Chapter 9 Short-term debt Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-1 Learning objectives LO 9.1 Understand why financial markets offer short-term debt and financing facilities. LO 9.2 Consider the concept and reasons for the provision of trade credit. LO 9.3 Explain the purpose and operation of a bank overdraft. LO 9.4 Describe the structure of a commercial bill. LO 9.5 Complete a range of calculations for discount securities, including: – – – – – price where the yield is known face value where the issue price and yield are known yield prices where the discount rate is known discount rate. Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e (cont.) 9-2 Learning objectives LO 9.6 Describe the structure, advantages, establishment, underwriting and calculation of promissory notes. LO 9.7 Explain the structure, issue and calculation of negotiable certificates of deposit. LO 9.8 Discuss the nature and operation of inventory finance, accounts receivable financing and factoring. Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-3 Chapter outline 9.1 9.2 9.3 9.4 9.5 9.6 9.7 Trade credit Bank overdrafts Commercial bills Calculations: discount securities Promissory notes Negotiable certificates of deposit Inventory finance, accounts receivable financing and factoring Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-4 9.1 Trade credit • Short-term debt is a financing arrangement for a period of less than one year with various characteristics to suit borrowers’ particular needs – Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds • Matching principle – Short-term assets should be funded with short-term liabilities. – The importance of this principle was highlighted by the GFC (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-5 9.1 Trade credit • A supplier provides goods or services to a purchaser with an arrangement for payment at a later date • Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days, otherwise the full amount is due within 30 days) • From the provider’s perspective: – advantages include increased sales – disadvantages include costs of discount and increased discount period, increased total credit period and accounts receivable, increased collection and bad debt costs (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-6 9.1 Trade credit • The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is: % discount 365 × 100 − % discount days difference between early and late settlement 1.0 365 = × 99.0 23 = 0.160298 or 16.03% p. a. Opportunity cost = Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-7 9.2 Bank overdrafts • Major source of short-term finance • Allows a firm to place its cheque (operating) account into deficit, to an agreed limit • Generally operated on a fully fluctuating basis • Lender also imposes an establishment fee, monthly account service fee and a fee on the unused overdraft limit (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-8 9.2 Bank overdrafts • Interest rates negotiated with bank at a margin above an indicator rate, reflecting the borrower’s credit risk – Financial performance and future cash flows – Length of mismatch between cash inflows and outflows – Adequacy of collateral • Indicator rate typically a floating rate based on a published market rate (e.g. BBSW) • In some countries the overdraft borrower may be required to hold a credit average balance or compensating credit balance Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-9 9.3 Commercial bills • A bill of exchange is a discount security issued with a face value payable at a future date • A commercial bill is a bill of exchange issued to raise funds for general business purposes • A bank-accepted bill is a bill that is issued by a corporation and incorporates the name of a bank as acceptor (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-10 9.3 Commercial bills • Features of commercial bills—parties involved (bankaccepted bill) – Drawer Issuer of the bill Secondary liability for repayment of the bill (after the acceptor) – Acceptor Undertakes to repay the face value to the holder of the bill at maturity Acceptor is usually a bank or merchant bank (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-11 9.3 Commercial bills • Features of commercial bills—parties involved (bankaccepted bill) (cont.) – Payee The specified party to whom the bill is to be paid (i.e. the party who receives the funds) Usually the drawer, but the drawer can specify some other party as payee – Discounter The party that discounts the face value and purchases the bill The provider or lender of the funds May also be the acceptor of the bill (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-12 9.3 Commercial bills • Features of commercial bills—parties involved (bankaccepted bill) (cont.) – Endorser The party that was previously a holder of the bill Signs the reverse side of the bill when selling, or discounting, the bill Order of liability for payment of the bill runs from acceptor to drawer and then to endorser (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-13 9.3 Commercial bills • The flow of funds (non-bank bills) – Alternatively, a bill can be drawn by the bank and