A corporation is planning to issue $10 million worth of 180-day commercial paper.In order to reduce the interest rates by 25 basis points (per year), it plans to back this issue with a standby letter of credit or a loan commitment.The standby letter of credit is available for 20 basis points (per year) to be paid up-front.The loan commitment for $10 million is available for an up-front fee of 15 basis points (per year) and a 5 basis points back-end fee. What are the savings to the corporation if it obtains a standby letter of credit to back its $10 million issue of commercial paper?
A)$1,250.
B)$2,500.
C)$3,750.
D)$5,000.
E)$6,250.

Question

Quizplus · Accepted Answer

Without any backing, the commercial paper will have an interest rate of x%. With the standby letter of credit, the interest rate can be reduced by 25 basis points, which means the new rate will be (x - 0.25)%.

The cost of the standby letter of credit is 20 basis points, which is paid up-front. This means the cost of the standby letter of credit is (10,000,000 x 0.002) = $20,000.

The savings for the corporation is the difference in interest rates multiplied by the amount of commercial paper issued, minus the cost of obtaining the standby letter of credit.

Savings = (x - x + 0.25)% x $10,000,000 - $20,000 
Savings = 0.25% x $10,000,000 - $20,000 
Savings = $25,000 - $20,000 
Savings = $5,000

Therefore, the corporation will save $5,000 by obtaining a standby letter of credit. However, the cost of obtaining the loan commitment is higher than the savings, so it is not the best choice in this scenario.

A Corporation Is Planning to Issue $10 Million Worth of 180-Day