FUND

MANAGEMENT
Group 7
FM 313
 SHORT TERM
FINANCING
refers to debt originally scheduled for repayment within one
year. Short-term financing is used to finance all or part of
the firm's working capital requirements and sometimes to meet
permanent financing needs.
2 BASIC PROBLEMS
ENCOUNTERED
1 Determining the level of sort term financing the
firm should use,and

2 Selecting the source of short-term financing

 FACTORS IN SELECTING A SOURCE OF SHORT-
TERM FUNDS
Effective Cost of Credit Availability of credit

Influence Additional covenants

 A. Accrual

Are current liabilities for

services received but for
which complete payments
have not been made as of
the reporting date.
Illustrative Problem
 B. Cost of Trade Credit

Implicit/hidden cost Opportunity Cost

Suppliers of Trade Trade credit does not
credit incur the costs have ecplicit cost if
of operating a credit there is no discount
department and offered or if the buyer
financing account pays the invoice during
receivables the discount period
Illustrative Problem
C. cost of Bank Loans
1. SIMPLE INTEREST
2. DISCOUNT INTEREST
3. ADD-ON INTEREST
4. SIMPLE INTEREST WITH
COMPENSATING BALANCES
5. DISCOUNT INTEREST WITH
COMPENSATING BALANCES
1. Simple Interest
2. Discount Interest
3. Add-on Interest
3. Add-on Interest
4. Simple Interest with compensating balance
Compensating balance is the minimum account balance
that a lending bank requires the borrower to maintain.
 4. Simple Interest with compensating balance
Sample problem

Assume that the bank offers to lend the company $100,000

for 1 year at a 12% simple rate but the company must
maintain a compensating balance equal to 10% of the loan
amount. What is the effective annual rate of the loan?
 4. Simple Interest with compensating balance
Assume that the bank offers to lend the company $100,000 for 1 year at a 12%
simple rate but the company must maintain a compensating balance equal to
10% of the loan amount. What is the effective annual rate of the loan?
 4. Simple Interest with compensating balance
Assume that the bank offers to lend the company $100,000 for 1 year at a 12%
simple rate but the company must maintain a compensating balance equal to
10% of the loan amount. What is the effective annual rate of the loan?
5. Discount interest with compensating balance
5. Discount interest with compensating balance
Sample problem

Assume the same data as in number 4 except, that the loan

is a discount loan. What is the effective annual rate of the
loan?
The effective annual interest rate is computed as follows:
5. Discount interest with compensating balance
Assume the same data as in number 4 except, that the loan is a
discount loan. What is the effective annual rate of the loan?
The effective annual interest rate is computed as follows:
D. Cost of Commercial Paper
 Example
The Pepcoke. Company uses commercial paper regularly to support its needs for short-
term financing. The firm plans to sell P100 Million in 270-day-maturity paper on which it
expects to have to pay discounted interest at an annual rate of 12 percent per annum. In
addition, Pepcoke expects to incur a cost of approximately P100,000 in dealer placement
fees and other expenses of issuing the paper. What is the effective cost of credit of
Pepcoke?
SOURCES OF SHORT-TERM FUNDS

Short-term funds can be obtained through either

unsecured credit or secured loans. They are either
spontaneous or negotiated
 UNSECURED CREDIT VERSUS SECURED CREDIT
Unsecured Credit
Unsecured credit includes all
those sources that have as
their security only the lender's
faith in the ability of the
borrower to repay the funds
when due. Unsecured short-
term financing is an obligation
without specific assets
pledged as collateral.
Secured credit
Secured loans involve the
pledge of specific assets as
collateral in the event the
borrower defaults in payment
of principal or interest.
Accounts receivable and
inventory are the most
common sources of collateral
for short-term financing
 Spontaneous Short-term Financing versus
Nonspontaneous/Negotiated Short- term Financing

Spontaneous Short-term Nonspontaneous/Neg

Financing
Spontaneous source of short-
term financing are sources
that arise automatically from
ordinary business transaction.
They do not require special
effort or negotiation on the
part of the finance officer.
otiated Short- term
Financing
Nonspontaneous negotiated/
short term financing are
sources that require special
effort or negotiation.
Accruals
-As the firm's sales increase, so does its labor expense,
value-added taxes, income taxes, and so on.
-Accrued expense items provide the firm with automatic
or spontaneous sources of financing.

Trade Credit
-Trade credit provides one the most flexible sources of
financing available to the firm. It is also a primary source
of spontaneous financing because it arises from ordinary
business transactions.
-Many firms attempt to "stretch the payment period" to
receive additional short- term financing.
Trade Credit
If the firm chooses to forego a possible cash discount
opportunity and utilize the funds made available to
finance its working capital, then the resulting cash, as an
annualized percent, can be very high indeed.

For example, if the seller offers terms of 2/10, n/30

which means a 2% discount from purchase price if paid
in full within ten days of the receipt of the bill, or the net
amount due within thirty days, then the buyer incurs an
opportunity cost of 36.7% per year if the cash discount is
not taken. This is computed using:
For example, if the seller offers terms of 2/10, n/30 which means a 2% discount
from purchase price if paid in full within ten days of the receipt of the bill, or
the net amount due within thirty days, then the buyer incurs an opportunity
cost of 36.7% per year if the cash discount is not taken. This is computed using:
 SHORT-TERM BANK LOANS

*Commercial banks are second in importance to trade credit as

a source of short- term financing. Banks provide
nonspontaneous funds
*Short-term loans vary in type, availability and cost. The most
common type is the commercial bank loan that is for a specific
purpose, short-term and self- liquidating.

