. (Table 30.8)
g.Dynamic’s treasurer decides he can scrape by on a $2 million operating cash balance. (Table 30.8)
7.True or false?
a.Most commercial bank loans are made under commitment.
b.A line of credit provides the lender with a put option.
c.Bank term loans typically have a maturity of several years.
d.If the interest rate on a one-year bank loan is stated as a discount of 10 percent, the actual yield on the loan is less than 10 percent.
e.The interest rate on term loans is usually linked to LIBOR, the federal funds rate, or the bank’s prime rate.
8.Complete the passage below by selecting the most appropriate terms from the following list: floating charge, commercial paper, warehouse receipt, collateral, commitment fee, line of credit, medium-term notes.
Companies with fluctuating capital needs often arrange a ______ with their bank. This is relatively expensive because companies need to pay a ______ on any unused amount.
Secured short-term loans are sometimes covered by a ______ on all receivables and inventory. Generally, however, the borrower pledges specific assets as ______. For example, if goods are stored in a warehouse, an independent warehouse company may issue a ______ to the lender. The goods can then only be released with the lender’s consent.
Banks are not the only source of short-term debt. Many large companies issue their own unsecured debt directly to investors, often on a regular basis. If the maturity is less than nine months, this debt is generally known as ______. Companies also make regular issues of longer term debt to investors. These are called ______.
1.Table 30.10 lists data from the budget of Ritewell Publishers. Half the company sales are for cash on the nail; the other half are paid for with a one-month delay. The company pays all its credit purchases with a one-month delay. Credit purchases in January were $30, and total sales in January were $180. Complete the cash budget in Table 30.11.
PRACTICE QUESTIONS
February
March
April
Total sales
200
220
180
Purchases of materials
For cash
70
80
60
For credit
40
30
40
Other expenses
30
30
30
Taxes, interest, and dividends
10
10
10
Capital investment
100
0
0
T A B L E 3 0 . 1 0
Selected budget data for Ritewell Publishers.
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PART IX
T A B L E 3 0 . 1 1
Cash budget for Ritewell Publishers.
Financial Planning and Short-Term Management
February
March
April
Sources of cash:
Collections on cash sales
Collections on accounts receivable
—
—
—
Total sources of cash
Uses of cash:
Payments of accounts payable
Cash purchases of materials
Other expenses
Capital expenditures
Taxes, interest, and dividends
Total uses of cash
—
—
—
Net cash inflow
Cash at start of period
100
Net cash inflow
Cash at end of period
Minimum operating cash balance
100
100
100
Cumulative short-term financing required
T A B L E 3 0 . 1 2
Year-end balance sheet for 1999 (figures in $ millions).
Current assets:
Current liabilities:
Cash
4
Bank loans
4
Marketable securities
2
Accounts payable
15
Inventory
20
Total current liabilities
19
Accounts receivable
22
Total current assets
48
Long-term debt
5
Net worth (equity and
retained earnings)
60
Fixed assets:
Gross investment
50
Less depreciation
14
Net fixed assets
36
Total liabilities
Total assets
84
and net worth
84
2.If a firm pays its bills with a 30-day delay, what fraction of its purchases will be paid in the current quarter? In the following quarter? What if the delay is 60 days?
3.Which items in Table 30.9 would be affected by the following events?
a.There is a rise in interest rates.
b.Suppliers demand interest for late payment.
c.Dynamic receives an unexpected bill in the third quarter from the Internal Revenue Service for underpayment of taxes in previous years.
4.Table 30.12 shows Dynamic Mattress’s year-end 1999 balance sheet, and Table 30.13 shows its income statement for 2000. Work out statements of sources and uses of cash and sources and uses of funds for 2000.
Sales
300
Operating costs
285
15
Depreciation
2
13
Interest
1
Pretax income
12
Tax at 50%
6
Net income
6
CHAPTER 30 Short-Term Financial Planning
877
T A B L E 3 0 . 1 3
Income statement for 2000 (figures in $ millions).
5.Work out a short-term financing plan for Dynamic Mattress Company, assuming the limit on the line of credit is raised from $38 to $50 million. Otherwise keep to the assumptions used in developing Table 30.9.
6.Dynamic Mattress decides to lease its new mattress-stuffing machines rather than buy them. As a result, capital expenditure in the first quarter is reduced by $30 million, but the company must make lease payments of $1.5 million for each of the four quarters. Assume that the lease has no effect on tax payments until after the fourth quarter. Construct two tables like Tables 30.8 and 30.9 showing Dynamic’s cumulative financing requirement and a new financing plan.
