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8 Sources of ShortTerm Financing Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • • • • • Trade credit from suppliers. Bank loans. Commercial paper. Borrowing in foreign markets. Using collaterals like accounts receivable and inventory for larger loans. 8-2 Financing Arrangements • Lines of credit are sometimes referred to as a revolving credit facility where interest cost: – Is based on LIBOR (the London Interbank Offering Rate) – Is based on the company’s senior unsecured credit rating - a percentage margin. • Primary aim of the borrowing firms: – Minimize cost. 8-3 Trade Credit • 40 percent of short-term financing is in the form of accounts payable or trade credit. – Accounts payable • Spontaneous source of funds. • Growing as the business expands. • Contracting when business declines. 8-4 Payment Period • Trade credit is usually extended for 30-60 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. 8-5 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. 8-6 Net-Credit Position • Determined by examining the difference between accounts receivable and accounts payable. – It is 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). 8-7 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. 8-8 Prime Rate and LIBOR • Prime rate – Rate a bank charges to its most creditworthy customers. – Increases as a customer’s 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. 8-9 Prime Rate versus LIBOR on U.S. Dollar Deposits 8-10 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. 8-11 Compensating Balances - Example • 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 as: Amount to be borrowed = Amount needed (1 - c) = $100,000 (1 – 0.2) = $125,000 – Where ‘c’ is the compensating balance expressed as a decimal. • To check on this calculation, the following can be done: $125,000 Loan - 25,000 20% compensating balance requirement $100,000 Available funds 8-12 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. 8-13 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 X Days in the year (360) Principal Days loan is outstanding 8-14 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 X year (360) compensating balances Principal – Compensating Days loan is balance in dollars outstanding 8-15 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. 8-16 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. 8-17 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 inflationladen inventory and receivables. – Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns. 8-18 The Credit Crunch Phenomenon (cont’d) • Credit conditions can change dramatically and suddenly due to: – Unexpected defaults. – Economic recessions. – Other economic setbacks. 8-19 Financing Through Commercial Paper • Short-term, unsecured promissory notes issued to the public. – 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. • Book-entry transactions – Computerized handling of commercial paper, where no actual certificate is created. 8-20 Total Commercial Paper Outstanding 8-21 Advantages of Commercial Paper • 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 elite market. 8-22 Comparison of Commercial Paper Rate to Prime Rate (annual rate) 8-23 Limitations on the Issuance 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. 8-24 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. 8-25 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. 8-26 Accounts Receivable Financing • Includes: – Pledging accounts receivables. – Factoring or an outright sale of receivables. • Advantage: – Permits borrowing to be tied directly to the level of asset expansion at any point of time. • Disadvantage: – Relatively expensive method of acquiring funds. 8-27 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. 8-28 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 determine and 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. 8-29 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 mush of the credit-checking cost to the factor. 8-30 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. 8-31 Inventory Financing • Factors influencing use of inventory: – Marketability of the pledged goods. – Associated price stability. – Perish-ability of the product. – Degree of physical control that the lender can exercise over the product. 8-32 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. 8-33 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. – Warehousing a receipt issue - goods can be moved only with the lender’s approval. • Public warehousing. • Field warehousing. 8-34 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. 8-35 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. 8-36 Hedging to Reduce Borrowing Risk (cont’d) – 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. 8-37 Hedging to Reduce Borrowing Risk (cont’d) – 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. 8-38