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Sources of ShortTerm Financing

Copyright 2009 by The McGraw-Hill Companies, Inc. All


Chapter Outline
Trade credit from suppliers Bank loans Commercial paper Borrowing larger amounts Using hedging to offset the risk


Financing Arrangements
Lines of credit are sometimes referred to as a revolving credit facility where interest cost:
Is based on LIBOR (the London Interbank Offered Rate) Is based on the companys senior unsecured credit rating a percentage margin

Primary aim of the borrowing firms:

Minimize cost


Trade Credit
Approximately 40 percent of short-term financing is in the form of accounts payable or trade credit
Accounts payable
Is a Spontaneous source of funds Grows as the business expands Contracts when business declines


Payment Period
Trade credit is usually extended for 3060 days Extending the payment period to an unacceptable period results in:
Alienate suppliers Diminished ratings with credit bureaus

Major variable in determining the payment period:

The possible existence of a cash discount

Cash Discount Policy

Allows reduction in price if payment is made within a specified time period
Example: A 2/10, net 30 cash discount means:
Reduction of 2% if funds are remitted 10 days after billing Failure to do so means full payment of amount by the 30th day


Net-Credit Position
Determined by examining the difference between accounts receivable and accounts payable
Positive if accounts receivable is greater than accounts payable and vice versa Larger firms tend to be net providers of trade credit (relatively high receivables) Smaller firms in the relatively user position (relatively high payables)

Bank Credit
Provide self-liquidating loans
Use of funds ensures a built-in or automatic repayment scheme

Changes in the banking sector today:

Centered around the concept of full service banking Expanded internationally to accommodate world trade and international corporations Deregulation has created greater competition among other financial institutions

Prime Rate and LIBOR

Prime rate
Rate a bank charges to its most creditworthy customers Increases as a customers credit risk increases

LIBOR (London Interbank Offered Rate)

Rate offered to companies:
Having an international presence Ability to use the London Eurodollar market for loans


Prime Rate versus LIBOR on U.S. Dollar Deposits


Compensating Balances
A fee charged by the bank for services rendered or an average minimum account balance
When interest rates are lower, the compensating balance rises Required account balance computed on the basis of:
Percentage of customer loans outstanding Percentage of bank commitments towards future loans to a given account

Maturity Provisions
Term loan
Credit is extended for one to seven years Loan is usually repaid in monthly or quarterly installments Only superior credit applicants, qualify Interest rate fluctuates with market conditions
Interest rate may be tied to the prime rate or LIBOR


Cost of Commercial Bank Financing

Effective interest on a loan is based on the:
Loan amount Dollar interest paid Length of the loan Method of repayment Discounted loan interest is deducted in advance effective rate increases
Effective rate = Interest Principal-interest Days in the year (360) Days loan is outstanding

Interest Costs with Compensating Balances

Assuming that 6% is the stated annual rate and that 20% compensating balance is required; Effective rate with compensating balances = = Interest (1 c) 6% = 7.5% (1 0.2)

When dollar amounts are used and the stated rate is not known, the following can be used for computation: Days in a

Effective rate with = Interest year (360) compensating balances Principal Compensating Days loan is balance in dollars outstanding


Rate on Installment Loans

Installment loans require a series of equal payments over the period of the loan
Federal legislation prohibits a misrepresentation of interest rates, however this may be misused
Effective rate on installment loan = 2 Annual no. of payments Interest (Total no. of payments + 1) Principal


Annual Percentage Rate

Truth in Lending Act of 1968 requires the actual APR to be given to the borrower Annual percentage rule:
Protects unwary consumer from paying more than the stated rate Requires the use of the actuarial method of compounded interest during computation
Lender must calculate interest for the period on the outstanding loan balance at the beginning of the period

It is based on the assumptions of amortization


The Credit Crunch Phenomenon

The Federal Reserve tightens the growth in the money supply to combat inflation the affect:
Decrease in funds to be lent and an increase in interest rates Increase in demand for funds to carry inflation-laden inventory and receivables Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns

Credit conditions can change dramatically and suddenly due to:

Unexpected defaults Economic recessions Changes in monetary policy Other economic setbacks

Financing Through Commercial Paper

Short-term, unsecured promissory notes issued to the public
Finance paper / direct paper Dealer paper Asset-backed commercial paper

