Question 3 (25 marks / Money Market and Equity Financing)

a) Assume the rate of interest quoted in the 90-day commercial paper market is 4.0%. You issued $10 million (face value) of 90-day commercial paper, with an interest rate of 4.0%.

i) How much did you borrow? Show the supporting calculations. (2 marks)

ii) If you borrowed the same amount in the Eurodollar deposit market and paid 4% interest in that market, how much would you pay back in 90 days? Show the supporting calculations. [Note: If you couldnt figure out the answer to part (i), just assume you borrowed an amount X.] (2 marks)

The following parts are independent of each other. [Note: You are strongly advised to provide concise answers and presenting your answers in point form).

(bi) Give TWO reasons why the interest rate for a given maturity in the commercial paper market is typically lower than the interest rate for the same maturity in the Eurodollar market. (4 marks)

(bii) A finance company wishes to raise money so that it can make (potentially) profitable loans. Is it more likely to use the RP market (rolling over overnight borrowing) or the commercial paper market (rolling over 90-day borrowing) to do so? Explain. (3 marks)

c) Explain why a startup might choose to issue equity instead of debt. Describe the nature of the equity. [Hint: When you supply financing (debt or equity) to a firm, what make it pay you back?] (6 marks)

d) Define what is meant by the statement that the typical IPO is underpriced. Provide THREE possible explanations for IPO underpricing.