Principles of Finance
Chapter 8 – Sources of Short-Term Financing
Overview of Short-term Financing Sources:
Trade – 40% of short-term financing is in the form of trade credit which is usually extended for
30 to 60 days. Attached to credit terms ie: 2/10, n/30.
Bank – We will look at bank’s as a source of short-term funds and discuss: Prime Rate, London
Interbank Offered Rate (LIBOR), Compensating Balances, Term Loans, Effective Rate,
Discounted Loans, Installment Loans, and Annual Percentage Rates (APR).
Commercial Paper – A paper certificate issued for the short-term, unsecured promissory notes
issued to the public in minimum units of $25,000.
Foreign Borrowing – Eurodollar loans made by International banks holding U.S. currency
Accounts Receivable – Can be used in financing by pledging A/R as collateral or selling
receivables called factoring.
Inventory – We may borrow against inventory to acquire funds.
Hedging – To engage in a transaction that partially or fully reduces a prior risk exposure. The
trading of a financial instrument at a future point in time.
Trade Discounts:
Used to get customers to pay quicker but can be used as a form of financing if the company
leverages the due dates and the discount periods. Should compare the dollars saved from
paying within the discount period to the cost of financing. If the cost of not taking the discount
is higher than the cost to finance, then we should take the discount and finance with a cheaper
rate.
Cost of Failing to take a Discount =
(Discount Percent / 100% - Discount Percent) x (360 / Final Due Date – Discount Period)
Practice Problem 1 & 2 page 249
Net Trade Credit – Accounts receivable is the use of funds and accounts payable is a surce of
funds
Funds tied up in the customers hands (AR) VS funds we control (AP)
A firm has a positive net trade credit when AR is larger than AP
Net Credit Position = Accounts Receivable – Accounts payable
A Company normally takes 29 days to pay for average daily credit purchases of $9,275.
Its average daily sales are $11,230, and it collects accounts in 31 days.
1. What is its net credit position?
AR: 11,230* 31 = 348,130
AP: 9,275*29 = 268,975
SUBTRACT A/R - A/P =79,155
b. If the firm extends its average payment period from 29 days to 38 days (and all else remains
the same), what is the firm’s new net credit position? Has it improved its cash flow?
348,130 – 352,450
= (4,320)
Bank Credit:
Prime Rate – The rate the bank charges customer with good credit
-Average customer will pay one or two points above this rate
-In times of tight money, interest rates may be five or more points above this rate
LIBOR & Foreign Borrowing – London Interbank Offered Rate. Eurodollar deposits (any U.S.
dollar held outside of the U.S. banking system) are mainly held in London. The rate offered is
consistently less than the Prime Rate making it desirable for large firms to borrow from London
Banks. Usually short-term to intermediate term in maturity. One approach is to borrow from
international banks in foreign currencies either directly or through a foreign subsidiary. The
subsidiary can convert the borrowed currencies to dollars and then send them to the U.S. to be
used by the parent company. There is the risk that the foreign funds may rise against the dollar
making it more expensive to pay back.
Compensating Balances – The amount that the bank requires a firm to keep on deposit or pay a
fee
- As interest rates increase, the amount of the compensating balance needed to cover
service fees decreases.
Compensating balances allow for lower interest rates on borrowed funds. Although, you
are not utilizing all the funds borrowed. Example:
If you borrow $200,000 with 10% interest and a compensating balance of 20%,
you will be paying $20,000 for the use of $160,000 in funds. An effective interest
rate of 12.5%.
To determine the amount of money to be borrowed:
Amount Needed / (1-c)
C = the Compensating Balance
Example: If you needed $225,000 in funds and were required to maintain a 20%
compensating balance.
225,000 / (1-.20) = 281,250 would need to be borrowed to maintain a balance of
56,250 (225,000*20%)
Term Loans – Credit extended for 1 to 7 years
- Requires monthly or quarterly installments over the life of the loan and only are
available to only superior applications. Does not have a fixed interest rate, instead the
rate fluctuates with the market.
Effective Interest Rate – Is the amount of interest received or paid due to compounding over a
certain time frame.
Effective rate = the amount of interest received or paid due to compounding over a
certain time
Effective rate = Interest / principle X days in the year / days of loan outstanding
Days in the year= 360
Example: The bank will loan you $4,000 for 45 days at a cost of $50 interest.
Makes the assumption that $50 is paid when the loan comes due. What is the
effective interest rate?
50 / 4000 x 360 / 45 = 10%
Effective Rate with Compensating Balances =
Example: A firm plans to borrow $300,000 for one year. The bank will lend the
money at 10% interest rate and requires a compensating balance of 20%. What
is the effective interest rate?
10% / (1-.20) = 12.5%
OR if the stated rate is unknown:
Example: Same example as above but interest will be $25,000
If the firm has idle cash (cash on hand to cover compensating balances) then we will add
this amount back to the Compensating Balance in the denominator
Example: A firm is seeking a $23,600 loan for one year from the bank. The stated
interest rate is 10%, and there is a 15% compensating balance requirement. The
firms always keeps a minimum of $2,280 in the accounts. These funds count
toward meeting compensating balance requirements. What will be the effective
rate of interest?
