[Anonymous]

Hi, I was hoping someone could help me with this question. My question about it is basically why the fees are being added to the numerator instead of being subtracted from the denominator. I understand that with a discounted note like this, that interest is normally deducted from the denominator. However, does that mean that they actually get the $980,000 and they don’t have to reduce that amount for the fees? Or is it because this question is asking for the cost of the loan and not the rate? I thought it was the same thing. How do I treat fees in a discounted note overall then? Or is cost just calculated separately altogether? Thanks!

Corbin Inc. can issue three-month commercial paper with a face value of

$1,000,000 for $980,000. Transaction costs would be $1,200. The effective

annualized percentage cost of the financing, based on a 360-day year,

would be:

a. 2.16% b. 8.48% c. 8.65% d. 8.00%

Explanation

Choice “c” is correct. The cost to issue the commercial paper is the $20,000

original issue discount ($1 million – $980,000), plus transaction costs of

$1,200 for a total of $21,200. Therefore, it costs $21,200 to borrow

$980,000 for 3 months. The 3-month interest cost is 2.16% ($21,200 /

$980,000).

The annual interest cost is 8.65%

[Anonymous]

I would say, because 20,000 is also a cost for the loan, and 20,000 + 1,200 is total cost for taking this loan. So cost to amount is actually got times 4 is the effective annualized percentage cost of the financing.

[Anonymous]

I understand why the $20,000 is in the numerator, it's the interest. But shouldn't the fees be removed from the proceeds in the denominator instead of being added to the $20,000 in the numerator?

[wldcatnc]

Think of it like a store offering $20 off a $100 item. Initially you'd say your discount is 20% but you forgot about sales tax. Sales tax is 10bucks. So in essence you only got $10 off of the item. So your effective rate is 10% instead of 20%.

The same application applies in this situation. The 1200 in the problem is like the sales tax in my example so it needs to be added back to determine the effective rate. Sorry if thats confusing

FAR: 81
REG: 85
AUD: 73,71,83
BEC: 82

DONE!!!!!!

[Anonymous]

That actually makes so much more sense! So does this only apply to discount notes then? In any other situation I would subtract the fees from the denominator right?

[Anonymous]

In my opinion since this is cost of what you get you have to add it to the cost in order to get total cost. Your question is “The effective annualized percentage cost of the financing” , so your dollar cost of your financing is 21,200, because you wanted to get 1,000,000, but only got 980,000, and 20,000 is the interest and cost of this financing plus you also paid 1,200. So total dollar amount you've paid is 21,200. Total financing you've got is 980,000. In order to get percentage cost of the financing and answer your question you need to divide your total cost to your total financing : 21,200/980,000 (and this is only for three months percentage, but you need annual effective percentage) *4 (based on 360-day year).

I believe what you are trying to answer is “what is the net amount of financing/cash you've got? “

[Author]

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