26. Bank loans, commercial paper, and medium-term notes (S25.3–S25.4) Term loans usually require firms to pay a fluctuating interest rate. For example, the interest rate may be set at 1% over SOFR. SOFR can sometimes vary by several percentage points within a single year. Suppose that your firm has decided to borrow $40 million for five years and that it has three alternatives:

a. Borrow from a bank at 1.5% over SOFR, currently 6.5%. The proposed loan agreement requires no principal payments until the loan matures in year 5.

b. Issue 26-week commercial paper, currently yielding 7%. Since funds are required for five years, the commercial paper will need to be rolled over semiannually; that is, financing the $40 million will require 10 successive commercial paper sales.

c. Issue a five-year medium-term note at a fixed rate of 7.5%. As in the case of the bank loan, no principal has to be repaid until the end of year 5.

What factors would you consider in analyzing these alternatives? In what circumstances would you prefer each of these possible loans?

CHALLENGE