Funding a 120-Day Inventory Build: Discount Paper, a Backstop, or the Overdraft
Mzigo Haulage Ltd, a Nairobi logistics operator, must fund a KES 50 million seasonal inventory build for exactly 120 days. Receipts from two signed contracts are expected on day 120, but the CFO warns that on past form either contract could slip by 30-45 days. The treasurer has three quotes. (1) A 120-day commercial paper issue at a discount rate of 9.00% p.a. on a 360-day basis; Mzigo is a first-time CP issuer and there is no committed back-up line. (2) The same 120-day CP issue backed by a committed standby letter of credit priced at 0.30% p.a. on the full KES 50 million. (3) A committed overdraft at 9.60% p.a. add-on interest plus a 0.25% arrangement fee on the amount drawn, available for the full 120 days. The board wants the cheapest headline rate justified on more than arithmetic.
1. Put the three alternatives on one comparable basis (effective annual cost, add-on, 360-day) and rank them.
Read the worked answer
Option 1 - unbacked 120-day CP at 9.00% discount
- Discount = 9.00% x 120/360 = 3.00% of face
- Proceeds = 50m x 0.97 = KES 48.50m; cost = KES 1.50m
- Period cost on money actually received = 1.50/48.50 = 3.093%; annualised x3 = 9.28%
Option 2 - CP plus standby LC at 0.30% p.a.
- LC fee = 50m x 0.30% x 120/360 = KES 50,000
- Total cost = 1.55m on 48.50m proceeds = 3.196% x3 = 9.59%
Option 3 - overdraft at 9.60% add-on plus 0.25% arrangement fee
- Interest = 50m x 9.60% x 120/360 = KES 1.60m; fee = KES 125,000; total KES 1.725m
- 1.725/50.0 = 3.45% x3 = 10.35%
Ranking: unbacked CP 9.28% < backed CP 9.59% < overdraft 10.35%. Note that the 9.00% discount rate understates true cost by 28bp; a discount quote is never directly comparable to an add-on quote.
2. The treasurer argues the LC is unnecessary because the receipts are 'confirmed'. Quantify the risk he is removing and decide whether 0.30% is worth paying.
Read the worked answer
What the 0.30% buys: 9.59% - 9.28% = 31bp = KES 50,000 over the 120 days, i.e. 0.10% of the amount funded.
What it protects against: if receipts slip, Mzigo faces a maturity it cannot repay. The realistic alternative is emergency funding at, say, 14% for 45 days:
- Extra cost = 50m x (14% - 9.59%) x 45/360 = 4.41% x 0.125 x 50m = KES 275,625
- Plus forced-sale risk on inventory if the emergency line is not granted at all.
Break-even probability: 50,000/275,625 = 18%. The CFO's own view is that slippage is plausible on two contracts; anything above an 18% chance of a 45-day slip makes the LC value-accretive. A first-time issuer in a shallow CP market should also price the chance that the issue cannot be placed at all.
Conclusion: pay the 0.30%. The comparison is not 9.28% versus 9.59% but 9.59% versus the expected cost of a liquidity cliff.
3. At what LC fee would the recommendation change, and what other conditions should the treasurer attach before signing?
Read the worked answer
Break-even LC fee against the overdraft: the backed CP is cheaper than the overdraft (10.35% - 9.28%) by 1.07%, and each 1% of LC fee adds about 1.03% to the effective CP cost (fee is charged on 50m but spread over 48.50m proceeds). Break-even fee = 1.07/1.03 = about 1.04% p.a. Above roughly 1.00% the committed overdraft wins outright; at 0.30% the LC is cheap insurance.
Conditions to attach:
- The standby must be committed and uncommitted-free - a 'best efforts' letter is not a backstop.
- Confirm the LC can be drawn to repay CP at maturity, not merely to support the issue.
- Check that drawing the LC does not itself breach any negative pledge or cross-default in existing loan notes.
- Re-run the comparison if the bank re-prices the overdraft, and remember the overdraft consumes committed headroom the company may need for working capital swings.
- Pre-agree the LC fee for the rollover period if receipts slip beyond 120 days, so the extension is not re-priced at the point of maximum weakness.