Chapter 16
Managing
Short-Term
Liabilities
(Financing)
Essentials of Managerial Finance by S. Besley & E. Brigham
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Short-term financing
Definition
• Any liability originally scheduled for repayment
within one year
Essentials of Managerial Finance by S. Besley & E. Brigham
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Sources of short-term financing
• Accruals
– Continually recurring short-term liabilities
– Liabilities, such as wages and taxes, that increase
spontaneously with operations
• Accounts Payable (Trade Credit)
– Credit created when one firm buys on credit from
another firm
• Trade credit discounts should be taken when offered.
Otherwise, the disadvantage is that the firm’s investment
in accounts payable rises
Essentials of Managerial Finance by S. Besley & E. Brigham
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Sources of short-term financing
• “Free” Trade Credit
– Credit received during the discount period
• Costly Trade Credit
– Credit taken in excess of “free” trade credit, the cost
of which is equal to the discount lost
• Short-Term Bank Loans
Essentials of Managerial Finance by S. Besley & E. Brigham
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Short-term bank loans
• Bank loans appear on a firm’s balance sheet as
notes payable and they are second in importance
to trade credit as a source of short-term financing.
Bank loans are nonspontaneous funds. As a firm’s
financing needs increase, it specifically requests
additional funds from its bank.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Key features of bank loans
• The bulk of banks’ commercial lending is on a short-term basis.
Bank loans to businesses frequently are written as 90-day
notes.
• When a firm obtains a bank loan, a promissory note is executed
specifying (1) the amount borrowed, (2) the percentage interest
rate, (3) the repayment schedule, (4) any collateral offered as
security, and (5) other terms and conditions of the loan to which
the bank and borrower have agreed.
• Banks sometimes require borrowers to maintain a
compensating balance (CB) equal to 10 to 20 percent of the
face value of the amount borrowed. Such required balances
generally increase the loan’s effective interest rate.
• A line of credit is an arrangement in which a bank agrees to
lend up to a specified maximum amount of funds during a
designated period.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Key features of bank loans (continued)
• A revolving credit agreement is a formal, or
guaranteed, line of credit often used by large firms.
– Unlike a line of credit, the bank has a legal obligation to
provide the funds when requested by the borrower.
– The borrower will pay the bank a commitment fee to
compensate the bank for guaranteeing that the funds will be
available. This fee is paid on the unused balance of the
commitment in addition to the regular interest charge on
funds actually borrowed.
– Neither the legal obligation nor the fee exists under the
general line of credit.
– As a general rule, the interest rate on “revolvers” is pegged
to the prime rate, so the cost of the loan varies over time as
interest rates change.
Essentials of Managerial Finance by S. Besley & E. Brigham
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The cost of bank loans
• The costs of bank loans vary for different types of
borrowers at any given point in time and for all
borrowers over time. Rates charged will vary
depending on economic conditions, the risk of the
borrower, and the size of the loan. Interest paid on a
bank loan generally is calculated in one of three ways:
(1) simple interest, (2) discount interest, and (3) addon interest.
– The prime rate is a published interest rate charged by banks
to short-term borrowers (usually large, financially secure
corporations) with the best credit. Rates on short-term loans
are generally scaled up from the prime rate.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Computing Cost of Short-Term Credit
Dollar cost of borrowing
Percentagecost
 k PER 
per period
Amount of usable funds
• The numerator represents the dollar amount that must be paid
for using the borrowed funds, which includes the interest paid,
application fees, charges for commitment fees, and so forth.
• The denominator, the amount of usable funds, is not
necessarily the same as the principal amount, or amount
borrowed, because discounts or other costs might be deducted
from the loan proceeds.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Computing Cost of Short-Term Credit
Effective annual  (1  k
m
)

