Short-Term Debt Markets

Chapter 9
Short-term debt
Copyright  2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 9-1
Slides prepared by Peter Phillips
Learning objectives
• Overview of the characteristics of various forms of
short-term debt
– Main types
▪ Trade credit, bank overdraft, commercial and bank-accepted
bills, promissory notes, negotiable certificates of deposit,
inventory accounts receivable and factoring
– Sources
– Reasons and patterns of use
– Advantages and disadvantages for borrowers and lenders
– Calculations relevant to discount securities

Chapter organisation
9.1 Trade credit
9.2 Bank overdrafts
9.3 Commercial bills
9.4 Calculations: discount securities
9.5 Promissory notes
9.6 Negotiable certificates of deposit
9.7 Inventory finance, accounts receivable,
financing and factoring
9.8 Summary

9.1 Trade credit
• Short-term debt is a financing arrangement for a period
of less than one year with various characteristics to suit
borrowers’ particular needs
– Timing of repayment, risk, interest rate structures (variable
or fixed) and the source of funds
• Matching principle
– Short-term assets should be funded with short-term liabilities
– The importance of this principle was highlighted by the GFC
(cont.)
9.1 Trade credit (cont.)
• A supplier provides goods or services to a purchaser
with an arrangement for payment at a later date
• Often includes a discount for early payment (e.g. 2/10,

n/30, i.e. 2% discount if paid within 10 days, otherwise
the full amount is due within 30 days)
• From provider’s perspective

– Advantages include increased sales
– Disadvantages include costs of discount and increased
discount period, increased total credit period and accounts
receivable, increased collection and bad debt costs
(cont.)
9.1 Trade credit (cont.)
• The opportunity cost of the purchaser forgoing the

discount on an invoice (1/7, n/30) is:
% discount 365
Opportunit y cost  
100  % discount days difference between
early and late settlement
1.0 365
 
99.0 23
 0.160298 or 16.03% p.a.

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

9.2 Bank overdrafts
• Major source of short-term finance
• Allows a firm to place its cheque (operating) account

into deficit, to an agreed limit
• Generally operated on a fully fluctuating basis
• Lender also imposes an establishment fee, monthly

account service fee and a fee on the unused overdraft
limit
(cont.)
9.2 Bank overdrafts (cont.)
• Interest rates negotiated with bank at a margin above
an indicator rate, reflecting the borrower’s credit risk
▪ Financial performance and future cash flows
▪ Length of mismatch between cash inflows and outflows
▪ Adequacy of collateral
• Indicator rate typically a floating rate based on a

published market rate, e.g. BBSW
• In some countries overdraft borrower may be required

to hold a credit average balance or compensating credit
balance

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

• A bill of exchange is a discount security issued with a

face value payable at a future date
• A commercial bill is a bill of exchange issued to raise

funds for general business purposes
• A bank-accepted bill is a bill that is issued by a

corporation and incorporates the name of a bank as
acceptor
(cont.)
9.3 Commercial Bills (cont.)
(cont.)
• Features of commercial bills—parties involved (bank-
accepted bill)
(cont.)
accepted bill) (cont.)
– Drawer
▪ Issuer of the bill
▪ Secondary liability for repayment of the bill (after the acceptor)
– Acceptor
▪ Undertakes to repay the face value to the holder of the bill at
maturity
▪ Acceptor is usually a bank or merchant bank
(cont.)
– Payee
▪ The specified party to whom the bill is to be paid, i.e. the party
who receives the funds
▪ Usually the drawer, but the drawer can specify some other
party as payee
– Discounter
▪ The party that discounts the face value and purchases the bill
▪ The provider or lender of the funds
▪ May also be the acceptor of the bill
(cont.)
– Endorser
▪ The party that was previously a holder of the bill
▪ Signs the reverse side of the bill when selling, or discounting,
the bill
▪ Order of liability for payment of the bill runs from acceptor to
drawer and then to endorser
(cont.)
• The flow of funds (bank-accepted bills)
(cont.)
• The flow of funds (non-bank bills)
– Alternatively, a bill can be drawn by the bank and accepted

by the borrower
– The bank is both drawer and discounter of the bill

▪ If the bank rediscounts a bill (sells to a third party), the bank
becomes the endorser, creating a bank-endorsed bill
– Funds are lent to borrower as payee
– At maturity date the borrower, as acceptor of the bill, is liable

to pay face value to the holder of the bill (cont.)
• Establishing a bill financing facility
– Borrower approaches bank or merchant bank