accepted by the borrower – The bank is both drawer and discounter of the bill If the bank rediscounts a bill (sells to a third party), the bank becomes the endorser, creating a bank-endorsed bill – Funds are lent to borrower as payee – At maturity date the borrower, as acceptor of the bill, is liable to pay face value to the holder of the bill (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-14 9.3 Commercial bills • Establishing a bill financing facility – Borrower approaches bank or merchant bank – Assessment made of borrower’s credit risk – Credit rating of borrower affects size of discount – Maturity usually 30, 60, 90, 120 or 180 days – Minimum face value usually $100 000 (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-15 9.3 Commercial bills • Advantages of commercial bill financing – Lower cost than other short-term borrowing forms (i.e. overdraft, fully-drawn advances) – Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest rates) – A bill line Arrangement with a bank where it agrees to discount bills progressively up to an agreed amount – Term of loan may be extended by ‘rollover’ at maturity Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-16 Talking markets and strategy • Legendary investor Peter Lynch hates debt markets and believes people should concentrate on buying good stocks. This might be a little bit extreme • Debt securities like bills and bonds can provide an important balance for a portfolio and investors in debt markets are always looking for new opportunities • One of these opportunities is the $12 trillion Chinese bond market. In 2018, the Chinese government undertook a raft of reforms designed to lure foreign investors • What benefits could Australian investors reap from looking into this potential opportunity? Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-17 9.4 Calculations: discount securities • Calculations considered – Calculating price—yield known – Calculating face value—issue price and yield known – Calculating yield – Calculating price—discount rate known – Calculating discount rate Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-18 Calculating price—yield known face value × days in year Price = yield days in year + × days to maturity 100 (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-19 Calculating price—yield known • Example 3: A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of 9.52% per annum and 9.48% per annum. • Which quote should the company accept, and what amount will the company raise? $500 000 × 365 = $496 118.04 365 + (0.0952 × 30) or $500 000 × 365 = $496 134.23 365 + (0.0948 × 30) (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-20 Calculating price—yield known • An alternative formula for calculating price: 𝐹 𝑃= (1 + 𝑟𝑡) where: 𝑃 = price of the discount security 𝐹 = face value 𝑟 = required yield expressed as a decimal 𝑡 = days to maturity 365 Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-21 Calculating face value—issue price and yield known 365 + Face value = price yield × days to maturity 100 365 (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-22 Calculating face value—issue price and yield known • Example 4: A company needs to raise additional funding of $500 000 to purchase inventory. The company has decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn? 365 + 0.0875 × 60 Face value = $500 000 365 = $507 191.78 Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-23 Calculating yield Yield (sell price - buy price) (days in year 100) buy price days to maturity (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-24 Calculating yield • Example 7: In Example 3, a company issued a 30-day bank-accepted bill with a face value of $500 000. The bill was discounted at a yield of 9.48% per annum, representing a price of $496 134.23 After seven days the discounter sells the bill in the shortterm money market for $497 057.36. The bill is not traded again in the market. Calculate the yield to the original discounter and to the holder at maturity (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-25 Calculating yield • Yield to original discounter: (497 057.36 − 496 134.23) 36 500 × = 9.70% 496 134.23 7 • Yield to holder at maturity: (500 000 − 497 057.36) 36 500 × = 9.39% 497 057.36 23 Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-26 Calculating price—discount rate known Price = Face value = days to maturity discount rate 1− × days in year 100 (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-27 Calculating price—discount rate known • Example 8: The price of a 180-day bill, with a face value of $100 000, selling at a discount of 14.75%, would be: 180 Price = $100 000 1 − × 0.1475 360 = $100 000 1 − 0.07375 = $92 625.00 – The discount in this formula is effectively the rate of return to the buyer of the bill (or the cost of funds to the drawer of the bill), expressed as a percentage per annum, in relation to the face value of the bill Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-28 Calculating discount rate Discount rate = (face value − current price) (days in year × 100) × face value days to maturity (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-29 Calculating