When a bank loan is approved, the agreement is executed by signing a promissory

note. The note specifies the:
1) amount borrowed,
2) percentage interest rate,
3) repayment schedule, any collateral that might have to be put up as security for
the loan, and
4) any other terms and conditions to which the bank and the borrower may have
agreed
 2 FORMS OF LINE CREDIT

1. Line of Credit 2. Revolving Credit Agreement

An informal arrangement where a bank A formal line of credit where the bank
agrees to lend up to a specified commits to extend credit up to a
maximum amount of funds during a maximum amount for a set period (a
designated period. few months to several years).
 COMMERCIAL PAPER
Unsecured short-term promissory note with a term of six months or less.

Disadvantages:
Fixed Maturity Date: Can pose liquidity risk due to a set repayment
date.

Limited Availability: Typically available only to very large firms, not

smaller businesses.
 Secured Short-Term Credit
THIS TYPE OF FINANCING REQUIRES PLEDGING CERTAIN ASSETS AS COLLATERAL FOR THE
LOAN. IN CASE OF DEFAULT, THE LENDER HAS THE FIRST CLAIM ON THESE ASSETS.
SHORT-TERM FINANCING IS OBTAINABLE THROUGH:

1. PLEDGING OR ASSIGNMENT OF ACCOUNTS RECEIVABLE

2. FACTORING OF ACCOUNTS RECEIVABLE

3. INVENTORY LOANS WITH

A) FLOATING OR BLANKET LIEN

B) CHATTEL MORTGAGE
C) FIELD WAREHOUSE FINANCING AGREEMENT
D) TERMINAL WAREHOUSE RECEIPT
Pledging or Assignment of Accounts
Receivable
USING ACCOUNTS RECEIVABLE AS COLLATERAL FOR A SECURED LOAN FROM A
COMMERCIAL BANK OR FINANCE COMPANY.

LOAN AMOUNT: DETERMINED AS A PERCENTAGE OF THE FACE VALUE OF THE

RECEIVABLES PLEDGED.

COST OF FINANCING:
HIGHER INTEREST RATES: THE INTEREST RATE FOR THESE LOANS IS TYPICALLY 2-
5% HIGHER THAN THE BANK'S PRIME RATE.

PROCESSING FEE: LENDERS OFTEN CHARGE A PROCESSING OR HANDLING FEE OF

ABOUT 1-2% ON THE PLEDGED ACCOUNTS RECEIVABLE.
 The XYZ Company sells plumbing supplies to building contractors on terms of net
60. The firm's average monthly sales are P200,000; thus its average accounts
receivable balance is P400,000, based on the two months credit period. The
company pledges all its receivables to a local bank, which in turn advances up to
70% of the face value of the receivables at 3% over prime and with a 1%
processing charge on all receivables pledged. XYZ Company follows a practice of
borrowing the maximum amount possible. The current prime rate is 12%.

What is the effective cost of using this source of financing for a full year?

Illustrative Problem:
SOLUTION:
In the preceding example, XYZ Company may save credit department expenses of
P15,000 per year by pledging all its accounts and letting the lender provide those
services. In this case, the cost of short-term credit will be:
 This is when a firm sells its outstanding customer invoices
(accounts receivable) to a finance company (factor).

Factoring Direct Remittance: Customers may be instructed to send

payments directly to the factor.

Accounts Cost of Financing:

Receivable Commission: The factor(finance company) charges a fee or
commission ranging from 1% to 3% of the accepted invoices.

Interest on Advances: In addition to the commission, the factor

charges interest on the funds advanced to the seller.
FOR EXAMPLE

If P200,000 a month is processed at a 1% commission and a 15% annual borrowing

rate is charged, what is the total effective annual cost of financing to the firm?

The effective annual cots of financing is computed as follows:

1.25% - interest for one month

1% - commission
_____
2.25% - Total Monthly fee
x 12 mos
________
27% annual rate
If P200,000 in receivable is factored which carry 30 day credit terms, a 1% factor's fee, a 6%
reserve, an interest at 1% per month on advances, then the proceeds the firm can receive is computed
as follows:

Face amount of receivables factored………… 200,000

Less: Fee (1% x P200,000)............................ (2,000)

Reserve (6% x P200,000)............................. (12,000)

Interest (1% x P200,000)............................ (2,000)

Net proceeds............................................ 184,000

 Inventory Financing
Borrowing against inventory to acquire funds.

Types of Inventory Financing: Types of Receipts

1. Blanket Inventory Lien: Gives the lender a general
claim against the borrower's inventory.
2. Trust Receipts / Chattel Mortgage Agreement
Acknowledges that the borrower holds the inventory and
proceeds from sales in trust for the lender.
3. Warehousing
Goods are identified, segregated, and stored under an
independent warehousing company's direction.
- Negotiable: Title can be transferred
through the sale of the receipt.
- Nonnegotiable: Title remains with the
lender; goods can only be released with
lender's written consent.
Illustrative Problem:
The EBC International Product follows practice a based on its seasonal finished
goods inventory. The firm builds up its inventories of obtaining short-term credit of
furniture and other household fixtures from July to October for sale in November
and December. Thus, for the two-month period ended October, it uses the
production of furniture as collateral for a short-term bank loan. The bank lends up
to 70% of the value of the inventory at 14% interest plus a fixed fee of P2,000 to
cover the costs of a field warehousing agreement. During this period, the firm
usually has about P200,000 in inventories, which are used as collateral for the
loan.

What is the effective annual cost of the short-term credit?

SOLUTION:
Thank you