– Assessment made of borrower’s credit risk
– Credit rating of borrower affects size of discount
– Maturity usually 30, 60, 90, 120 or 180 days
– Minimum face value usually $100 000
(cont.)
• Advantages of commercial bill financing
– Lower cost than other short-term borrowing forms, i.e.

overdraft, fully-drawn advances
– Borrowing cost (yield) determined at issue date (not affected
by subsequent changes in interest rates)
– A bill line
▪ Arrangement with a bank where it agrees to discount bills
progressively up to an agreed amount
– Term of loan may be extended by ‘rollover’ at maturity

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

• Calculations considered
– Calculating price—yield known

– Calculating face value—issue price and yield known
– Calculating yield
– Calculating price—discount rate known
– Calculating discount rate
(cont.)
Calculating price—yield known
(cont.)
Calculating price—yield known (cont.)
• Example 3: A company decides to fund its short-term

inventory needs by issuing a 30-day bank-accepted bill with
a face value of $500 000. Having approached two
prospective discounters, the company has been quoted
yields of 9.52% per annum and 9.48% per annum. Which
quote should the company accept, and what amount will the
company raise?
$500 000  365

 $496 118.04
365  (0.0952 30)
or
$500 000  365
 $496 134.23
365  (0.0948  30)
(cont.)
Calculating price—yield known (cont.)
• An alternative formula for calculating price

Calculating face value—issue price and yield known
yield
365  (  days to maturity)
Face value  price[ 100 ]
365
(cont.)
Calculating face value—issue price and yield known
(cont.)
• Example 4: A company needs to raise additional funding of $500
000 to purchase inventory. The company has decided to raise the
funds through the issue of a 60-day bank-accepted bill rollover
facility. The bank has agreed to discount the bill at a yield of
8.75%. At what face value will the initial bill be drawn?
365  (0.0875  60)

Face value  $500 000[ ]
365
 $507 191.78

Calculating yield
(sell price - buy price) (days in year  100)

Yield  
buy price days to maturity
(cont.)
Calculating yield (cont.)
• Example 7: In Example 3, a company issued a

30-day bank-accepted bill with a face value of
$500 000. The bill was discounted at a yield of
9.48% per annum, representing a price of
$496 134.23. After seven days the discounter
sells the bill in the short-term money market for
$497 057.36. The bill is not traded again in the
market. Calculate the yield to the original
discounter and to the holder at maturity.
(cont.)
Calculating yield (cont.)
Yield to original discounter:
(497 057.36  496 134.23) 36 500

  9.70%
496 134.23 7
Yield to holder at maturity:
(500 000.00  497 057.36) 36 500

  9.39%
497 057.36 23

Calculating price—discount rate known
days to maturity discount rate

Price  face value  [1  ]
days in year 100
(cont.)
Calculating price—discount rate known (cont.)
• Example 8: The price of a 180-day bill, with a face
value of $100 000, selling at a discount of 14.75%,
would be:
180
Price  $100 000[1-  0.1475]
360
 $100 000(1- 0.07375)
 $92 625.00
– The discount in this formula is effectively the rate of return to the
buyer of the bill (or the cost of funds to the drawer of the bill),
expressed as a percentage per annum, in relation to the face value
of the bill.

Calculating discount rate
face value - current price days in year  100

Discount rate  
face value days to maturity
(cont.)
Calculating discount rate (cont.)
• Example 9: A 180-day bill with a face value of $100

000 and selling currently at $92 000, with a full 180
days to run to maturity, has a discount rate of:
(100 000 - 92 000  36 500

Discount rate  
100 000 180
 0.08  202.778
 16.22%

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

• Also called P-notes or commercial paper, they are
discount securities, issued in the money market with a
face value payable at maturity but sold today by the
issuer for less than face value
• Typically available to companies with an excellent

credit reputation because:
– there is no acceptor or endorser

– they are unsecured instruments
(cont.)
9.5 Promissory notes (cont.)
• Calculations—use discount securities formulae
• Issue programs
– Usually arranged by major commercial banks and money
market corporations
– Standardised documentation
– Revolving facility
– Most P-notes are issued for 90 days
▪ By tender, tap issuance or dealer bids
(cont.)
9.5 Promissory notes (cont.)
• Underwritten issues
– Underwriting guarantees the full issue of notes is purchased
and typical fee is 0.1% per annum
– Underwriter is usually a commercial bank, investment bank
or merchant bank
– The underwritten issue can incorporate a rollover facility,
effectively extending the borrower’s line of credit beyond the
short-term life of the P-note issue
• Issues may also be non-underwritten

