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- 1. Chapter 08 • Sourcesof Short-Term Financing By Md. Shahedur Rahaman Chowdhury 8-1
- 2. Chapter Outline • Trade credit from suppliers • Bank loans • Commercial paper • Borrowing larger amounts • Using hedging to offset the risk 8-2
- 3. Financing Arrangements • Linesof 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. Trade Credit • Approximately40 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. Payment Period • Tradecredit 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. 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. Net-Credit Position • Determinedby 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. Bank Credit • Provideself-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. Prime Rate andLIBOR • 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. Prime Rate versusLIBOR on U.S. Dollar Deposits 8-10
- 11. Compensating Balances • Afee 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. Maturity Provisions • Termloan – 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. Cost of CommercialBank 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. Interest Costs withCompensating 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 a Effective rate with = Interest × year (360) compensating balances Principal – Compensating Days loan is balance in dollars outstanding 8-14
- 15. Rate on InstallmentLoans • 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. 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. The Credit CrunchPhenomenon • 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. 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. Total Commercial Paper Outstanding 8-19
- 20. Advantages of CommercialPaper • 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. Disadvantages of CommercialPaper • 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. Foreign Borrowing • Eurodollarloan – 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. Use of Collateralin 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. 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. 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. Factoring Receivables • Receivablesare 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. 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. Asset Backed PublicOffering • 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. Inventory Financing • Factorsinfluencing 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. 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. Nature of LenderControl • 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. Appraisal of InventoryControl 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. Hedging to ReduceBorrowing 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. Hedging to ReduceBorrowing 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 8-34
- 35. Hedging to ReduceBorrowing 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. End Q 8-36
- 37. Q&A 8-37
- 38. Thank You. 8-38