Estimating Cost of Short-Term Credit

1. Cost of Trade Credit

Trade Credit – an agreement whereby a buyer/customer can purchase goods or services
but pay at a later scheduled date.

*Trade Credit is more advantageous to buyers than sellers.

FORMULA:

Sample Problem 1:
 BTS Company has been offered credit terms of 2/10,
net 20. What is the nominal cost of not taking advantage of the discount if the firm pays
on the 25th day after the purchase?
Solution:

ANSWER: 48.98%

Sample Problem 2:
TXT Corporation is offered trade credit terms of 3/20, net 40. The firm does not
take advantage of the discount, and it pays the account after 55 days. Using a 365-day
year, what is the nominal annual cost of not taking the discount?

Solution:

X
 ANSWER: 32.25%

2. Cost of Bank Loans

Bank Loan – is an amount loaned by a bank to a borrower with an expectation that the
latter will repay the principal along with the interest at a specified period or future date.

FIVE WAYS OF CALCULATING BANK LOANS:

1. Simple Interest
2. Discount Interest
3. Add-on Interest
4. Simple Interest with Compensating Balance
5. Discount Interest with Compensating Balance.
1. Simple Interest
-borrower receives the face value of the loan and repays the principal and interest at
maturity date.
-on a simple interest loan of 1 year or more, the nominal rate equals the effective rate.
FORMULAS:
Effective Annual Rate simple = Interest / Face Value
Interest = Face Value x Nominal Interest Rate

Sample Problem 1:
TK plans on borrowing 20,000 from Jeontae Bank, which offered to lend the
amount at a 7% stated rate on a 1-year-loan. What is the effective interest rate if the loan
is a simple loan?
 Solution:
Interest = 20,000 x 7%
= 1,400
EAR = 1,400 / 20,000
= 7%

As aforementioned, nominal rate equals effective rate in a simple loan.

Sample Problem 2:

TK plans on borrowing 20,000 from Jeontae Bank, which offered to lend the amount at a
7% stated rate on a term of 180 days. What is the effective interest rate if the loan is a simple
loan?

Solution:

EAR = (1 + 7% / 2)2 -1

EAR = 7.12%

2. Discount Interest
-borrower receives the loan that is net of the interest payment because bank deducts the
interest in advance.
FORMULAS:

Amount Received = Face Value – Interest

Effective Annual Rate simple = (1 + Interest / Amount Received)n - 1
Sample Problem 1:
TK plans on borrowing 20,000 from Jeontae Bank, which offered to lend the
amount at a 7% stated rate on a 1-year-loan. What is the effective interest rate if the loan
is a discount loan?
 Solution:
Interest = 20,000 x 7%
= 1,400
Amount Received = 20,000 – 1,400
= 18,600
EAR = 1,400 / 18,600
= 7.53%

Sample Problem 2:

TK plans on borrowing 20,000 from Jeontae Bank, which offered to lend the amount at a
7% stated rate on a term of 180 days. What is the effective interest rate if the loan is a discount
loan?

Solution:

EAR = (1 + 1,400 / 18,600)2 -1

EAR = 15.62%

Sources of Short-Term Funds

-Short-term funds can be obtained through either unsecured credit or secured loans.

Unsecured Credit - when unpaid, cannot be reclaimed through the seizure of an asset because
there is no collateral or lien.

- Lender relies on the borrower’s creditworthiness.

-Riskier than secured loans

-Easier to acquire in a small-scale; extremely difficult in a large-scale

Secured Loans – involve specific assets that are pledged as collaterals which serve as security
when borrower defaults in payment.

Major Sources of Unsecured Short-Term Credit

1. Accruals
 -  are revenues earned or expenses incurred but cash has not yet flowed.
-liabilities that need to be paid for the goods and services received.
-arise spontaneously with sales.
Examples are wages, taxes, and utilities
2. Trade Credit
-an arrangement to buy goods or services on account without making immediate cash or
cheque payments.
-lengthening of credit period and increasing purchases generates additional financing.
-major disadvantage is its quick availability.
-less desirable because of its relatively high cost of trade credit
3. Short-Term Bank Loans
- obtained to support a temporary personal or business capital need.
-nonspontaneous because they require approval by bank
-most common is the commercial bank loan that is for a specific purpose, short-term, and
self-liquidating.
-cash flow forecasts and detailed financial statements are required by banks.
Content of Note:
 Amount borrowed
 Percentage Interest Rate
 Repayment Schedule
 Collateral
 Other Terms and Conditions
4. 1. Line of Credit
-informal arrangement whereby a borrower can take money out of the bank until
specified maximum amount agreed upon.
-Disadvantage include high interest rates, charged fee, and severe penalties for late
payments.
4. 2. Revolving Credit Agreement
-a formal agreement that permits an account holder to borrow money repeatedly up to a
set maximum limit while repaying a portion of the current balance due in regular
payments.
 -Each payment, minus the interest and fees charged, replenishes the amount available to
the account holder.
-Bank has a legal commitment and thus, must honor the agreement.
5. Commercial Paper
-unsecured short-term promissory note sold in the money market by highly credit-worthy
firms.
-Has same features as a treasury bill but with a higher yield.
-Sellers issue commercial papers for financing their working capital
-Buyers buy for cash management purposes.
-Advantages include lower costs and less restrictive covenants than bank loans.
-Disadvantages include liquidity risk and lack of user availability