Duro Auto Parts would like to exploit a production opportunity overseas, and is

Question

Duro Auto Parts would like to exploit a production opportunity overseas, and is seeking additional capital to finance this expansion. The company plans a commercial paper issue of $15 million on February 3, 2000. The firm has never issued commercial paper before, but has been assured by the investment banker placing the issue that it will have no difficulty raising the funds, and that this method of financing is the least expensive option, even after the $150,000 placement fee. The issue will carry a 270-day maturity and will require interest based on an annual rate of 12%. What is the effective cost of the commercial paper issue to Duro?

Explanation / Answer

Interest expense for the commercial paper issue is calculated as follows:

Interest = 12%* $15 million x (270/360) = $1,350,000

The effective rate of interest to Duro Auto Parts (including the issue fee of $150,000) is calculated as follows:

APR = [($1,350,000 + 150,000)/($15 million - 1,350,000 - 150,000)]* (360/270) = 14.81%

Note that both the interest expense and the issue fee are prepaid.

So effective cost is Int + Issue cost = 1350000+150000

= $1,500,000

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