discount rate • Example 9: A 180-day bill with a face value of $100 000 and selling currently at $92 000, with a full 180 days to run to maturity, has a discount rate of: (100 000 − 92 000) 36 500 Discount rate = × 100 000 180 = 0.08 × 202.778 = 16.22% Note: if issued in the United States, the number of days will be 360 days and the answer will be 16.00% Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-30 9.5 Promissory notes • Also called P-notes or commercial paper, they are discount securities, issued in the money market with a face value payable at maturity but sold today by the issuer for less than face value • Typically available to companies with an excellent credit reputation because: – there is no acceptor or endorser – they are unsecured instruments (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-31 Talking markets and strategy • In 2018, the US Treasury launched its inaugural issue of two-month Treasury bills • Issued at a yield of 2.170%, the bill issue was largely sold out, with $25 billion snapped up by traders • In 2018, the yield on most short-term government securities in the United States surpassed the inflation rate for the first time since the GFC • The yield on Treasury bills is also above the dividend yield on US stocks • With their lower volatility and higher yields, investors are looking seriously at Treasury bills as investment alternatives for the first time in many years Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-32 9.5 Promissory notes • Calculations—use discount securities formulae • Issue programs – Usually arranged by major commercial banks and money market corporations – Standardised documentation – Revolving facility – Most P-notes are issued for 90 days By tender, tap issuance or dealer bids (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-33 9.5 Promissory notes • Underwritten P-note issues – Underwriting guarantees the full issue of notes is purchased and typical fee is 0.1% per annum – Underwriter is usually a commercial bank or investment bank – The underwritten issue can incorporate a rollover facility, effectively extending the borrower’s line of credit beyond the short-term life of the P-note issue – Credit rating • Issues may also be non-underwritten – Issuer may approach money market directly – Commercial bank or investment bank may be retained as lead manager and receive fees Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-34 9.6 Negotiable certificates of deposit • Short-term discount security issued by banks to manage their liabilities and liquidity • Maturities range up to 180 days • Issued to institutional investors in the wholesale money market • The short-term money market has an active secondary market in CDs • Calculations—use discount securities formulae Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-35 9.7 Inventory finance, accounts receivable financing and factoring • Inventory finance – Most common form is ‘floor plan finance’ – Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles Bailment common—finance company holds title to dealership’s stock – Dealer is expected to promote financier’s financial products (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-36 9.7 Inventory finance, accounts receivable financing and factoring • Accounts receivable financing – A loan to a business secured against its accounts receivable (debtors) – Mainly supplied by finance companies – Lending company takes charge of a company’s accounts receivable; however, the borrowing company is still responsible for the debtor book and bad debts (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-37 9.7 Inventory finance, accounts receivable financing and factoring • Factoring – Company sells its accounts receivable to a factoring company Converting a future cash flow (receivables) into a current cash flow – Factoring provides immediate cash to the vendor; plus it removes administration costs of accounts receivable – The main providers of factor finance are the finance companies – Factor is responsible for collection of receivables (cont.) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-38 9.7 Inventory finance, accounts receivable financing and factoring • Factoring (cont.) – Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be made to the factor – Recourse arrangement Factor has a claim against the vendor if a receivable is not paid – Non-recourse arrangement Factor has no claim against vendor company Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-39 Summary • Short-term debt is appropriate for funding short-term assets (matching principle) • Trade credit—simple and common • Bank overdraft—common • Discount securities – Bill financing—important source of funds – Promissory notes (P-notes)—good credit rating required – Certificates of deposit (CDs)—issued by banks to manage liabilities and liquidity • Inventory loans, accounts receivable finance and factoring— alternative sources of finance for small and medium-sized businesses (SMEs) Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Viney & Phillips, Financial Institutions, Instruments and Markets, 9e 9-40
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