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CHAPTER 23
Short-Term Financing
Working capital financing policies
Accounts payable (trade credit)
Commercial paper
Short-term bank loans
Secured short-term credit
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Working Capital Financing Policies
Maturity Matching: Matches the
maturity of the assets with the
maturity of the financing.
Aggressive: Uses short-term
(temporary) capital to finance some
permanent assets.
Conservative: Uses long-term
(permanent) capital to finance some
temporary assets.
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Maturity Matching Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
What are “permanent” assets?
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Aggressive Financing Policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
More aggressive the lower the dashed line.
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Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm C.A.
Fixed Assets
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years
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The choice of working capital policy is
a classic risk/return tradeoff.
The aggressive policy promises the
highest return but carries the greatest
risk.
The conservative policy has the least
risk but also the lowest expected
return.
The moderate (maturity matching)
policy falls between the two extremes.
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What is short-term credit?
What are the major sources?
Short-term credit: Debt requiring
repayment within one year.
Major sources:
Accruals
Accounts payable (trade credit)
Commercial paper
Bank loans
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 Short-term debt is riskier than
long-term debt for the borrower.
 Short-term rates may rise.
 May have trouble rolling debt over.
 Advantages of short-term debt.
 Typically lower cost.
 Can get funds relatively quickly with
low transactions costs.
 Can repay without penalty.
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Is there a cost to accruals?
Do firms have much control over
amount of accruals?
Accruals are free in the sense that
no explicit interest is charged.
However, firms have little control
over accrual levels, which are
influenced more by industry
custom, economic factors, and tax
laws than by managerial actions.
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What is trade credit?
Trade credit is credit furnished by a
firm’s suppliers.
Trade credit is often the largest
source of short-term credit for small
firms.
Trade credit is spontaneous and
relatively easy to get, but the cost
can be high.
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B&B buys $3,030,303 gross, or
$3,000,000 net, on terms of 1/10, net
30. However, the firm pays on Day 40.
How much free and costly trade credit
are they getting?
What is the cost of the costly trade
credit?
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Gross/Net Breakdown
Company buys goods worth
$3,000,000. That’s the cash price.
They must pay $30,303 more over
the year if they forego the discount.
Think of the extra $30,303 as a
financing cost similar to the interest
on a loan.
Must compare that cost with the
cost of alternative credit.
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Net daily purchases = $3,000,000/360
= $8,333.
Payables level if discount is taken:
Payables = $8,333 (10) = $83,333.
Payables level if don’t take discount:
Payables = $8,333 (40) = $333,333.
Credit Breakdown:
Total trade credit = $333,333
Free trade credit = 83,333
Costly trade credit = $250,000
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Nominal Cost of Costly Trade Credit
Firm loses 0.01($3,030,303) = $30,303
of discounts to obtain $250,000 in
extra trade credit, so
k Nom
$30,303

 0.1212  12.12%.
$250,000
But the $30,303 in lost discounts is
paid all during the year, not just at
year-end, so the EAR is higher.
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Nominal Cost Formula, 1/10, net 40
%
kNom = 1 -Discount
Discount % x
=
1
99
x
360
30
360
Days taken - Discount period
= 0.0101 x 12
= 0.1212 = 12.12%.
Pays 1.01% 12 times per year.
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Effective Annual Rate, 1/10, net 40
Periodic rate = 0.01/0.99 = 1.01%.
Periods/year = 360/(40 - 10) = 12.
EAR = (1 + Periodic rate)n - 1.0
= (1.0101)12 - 1.0 = 12.82%.
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Commercial Paper (CP)
CP are short term notes issued by
large, strong companies. B&B could
not issue CP; the company is too
small.
CP trades in the market at rates just
above the T-bill rate.
CP is bought by banks and other
companies, then held as marketable
securities for liquidity purposes.
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A bank is willing to lend B&B $100,000
for 1 year at an 8 percent nominal rate.
What is the EAR under the following
five loans?
1. Simple annual interest, 1 year.
2. Simple interest, paid monthly.
3. Discount interest.
4. Discount interest with 10 percent
compensating balance.
5. Installment loan, add-on, 12 months.
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Why must we use Effective Annual
Rates (EARs) to evaluate the loans?
In our examples, the nominal
(quoted) rate is 8% in all cases.
We want to compare loan cost rates
and choose the alternative with the
lowest cost.
Because the loans have different
terms, we must make the
comparison on the basis of EARs.
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Simple Annual Interest, 1-Year Loan
“Simple interest” means not discount
or add-on.
Interest = 0.08($100,000) = $8,000.
k Nom
$8,000
 EAR 
 0.08  8.0%.
$100,000
On a simple interest loan of one year,
kNom = EAR.
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Simple Interest, Paid Monthly
Monthly interest = (0.08/12)($100,000)
= $666.67.
0
1
12
...
100,000 -666.67
12
N
-667.67
-100,000.00
100000 -666.67 -100000
I/YR
PV
PMT
FV
0.66667
(More…)
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kNom = (Monthly rate)(12)
= 0.66667%(12) = 8.00%.
0.08 