– Issuer may approach money market directly
– Commercial bank, investment bank or merchant bank may
be retained as lead manager and receive fees

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

• Short-term discount security issued by banks to
manage their liabilities and liquidity
• Maturities range up to 180 days
• Issued to institutional investors in the wholesale money

market
• The short-term money market has an active secondary

market in CDs
• Calculations—use discount securities formulae

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

9.7 Inventory finance, accounts receivable
• Inventory finance
– Most common form is ‘floor plan finance’

– Particularly designed for the needs of motor vehicle dealers
to finance their inventory of vehicles
▪ Bailment common—finance company holds title to dealership’s
stock
– Dealer is expected to promote financier’s financial products
(cont.)
financing and factoring (cont.)
• Accounts receivable financing
– A loan to a business secured against its accounts receivable

(debtors)
– Mainly supplied by finance companies
– Lending company takes charge of a company’s accounts
receivable; however, the borrowing company is still
responsible for the debtor book and bad debts
(cont.)
• Factoring
– Company sells its accounts receivable to a factoring

company
▪ Converting a future cash flow (receivables) into a current cash
flow
– Factoring provides immediate cash to the vendor; plus it
removes administration costs of accounts receivable
– Main providers of factor finance are the finance companies
– Factor is responsible for collection of receivables
(cont.)
• Factoring (cont.)
– Notification basis: vendor is required to notify its (accounts

receivables) customers that payment is to be made to the
factor
– Recourse arrangement
▪ Factor has a claim against the vendor if a receivable is not paid
– Non-recourse arrangement
▪ Factor has no claim against vendor company

9.1 Trade credit
9.2 Bank overdrafts
9.8 Summary

9.8 Summary
• Short-term debt is appropriate for funding short-term
assets (matching principle)
• Trade credit—simple and common
• Bank overdraft—common
• Discount securities
– Bill financing—important source of funds
– Promissory notes (P-notes)—good credit rating required
– Certificates of deposit (CDs)—issued by banks to manage
liabilities and liquidity
• Inventory loans, accounts receivable finance and
factoring—alternative sources of finance for small and
medium-sized businesses (SMEs)


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Chapter 9

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Often includes a discount for early payment (e.g. 2/10,

• From provider’s perspective

• The opportunity cost of the purchaser forgoing the

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Allows a firm to place its cheque (operating) account

• Generally operated on a fully fluctuating basis

• Lender also imposes an establishment fee, monthly

• Indicator rate typically a floating rate based on a

• In some countries overdraft borrower may be required

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• A bill of exchange is a discount security issued with a

• A commercial bill is a bill of exchange issued to raise

• A bank-accepted bill is a bill that is issued by a

• The flow of funds (non-bank bills)

– Alternatively, a bill can be drawn by the bank and accepted

– The bank is both drawer and discounter of the bill

– Funds are lent to borrower as payee

– At maturity date the borrower, as acceptor of the bill, is liable

• Establishing a bill financing facility

– Borrower approaches bank or merchant bank

• Advantages of commercial bill financing

– Lower cost than other short-term borrowing forms, i.e.

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

– Calculating price—yield known

• Example 3: A company decides to fund its short-term

$500 000  365

• An alternative formula for calculating price

Copyright  2012 McGraw-Hill Australia Pty Ltd

365  (0.0875  60)

Copyright  2012 McGraw-Hill Australia Pty Ltd

(sell price - buy price) (days in year  100)

• Example 7: In Example 3, a company issued a

Yield to original discounter:

(497 057.36  496 134.23) 36 500

Yield to holder at maturity:

(500 000.00  497 057.36) 36 500

Copyright  2012 McGraw-Hill Australia Pty Ltd

days to maturity discount rate

Copyright  2012 McGraw-Hill Australia Pty Ltd

face value - current price days in year  100

• Example 9: A 180-day bill with a face value of $100

(100 000 - 92 000  36 500

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Typically available to companies with an excellent

– there is no acceptor or endorser

• Issues may also be non-underwritten

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Maturities range up to 180 days

• Issued to institutional investors in the wholesale money

• The short-term money market has an active secondary

• Calculations—use discount securities formulae

Copyright  2012 McGraw-Hill Australia Pty Ltd

Copyright  2012 McGraw-Hill Australia Pty Ltd

– Most common form is ‘floor plan finance’

– A loan to a business secured against its accounts receivable