1
.
0
PER
rate (EAR)
• The EAR incorporates interest compounding in the calculation
while the annual percentage rate (APR) does not.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Computing Cost of Short-Term Credit
Annual percentage
 k PER  m  k SIMPLE
rate (APR)
Essentials of Managerial Finance by S. Besley & E. Brigham
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The Cost of Trade Credit
• Determining the cost of trade credit is accomplished
by calculating the periodic cost and multiplying it by
the number of periods in a year.
• The following equation may be used to calculate the
approximate annual percentage rate of not taking cash
discounts:
APR = Periodic cost  Periods per year
APR
=
Discount %

100  Discount %
Essentials of Managerial Finance by S. Besley & E. Brigham
360 days
.
Total days
Discount

net credit is available
period
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The Cost of Trade Credit - Example
• For example, the approximate cost of not taking the
cash discount when the credit terms are 2/10, net 30,
is
Approximat e
2
360
– percentage  
= 0.0204(18) = 0.367 = 36.7%.
98 30  10
cost
– The approximation formula does not consider compounding,
so the result is the simple annual percentage rate, or APR.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Regular or simple interest rate loans
• With a regular, or simple, interest loan the borrower
receives the face value of the loan (amount borrowed,
or principal) and repays both the principal and interest
at maturity.
– The face value is the amount of the loan, or the amount
borrowed; it is also called the principal amount of the loan.
– The only case in which the effective annual rate is the same
as the simple interest rate is if the borrower has use of the
entire face value of the loan for one full year, and the only
cost associated with the loan is the interest paid on the face
value.
– In such cases, interest compounding occurs annually
Essentials of Managerial Finance by S. Besley & E. Brigham
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Discount interest rate loans
• A discount interest loan is one in which the interest,
which is calculated on the amount borrowed, is paid at
the beginning of the loan period; interest is paid in
advance so the borrower receives less than the face
value of the loan.
– The effective annual rate for a discounted loan is
considerably greater than the effective annual rate for a
simple interest loan with the same quoted rate and the same
maturity because the borrower does not get to “use” the
entire face value of the loan.
– If the discount loan is for a period of less than one year,
interest compounding must be considered to determine the
effective annual rate.
• Discount interest imposes less of a penalty on shorter-term loans
than on longer-term loans.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Installment loans: Add-on interest
• Add-on interest is interest that is calculated and then
added to the amount borrowed to obtain the total
dollar amount to be paid back in equal installments.
– The approximate rate for an add-on loan can be determined
by dividing the total interest paid by one-half of the loan’s
face amount.
– To determine the precise effective annual rate of an add-on
loan, the techniques of present value annuity calculations
are used.
• The face value of the loan is the present value (PV), the annuity
payments (PMT) are the face value plus the interest divided by the
number of periods the loan is outstanding, and N is the number of
periods the loan is outstanding.
• Once these values are entered in the calculator the periodic interest
rate can be obtained. Then the periodic interest rate is used to
determine the effective annual rate of the loan.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Bank loans: Computing the annual cost
• Simple interest with compensating balances
Compensating
balance
requirement = CB =
Required loan
(principal) amount
(
Principal
amount
) (
X
Compensating balance
stated as a decimal
)
(Amount of usable funds needed)
1 - (CB as a decimal)
=
• The cost of loan with compensating balance is
APR
APR
= kPER 
=
 12 
 
N
,


N 
 Req. loan  k SIMPLE     

 12     12 

 Req. loan  Req. loan(CB)    N 

  




where N is the number of months of the loan’s maturity
and CB is the compensating balance as a decimal.
Essentials of Managerial Finance by S. Besley & E. Brigham
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The effective cost of the loan
• The effective cost of the loan is calculated as follows:
(where kper is the percentage cost per period)
EAR  1  k
 12 


N 
PER 

 1.
or
k SIMPLE
EAR 
1  Compensating balance %
• If a firm normally keeps a positive checking account
balance at the lending bank, then less needs to be
borrowed to have a specific amount of funds available
for use and the effective cost of the loan will be lower.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Proposed problem
15-3 cost of bank loans (page 643)
Essentials of Managerial Finance by S. Besley & E. Brigham
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