Chapter 9
Short-term debt
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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.
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(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.
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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
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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.)
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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.)
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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 =
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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.)
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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
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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.)
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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.)
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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.)
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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.)
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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.)
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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.)
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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
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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?
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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
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Calculating price—yield known
face value × days in year
Price =
yield
days in year +
× days to maturity
100
(cont.)
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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.)
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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
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Calculating face value—issue price
and yield known
365 +
Face value = price
yield
× days to maturity
100
365
(cont.)
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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
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Calculating yield
Yield 
(sell price - buy price) (days in year  100)

buy price
days to maturity
(cont.)
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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.)
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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
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Calculating price—discount rate
known
Price =
Face value =
days to maturity discount rate
1−
×
days in year
100
(cont.)
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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
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Calculating discount rate
Discount rate =
(face value − current price) (days in year × 100)
×
face value
days to maturity
(cont.)
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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%
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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.)
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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
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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.)
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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
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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
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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.)
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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.)
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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.)
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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
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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)
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