Book-entry transactions
Computerized handling of commercial paper, where no actual certificate is created


Total Commercial Paper Outstanding


Advantages of Commercial Paper

May be issued at below the prime interest rate No associated compensating balance requirements Associated prestige for the firm to float their paper in an elite market


Disadvantages of Commercial Paper

Many lenders have become risk-averse post a multitude of bankruptcies Firms with downgraded credit rating do not have access to this market The funds generation associated with this is less predictable Lacks the degree of commitment and loyalty associated with bank loans

Foreign Borrowing
Eurodollar loan
Denominated in dollars and made by foreign bank holding dollar deposits Short-term to intermediate terms in maturity LIBOR is the base interest paid on loans for companies of the highest quality

One approach borrow from international banks in foreign currency

Borrowing firm may suffer currency risk

Use of Collateral in Short-Term Financing

Secured credit arrangement when:
Credit rating of the borrower is too low Need for funds is very high Primary concern whether the borrower can generate enough cash flow to liquidate the loan when due

Uniform Commercial Code

Standardizes and simplifies the procedures for establishing security against a loan

Accounts Receivable Financing

Pledging accounts receivables Factoring or an outright sale of receivables

Permits borrowing to be tied directly to the level of asset expansion at any point of time

Relatively expensive method of acquiring funds

Pledging Accounts Receivables

Lending firm decides on the receivables that it will use as a collateral Loan percentage depends on the firms:
The financial strength The creditworthiness

Interest rate is well above the prime rate

Computed against the balance outstanding


Factoring Receivables
Receivables are sold outright to the finance company
Factoring firms do not have recourse against the seller of the receivables Finance companies may do all or part of the credit analysis to ensure the quality of the accounts Factoring firm is:
Absorbing risk for which a fee is collected Actually advancing funds to the seller paid a lending rate

Factoring Receivables Example

If $100,000 a month is processed at a 1% commission, and a 12% annual borrowing rate, the total effective cost is computed on an annual basis 1%......Commission 1%......Interest for one month (12% annual/12) 2%......Total fee monthly 2%......Monthly X 12 = 24% annual rate The rate may not be considered high due to factors of risk transfer, as well as early receipt of funds It also allows the firm to pass on much of the credit-checking cost to the factor


Asset Backed Public Offering

There is an increasing trend in public offerings of security backed by receivables as collateral
Interest paid to the owners is tax free Advantages to the firm:
Immediate cash flow High credit rating of AA or better Provides
Corporate liquidity Short-term financing

Disadvantage to the buyer:

Risk associated receivables actually being paid

Inventory Financing
Factors influencing use of inventory:
Marketability of the pledged goods Associated price stability Perishability of the product Degree of physical control that the lender can exercise over the product


Stages of Production
Stages of production
Raw materials and finished goods usually provide the best collateral Goods in process may qualify only a small percentage of the loan


Nature of Lender Control

Provides greater assurance to the lender but higher administrative costs Types of Arrangements:
Blanket inventory liens
Lender has a general claim against inventory

Trust receipts (floor planning)

An instrument the proceeds from sales go to the lender

A receipt issue goods can be moved only with the lenders approval Public warehousing Field warehousing

Appraisal of Inventory Control Devices

Well-maintained control measures involves:
Substantial administrative expenses Raise overall cost of borrowing Extension of funds is well synchronized with needs


Hedging to Reduce Borrowing Risk

Engaging in a transaction that partially or fully reduces a prior risk exposure The financial futures market:
Allows the trading of a financial instrument at a future point in time No physical delivery of goods


Hedging to Reduce Borrowing Risk (contd)

In selling a Treasury bond futures contract, the subsequent pattern of interest rates determine if it is profitable or not
Sales price, June 2006 Treasury bond contract* (sale occurs in January 2006.)$100,000 Purchase price, June 2006 Treasury bond contract (purchase occurs in June 2006). $95,000 Profit on futures contract..$5,000
* Only a small percentage of the actual dollars involved must be invested to initiate the contract. This is known as the margin


Hedging to Reduce Borrowing Risk (contd)

If interest rates increase
The extra cost of borrowing money to finance the business can be offset by the profit of the futures contract

If interest rates decrease

A loss is garnered on the futures contract as the bond prices rise This is offset by the lower borrowing costs of the financing firm

The purchase price of the futures contract is established at the time of the initial purchase transaction