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Topic 005

  1. 1. Chapter 08• Sources of Short-Term Financing By Md. Shahedur Rahaman Chowdhury 8-1
  2. 2. Chapter Outline• Trade credit from suppliers• Bank loans• Commercial paper• Borrowing larger amounts• Using hedging to offset the risk 8-2
  3. 3. 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 company’s senior unsecured credit rating – a percentage margin• Primary aim of the borrowing firms: – Minimize cost 8-3
  4. 4. 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 8-4
  5. 5. 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
  6. 6. 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
  7. 7. 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) 8-7
  8. 8. 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
  9. 9. 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
  10. 10. Prime Rate versus LIBOR on U.S. Dollar Deposits 8-10
  11. 11. 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
  12. 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 8-12
  13. 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 × Days in the year (360) Principal-interest Days loan is outstanding 8-13
  14. 14. Interest Costs with Compensating Balances• Assuming that 6% is the stated annual rate and that 20% compensating balance is required; Effective rate with = Interest compensating balances (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 aEffective rate with = Interest × year (360)compensating balances Principal – Compensating Days loan is balance in dollars outstanding 8-14
  15. 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 Effective rate on installment loan = 2 × Annual no. of payments × Interest (Total no. of payments + 1) × Principal 8-15
  16. 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 8-16
  17. 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 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 8-17
  18. 18. 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 8-18
  19. 19. Total Commercial Paper Outstanding 8-19
  20. 20. 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 8-20
  21. 21. 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 8-21
  22. 22. 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 8-22
  23. 23. 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 8-23
  24. 24. 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 8-24
  25. 25. 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 8-25
  26. 26. 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 8-26
  27. 27. 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 8-27
  28. 28. 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 8-28
  29. 29. 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 8-29
  30. 30. 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 8-30
  31. 31. 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 8-31
  32. 32. 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 8-32
  33. 33. 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 8-33
  34. 34. 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 notSales price, June 2006 Treasurybond contract* (sale occurs in January 2006.)……………$100,000Purchase price, June 2006 Treasurybond contract (purchase occurs in June 2006)……………. $95,000Profit 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 8-34
  35. 35. 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 8-35
  36. 36. EndQ 8-36
  37. 37. Q&A 8-37
  38. 38. Thank You. 8-38