2360 / 23600 – 3540 + 2280 x 360 / 360 = 10.56%
Discounted Loans – Bank will deduct the interest due at the time the loan is issued. This causes
the effective interest rate to increase.
Effective rate = Interest / Principle – Interest x 360 / Days loan outstanding
Example: A firm borrows $5,000 for one year at 13%. What is the effective
interest rate if the loan is discounted?
(5000*13%) / (5000-650) *360 / 360 = 14.94%
What if there was also a 10% compensating balance?
(5000*13%) / (5000-650-500) *360 / 360 = 16.88%
Installment Loans – A series of equal payments over the life of the loan. Each payment is part
principle and interest.
Example: A firm is borrowing $60,000 from a bank. The total interest is $15,000
for one year, what is the effective interest rate an annual payment?
15,000 / 60,000 = 25%
Effective rate =
2 x annual number of payments x interest / (total # of payments + 1) x principle
Example: A firm is borrowing $60,000 from a bank. The total interest is $15,000.
The loan will be paid by making equal monthly payments for the next three
years. What is the effective rate of interest on this installment loan?
(2 x 12 x 15,000) / (36+1) x 60,000 = 16,21%
Example: For Quarterly payments for two years?
(2 x 4 x 15,000) / (8+1) x 60,000 = 22.22%
Example: For Semiannual payments for one year?
(2 x 2 x 15,000) / (2+1) x 60,000 = 33.33%
Annual Percentage Rate – Because of the way interest is calculated this often makes the
effective rate different from the stated rate. APR is a measure of the effective rate already
discussed. In 1968 Congress degreed that the APR be given to customers to protect them from
paying more than the stated rate. APR is calculated using time-value of money concepts. A
lender must calculate interest for the period on the outstanding balance at the beginning of the
period. Any payments are first credited against interest due and any amount left is used to
reduce the principal balance.
Commercial Paper – Three Categories
1. Finance Companies – General Motors Acceptance Corporation (GMAC) and General
Electric Capital Corporation
a. Issue to pension funds, insurance companies and money market mutual funds &
referred to as finance paper
2. Industrial Companies, utility firms, and financial companies who use an intermediate
dealer & referred to as dealer paper
3. Asset-backed commercial paper
Advantages:
 May be issued below the prime rate
 No compensating balance requirements
 Prestige associated with being able to float their commercial paper
Disadvantages:
 Recessions, bankruptcies, fraud and others cause lenders to become risk-averse.
Which means only high-quality, high credit rating companies can access the
commercial paper market.
 Less predictable as interest rates fluctuate more than prime rates
Accounts Receivable Financing:
As A/R increases it allows for more funds to be borrowed but it is an expensive way (more than
prime rate) to acquire funds, wouldn’t be first choice and should be compared to other
methods first.
Can be Pledged – used as collateral
The lender will have say over which of the A/R can be used as collateral.
We may borrow 60 to 90% of the value of the acceptable A/R.
The percentage will depend on the strength of the borrowing firm (credit).
If any accounts go back the lender can come back on the firm.
Can be Sold – factoring
Customers will be instructed to pay the purchaser of the receivables.
No recourse. Funds are immediately transferred to the seller.
Purchasing firms receives a fee or commission equal to 1 to 3% of the invoices accepted
and is paid a lending rate for advancing the funds early.
Asset-Backed Securities:
Really just the sale of receivables. IBM added receivables due from state and municipal
governments.
Benefit to issuer:
Trade future cash for immediate cash
Likely to carry a high credit rating and allows the issuing firm to secure short-term cash flows at
a low interest rate
Great for corporate liquidity and short-term financing
Disadvantages:
Must consider likelihood that they won’t be paid
Less likely in tight money times (recessions, etc…)
Inventory Financing:
We can use Inventory to acquire funds for operation. How much will depend on
- How easily inventory is sold
- Price stability
- Perishability
- How much control the lender has on the inventory
The percentage of completeness of the product will also have an impact on funding
Stages of Production:
Raw materials and finished goods
Lumber, metals, grain, cotton, wool, tires, canned goods, building products are the best
collateral
Loan of 70-80% possible
Goods in process; not raw or finished, so a loan of 25% of their value may be the only possibility
Types of Lender Arrangements:
Blanket Inventory Liens –
Trust Receipts –
Warehousing –
Hedging:
The Financial Futures Market allows for trading of financial instruments at a future point in time
at a specified price at the date of sale or purchase regardless of the price at the maturity date.
Must have a companion transaction to close out the transaction, for example: If you sell a
contract you must buy one and vs. versa. Goods are not physically exchanged you just execute a
later transaction.
Treasury bond prices will increase when interest rates decline and vs. versa. So if interest rates
are increasing then profits can be made in the Financial Futures Market if you sell and then buy
it back.
In the case of rising interest rates, the financial futures market can be used to help hedge
against some of those increased expenses.