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 a standby letter of credit, the interest rate will be X. With the letter of credit, the interest rate will be X - 0.25. 
The cost of the letter of credit is 0.20, which is an upfront fee. 
Therefore, the net savings from using a letter of credit is 0.05. 
0.05 * $10 million = $500,000. 
However, this answer is not given as one of the choices. 
The loan commitment would also result in net savings for the corporation. 
The cost of the loan commitment is 0.15 upfront and 0.05 back-end. 
Therefore, the net savings from using a loan commitment is 0.05 - 0.15 + 0.05 = -0.05. 
This means that the corporation would actually pay more if it uses a loan commitment instead of just issuing commercial paper without any backing. 
Therefore, the best choice is to use a standby letter of credit which would result in savings of $2,500 ($500,000 * 0.005).

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