EAR   1 


12 
or: 8
12
 1  8.30%.
NOM%, 12
P/YR,
EFF% = 8.30%.
Note: If interest were paid quarterly, then:
4
0.08 

EAR   1 
  1  8.24%.

4 
Daily, EAR = 8.33%.
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8% Discount Interest, 1 Year
Interest deductible = 0.08($100,000)
= $8,000.
Usable funds
= $100,000 - $8,000
= $92,000.
0
1
i=?
92,000
-100,000
1
N
I/YR
92
PV
0
PMT
-100
FV
8.6957% = EAR
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Discount Interest (Continued)
Amount needed
Amt. borrowed = 1 - Nominal rate (decimal)
$100,000
= 0.92
= $108,696.
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Need $100,000. Offered loan with
terms of 8% discount interest, 10%
compensating balance.
Face amount of loan =
=
Amount needed
1 - Nominal rate - CB
$100,000
= $121,951.
1 - 0.08 - 0.1
(More...)
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Interest = 0.08 ($121,951) = $9,756.
Interest paid
Cost 
.
Amount received
$9,756
EAR 
 9.756%.
$100,000
EAR correct only if amount is borrowed
for 1 year.
(More...)
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8% Discount Interest with 10%
Compensating Balance (Continued)
0
121,951
-9,756
-12,195
100,000
1
i=?
Loan
Prepaid interest
CB
Usable funds
1
N
-121,951
+ 12,195
-109,756
100000 0 -109756
I/YR
PV PMT
FV
9.756% = EAR
This procedure can handle variations.
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1-Year Installment Loan, 8% “Add-On”
Interest = 0.08($100,000) = $8,000.
Face amount = $100,000 + $8,000 = $108,000.
Monthly payment = $108,000/12 = $9,000.
Average loan
= $100,000/2 = $50,000.
outstanding
Approximate cost = $8,000/$50,000 = 16.0%.
(More...)
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Installment Loan
To find the EAR, recognize that the firm
has received $100,000 and must make
monthly payments of $9,000. This
constitutes an ordinary annuity as
shown below:
0
1
2
i=?
100,000
Months
12
...
-9,000 -9,000
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12
N
100000 -9000
I/YR
PV PMT
0
FV
1.2043% = rate per month
kNom = APR = (1.2043%)(12) = 14.45%.
EAR = (1.012043)12 - 1 = 15.45%.
14.45
12
1
NOM
enters nominal rate
P/YR
enters 12 pmts/yr
EFF% = 15.4489 = 15.45%.
P/YR to reset calculator.
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What is a secured loan?
In a secured loan, the borrower
pledges assets as collateral for the
loan.
For short-term loans, the most
commonly pledged assets are
receivables and inventories.
Securities are great collateral, but
generally firms needing short-term
loans generally do not have securities.
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What are the differences between
pledging and factoring receivables?
If receivables are pledged, the lender
has recourse against both the
original buyer of the goods and the
borrower.
When receivables are factored, they
are generally sold, and the buyer
(lender) has no recourse to the
borrower.
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What are three forms of inventory
financing?
Blanket lien.
Trust receipt.
Warehouse receipt.
The form used depends on the
type of inventory and situation at
hand.
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Legal stuff is vital.
Security agreement: Standard form
under Uniform Commercial Code.
Describes when lender can claim
collateral.
UCC Form-1: Filed with Secretary of
State to establish claim. Future
lenders do search, won’t lend if prior
UCC-1 is on file.
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