Question 20.2: A firm issues three-month commercial paper with a $100,000 f...

PLAN

First, put the firm’s cash flows on a timeline:

The three-month rate can be computed by comparing the present value received ($98,000) with the future value paid ($100,000). From there, we can convert it into an EAR using Eq. 5.1:

Equivalent n-period Discount Rate = (1+r)^{n} -1                 (5.1)

EAR = equivalent one-year rate = (1+r)^{n} -1,

where n is the number of three-month periods in a year.

EXECUTE

The actual three-month interest rate paid is:

Expressing this as an EAR gives   1.0204^{4} -1=8.42\%

EVALUATE

The financial manager needs to know the EAR of all of the firm’s funding sources to be able to make comparisons across them and choose the least costly way to finance the firm’s short-term needs.