FM- II Chapter 3: Sources of Short-Term Financing

Chapter Outline
• Trade credit from suppliers.
Chapter Sources of Short- • Bank loans.

3 Term Financing •
•
•
Commercial paper.
Borrowing in foreign markets.
Using collaterals like accounts receivable
and inventory for larger loans.

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Trade Credit Payment Period

• 40 percent of short-term financing is in the • Trade credit is usually extended for 30-60
form of accounts payable or trade credit. days.
– Accounts payable • Extending the payment period to an
• Spontaneous source of funds. unacceptable period results in:
• Growing as the business expands.
– Alienate suppliers.
• Contracting when business declines.
– Diminished ratings with credit agencies.
• Major variable in determining the payment
period:
– The possible existence of a cash discount.
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 FM- II Chapter 3: Sources of Short-Term Financing

Cash Discount Policy Net-Credit Position

• Cash Discount Policy allows reduction in • Net-Credit Position is Determined by
price if payment is made within a specified examining the difference between accounts
time period. receivable and accounts payable.
– Example: A 2/10, net 30 cash discount means: – It is positive if accounts receivable is greater
• Reduction of 2% if funds are remitted 10 days after than accounts payable and vice versa.
billing. – Larger firms tries to be net providers of trade
• Failure to do so means full payment of amount by the credit (relatively high receivables).
30th day.
– Smaller firms in the relatively user position
(relatively high payables).

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Bank Credit Prime Rate and LIBOR

• Provide self-liquidating loans • Prime rate is
– Use of funds ensures a built-in or automatic – Rate a bank charges to its most creditworthy
repayment scheme. customers.
• Changes in the banking sector today: – Increases as a customer’s credit risk increases.
– Centered around the concept of ‘full service • LIBOR (London Interbank Offered Rate) is
banking’. – Rate offered to companies:
– Expanded internationally to accommodate world • Having an international presence.
trade and international corporations. • Ability to use the London Eurodollar market for loans.
– Deregulation has created greater competition
among other financial institutions.
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 FM- II Chapter 3: Sources of Short-Term Financing

Prime Rate versus LIBOR on U.S.

Compensating Balances
Dollar Deposits
• Compensating Balances is 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.
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Compensating Balances - Example Maturity Provisions

• If one needs $100,000 in funds, he/ she must borrow $125,000 to
ensure the intended amount will be available. This would be calculated • Term loan
as:
Amount to be borrowed = Amount needed – Credit is extended for one to seven years.
(1 - c)
= $100,000
– Loan is usually repaid in monthly or quarterly
(1 – 0.2) installments.
= $125,000
– Where ‘c’ is the compensating balance expressed as a decimal.
– Only superior credit applicants, qualify.
– Interest rate fluctuates with market conditions.
• To check on this calculation, the following can be done:
$125,000 Loan • Interest rate may be tied to the prime rate or LIBOR.
- 25,000 20% compensating balance requirement
$100,000 Available funds

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 FM- II Chapter 3: Sources of Short-Term Financing

Interest Costs with Compensating

Cost of Commercial Bank Financing
Balances
• Assuming that 6% is the stated annual rate and that 20% compensating
• Effective interest on a loan is based on the: balance is required;
– Loan amount.
Effective rate with = Interest
– Dollar interest paid. compensating balances (1 – c)
– Length of the loan. = 6% = 7.5%
(1 – 0.2)
– Method of repayment.
• When dollar amounts are used and the stated rate is not known, the
– Discounted loan - interest is deducted in following can be used for computation:
advance - effective rate increases. Days in a
Effective rate with = Interest X year (360)
compensating balances Principal – Compensating Days loan is
Effective rate = Interest X Days in the year (360)
balance in dollars outstanding
Principal Days loan is outstanding
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Rate on Installment Loans Annual Percentage Rate

• Congress passed the truth in Lending Act of
• Installment loans is a series of equal 1968 requires the actual APR to be given to
payments over the period of the loan. the borrower.
– Federal legislation prohibits a • Annual percentage rule:
misrepresentation of interest rates, however – Protects unguarded consumer from paying more
than the stated rate.
this may be misused.
– 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.
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 FM- II Chapter 3: Sources of Short-Term Financing

Financing Through Commercial

Total Commercial Paper Outstanding
Paper

• Commercial Paper is Short-term, unsecured

promissory notes issued to the public.
• Commercial paper falls into these categories
– Finance paper/ direct paper
• Sold by financial firms, directly to the lender.
– Dealer paper
• Sold by industrial companies, use of intermediate
dealer network for its distribution.

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Comparison of Commercial Paper

Advantages of Commercial Paper
Rate to Prime Rate (annual rate)
• Fuelled by the rapid growth of money-market
mutual funds, and their need for short-term
securities for investments.
• No associated compensating balance
requirements.
• Associated prestige for the firm to float their
paper in an best market.

