Cost of Issuing the Commercial Paper. Cartele, Inc., will need $4 million over the next year to finance its short-term requirements. The company is considering financing alternatives—bank financing and the sale of commercial paper.
Addison Union Bank is willing to loan Cartele the necessary funds providing the company maintains a 20 percent compensating balance. The effective cost of the bank loan, considering the compensating balance requirement, is 10.4 percent on a pretax basis
Under the other alternative Cartele would sell $4 million of 90-day maturity commercial paper every 3 months. The commercial paper will carry a rate of 73 4 percent; the interest rate is expected to remain at this level throughout the year. The commercial paper dealer’s fee to place the issue would be a one-time charge of 1 8 percent. The commercial paper dealer will require Cartele to establish a $400,000 compensating balance.
Management prefers the flexibility of bank financing. However, if the cost of bank financing should exceed the cost of the commercial paper by more than 1 percent, Cartele plans to issue the commercial paper.
(a) Calculate the effective cost on a pretax basis of issuing the commercial paper and, based solely upon your cost calculations, recommend the method of financing Cartele, Inc., should select. (b) Identify the characteristics Cartele should possess in order to deal regularly in the commercial paper market. (CMA, adapted.)