7.You need to borrow $10 million for 90 days. You have the following alternatives:
a.Issue high-grade commercial paper, with a back-up line of credit costing .3 percent a year.
b.Borrow from First Cookham Bank at an interest rate of .25 percent over LIBOR.
c.Borrow from the Test Bank at prime.
Given the rates currently prevailing in the market (see, for example, The Wall Street Journal), which alternative would you choose?
8.Suppose that you are a banker responsible for approving corporate loans. Nine firms are seeking secured loans. They offer the following assets as collateral:
a.Firm A, a heating oil distributor, offers a tanker load of fuel in transit from the Middle East.
b.Firm B, a wine wholesaler, offers 1,000 cases of Beaujolais Nouveau, located in a warehouse.
c.Firm C, a stationer, offers an account receivable for office supplies sold to the City of New York.
d.Firm D, a bookstore, offers its entire inventory of 15,000 used books.
e.Firm E, a wholesale grocer, offers a boxcar full of bananas.
f.Firm F, an appliance dealer, offers its inventory of electric typewriters.
g.Firm G, a jeweler, offers 100 ounces of gold.
h.Firm H, a government securities dealer, offers its portfolio of Treasury bills.
i.Firm I, a boat builder, offers a half-completed luxury yacht. The yacht will take four months more to complete.
Which of these assets are most likely to be good collateral? Which are likely to be bad collateral? Explain.
9.Any of the assets mentioned in the preceding question could be acceptable collateral under certain circumstances if appropriate safeguards were taken. What circumstances? What safeguards? Explain.
10.Interest rates on bank loans exceed rates on commercial paper. Why don’t all firms issue commercial paper rather than borrow from banks?
878PART IX Financial Planning and Short-Term Management
11.Do you think you could make money by setting up a firm which would (a) issue commercial paper and (b) relend money to businesses at a rate slightly higher than the commercial paper rate but still less than the rate charged by banks?
12.Use the Market Insight database (www.mhhe.com/edumarketinsight) to find recent balance sheets and income statements for two companies. Draw up a sources and uses of cash statement and a sources and uses of funds statement as in Tables 30.4 and 30.6.
13.Use the Market Insight database (www.mhhe.com/edumarketinsight) to compare the investment in current assets of different companies. Which of these companies make a heavy investment in inventories or receivables? Can you explain why?
14.The Federal Reserve Bulletin publishes the results of a quarterly survey of bank lending (see www.federalreserve.gov/releases/E2/). Use the latest survey to describe the pattern of bank lending by domestic banks. Examine, for example, whether most loans are secured and whether they are made under commitment. What are the different characteristics of small and large loans? Now compare the results of this survey with an earlier one. Have there been any important changes?
CHALLENGE QUESTIONS
1.In some countries the market for long-term corporate debt is limited, and firms turn to short-term bank loans to finance long-term investments in plant and machinery. When a short-term loan comes due, it is replaced by another one, so that the firm is always a short-term debtor. What are the advantages and disadvantages?
2.Axle Chemical Corporation’s treasurer has forecasted a $1 million cash deficit for the next quarter. However, there is only a 50 percent chance this deficit will actually occur. The treasurer estimates that there is a 20 percent probability the company will have no deficit at all and a 30 percent probability that it will actually need $2 million in shortterm financing. The company can either take out a 90-day unsecured loan for $2 million at 1 percent per month or establish a line of credit, costing 1 percent per month on the amount borrowed plus a commitment fee of $20,000. If excess cash can be reinvested at 9 percent, which source of financing gives the lower expected cost?
3.Term loans usually require firms to pay a fluctuating interest rate. For example, the interest rate may be set at “1 percent above prime.” The prime rate sometimes varies by several percentage points within a single year. Suppose that your firm has decided to borrow $40 million for five years. It has three alternatives. It can (a) borrow from a bank at the prime rate, currently 10 percent. The proposed loan agreement requires no principal repayments until the loan matures in five years. It can (b) issue 26-week commercial paper, currently yielding 9 percent. Since funds are required for five years, the commercial paper will have to be rolled over semiannually. That is, financing the $40 million requirement for five years will require 10 successive commercial paper sales. Or, finally, it can (c) borrow from an insurance company at a fixed rate of 11 percent. As in the bank loan, no principal has to be repaid until the end of the five-year period. What factors would you consider in analyzing these alternatives? Under what circumstances would you choose (a)? Under what circumstances would you choose (b) or (c)? (Hint: Don’t forget Chapter 24.)