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 FM- II Chapter 3: Sources of Short-Term Financing

Use of Collateral in Short-Term

Foreign Borrowing
Financing
• Eurodollar loan • Secured credit arrangement when:
– Denominated in dollars and made by foreign – Credit rating of the borrower is too low.
bank holding dollar deposits. – Need for funds is very high.
– Short-term to intermediate terms in maturity. – Primary concern - whether the borrower can
– LIBOR is the base interest paid on loans for generate enough cash flow to liquidate the loan
companies of the highest quality. when due.
• One approach – borrow from international • Uniform Commercial Code: standardizes
banks in foreign currency. and simplifies the procedures for
– Borrowing firm may suffer currency risk. establishing security against a loan.
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Accounts Receivable Financing Pledging Accounts Receivables

• Includes: • Pledging Accounts Receivables is when
– Pledging accounts receivables. Lending firm decides on the receivables that
– Factoring or an outright sale of receivables. it will use as a collateral.
Loan percentage depends on 60%-90% of the firms’ receivables
• Advantage:
– The financial strength.
– Permits borrowing to be tied directly to the level
of asset expansion at any point of time. – The creditworthiness.
• Disadvantage: • Interest rate is well above the prime rate.
– Relatively expensive method of acquiring funds. – Computed against the balance outstanding.

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 FM- II Chapter 3: Sources of Short-Term Financing

Factoring Receivables Factoring Receivables - Example

• Factoring Receivables is when Receivables • If $100,000 a month is processed at a 1% commission, and a
are sold outright to the finance company. 12% annual borrowing rate, the total effective cost is computed
on an annual basis.
– Factoring firms do not have recourse against the 1%......Commission
seller of the receivables. 1%......Interest for one month (12% annual/12)
– Finance companies may do all or part of the 2%......Total fee monthly
credit analysis. 2%......Monthly X 12 = 24% annual rate.
• To determine and ensure the quality of the accounts.
– Factoring firm is: • The rate may not be considered high due to factors of risk
• Absorbing risk – for which a fee is collected transfer, as well as early receipt of funds.
• Actually advancing funds to the seller - paid a lending • It also allows the firm to pass on mush of the credit-checking cost
rate. to the factor.

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Asset Backed Public Offering Inventory Financing

• There is an increasing trend in public • Factors influencing use of inventory:
offerings of security backed by receivables – Marketability of the pledged goods.
as collateral. – Associated price stability.
– Interest paid to the owners is tax free. – Perish-ability of the product.
– Advantages to the firm: – Degree of physical control that the lender can
• Immediate cash flow. exercise over the product.
• High credit rating of AA or better.
• Provides - corporate liquidity, short-term financing.
– Disadvantage to the buyer:
• Risk associated – receivables actually being paid.
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 FM- II Chapter 3: Sources of Short-Term Financing

Stages of Production Nature of Lender Control

• Stages of production • Provides greater assurance to the lender but
– Raw materials and finished goods usually higher administrative costs.
provide the best collateral. • Types of Arrangements:
– Goods in process may qualify only a small – Blanket inventory liens: Lender has a general
percentage of the loan. claim against inventory.
– Trust receipts (floor planning) an instrument -
the proceeds from sales go to the lender.
– Warehousing a receipt issue - goods can be
moved only with the lender’s approval.
• Public warehousing.
• Field warehousing.
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Appraisal of Inventory Control

Hedging to Reduce Borrowing Risk
Devices
• Well-maintained control measures involves: • Engaging in a transaction that partially or
– Substantial administrative expenses. fully reduces a prior risk exposure.
– Raise overall cost of borrowing. • The financial futures market:
– Extension of funds is well synchronized with – Allows the trading of a financial instrument at a
needs. future point in time.
– No physical delivery of goods.

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 FM- II Chapter 3: Sources of Short-Term Financing

Hedging to Reduce Borrowing Risk Hedging to Reduce Borrowing Risk

(cont’d) (cont’d)
– In selling a Treasury bond futures contract, the – If interest rates increase:
subsequent pattern of interest rates determine if • The extra cost of borrowing money to finance the
it is profitable or not. business can be offset by the profit of the futures
contract.
Sales price, June 2006 Treasury – If interest rates decrease:
bond contract* (sale occurs in January 2006.)……………$100,000 • A loss is garnered on the futures contract as the bond
Purchase price, June 2006 Treasury prices rise.
bond contract (purchase occurs in June 2006)…………….$95,000 • This is offset by the lower borrowing costs of the
Profit on futures contract………….…………………………….$5,000 financing firm.
– The purchase price of the futures contract is
* Only a small percentage of the actual dollars involved must be established at the time of the initial purchase
invested to initiate the contract. This is known as the margin.
transaction.
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The End

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