Reference no: EM13910421
Kellogg Company, the breakfast food people, manufactures its products in 20 countries and distributes them in more than 150 countries. Not too long ago, Kellogg was considering three short-term borrowing alternatives:
1. 90-day commercial paper at a 6.50% discount rate
2. Commercial bank loan with three interest rate alternatives:
a. Prime rate with interest payable quarterly
b. Three-month London Interbank Offer Rate (LIBOR) plus 0.25%
c. Three-month certificate of deposit (CD) rate plus 0.50%
3. Fixed-rate note maturing after two years and paying interest at the rate of 8% APR with interest payable semiannually
At the time, the prime rate was 10% APR, three-month LIBOR was 6% APR, and the three-month CD rate was 6% APR.
Questions:
1. Consider the commercial paper alternative.
a. What is the true interest cost (APY)?
b. Kellogg has a policy of maintaining a backup line of credit for its commercial paper. The cost is 0.25% per year. What is the true interest cost of the commercial paper (APY), including the cost of the backup line?
c. Assume the 90-day commercial paper rate is expected to increase to 6.75% after 90 days, to 7.00% 90 days thereafter, and to 7.50% 90 days thereafter. Borrowing for one year, calculate the APY of the commercial paper alternative, including the cost of the backup line.
2. Consider the commercial bank loan alternatives.
a. Calculate the APY for each bank loan interest rate alternative. Which one is the cheapest?
b. Suppose that the bank requires a 10% compensating balance. Calculate the APY for the bank loan, including the cost of the compensating balance.
c. Suppose the prime rate is not expected to change over the next year, but three-month LIBOR is expected to increase by 0.30% every three months, and the three-month CD rate is expected to increase by 0.20% every three months. Borrowing for one year, calculate the APY for each bank loan alternative.
d. Which is cheaper, issuing commercial paper or borrowing from the bank? Are there any options that might affect the value of one alternative or the other?
3. Compare the APYs for the fixed-rate note and the floating-rate alternatives. Which alternative is cheapest on this basis? How might interest rate risk affect Kelloggâ??s choice? Find the average interest cost (APR) for year 2 for the cheapest floating-rate alternative in question 2 that would make Kellogg indifferent to choosing between that alternative and issuing the two-year note. (This is called the break-even rate.)
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