Chapter 20
Short-Term
Financial Planning
Chapter 20
Short-Term Financial Planning
Chapter Outline
20.1 Forecasting Short-Term Financing Needs
20.2 The Matching Principle
20.3 Short-Term Financing with Bank Loans
20.4 Short-Term Financing with Commercial Paper
20.5 Short-Term Financing with Secured Financing
20.6 Putting it All Together: Creating a Short-Term Financial
Plan
Learning Objectives



Forecast cash flows and short-term financing needs
Understand the principle of matching short-term needs to
short-term funding sources
Know the types of different bank loans and their tradeoffs
Learning Objectives



Understand the use of commercial paper as an alternative
to bank financing
Use financing secured by accounts receivable or inventory
Know how to create a short-term financial plan
20.1 Forecasting Short-Term Financing Needs

The first step in short-term financing is to forecast the
company’s future cash flows to discover:


Cash surplus or deficit?
Temporary or permanent?
20.1 Forecasting Short-Term Financing Needs


For example, look at the quarterly cash flows for
Springfield Snowboards on the following slide.
Is this company considered profitable?
Table 20.1 Projected Financial Statements for
Springfield Snowboards, 2010, Assuming Level Sales
20.1 Forecasting Short-Term Financing Needs



Springfield is considered a profitable company.
Quarterly net income is almost $500,000.
Based on these current projections, Springfield will be able
to fund projected sales growth from operating profit and
will accumulate excess cash on an on-going basis.
20.1 Forecasting Short-Term Financing Needs

Three reasons for short-term financing



Negative cash flow shocks
Positive cash flow shocks
Seasonalities
20.1 Forecasting Short-Term Financing Needs

Negative Cash Flow Shocks


A circumstance in which cash flows are temporarily negative
for an unexpected reason.
Firm will have to arrange for other financing to cover the
shortfall.
20.1 Forecasting Short-Term Financing Needs

Positive Cash Flow Shocks


Increased expected sales often require increased short-term
financing for items like marketing and production.
Negative cash flow is created before the positive cash flow
arrives.
20.1 Forecasting Short-Term Financing Needs

Seasonalities



When sales are concentrated during a few months, sources and
uses of cash are also likely to be seasonal.
In Table 20.1 we assumed sales occur uniformly throughout the
year.
In reality, for a snowboard manufacturer, sales are likely to be
seasonal.
Table 20.2 Projected Financial Statements for
Springfield Snowboards, 2013, Assuming Seasonal
Sales
20.1 Forecasting Short-Term Financing Needs

The Cash Budget


A forecast of cash inflows and outflows on a quarterly or
monthly basis.
Forecasting cash inflows

Assume that Springfield receives payment for 70% of sales in the
quarter they are made, with the remaining 30% coming in the following
quarter.
Table 20.3 Projected Cash Receipts for
Springfield Snowboards, Assuming Seasonal
Sales
20.1 Forecasting Short-Term Financing
Needs

The Cash Budget

Forecasting Cash Outflows


Since Springfield produces a constant amount each quarter and sells seasonally,
they pay a constant amount to suppliers each quarter.
Other cash disbursements:




Selling, general and administrative expenses
Taxes
Interest
Capital expenditures
Table 20.4 Projected Cash Disbursements for
Springfield Snowboards, Assuming Seasonal
Sales
20.1 Forecasting Short-Term Financing
Needs

The Cash Budget
20.2 The Matching Principle

The matching principle

Short-term needs should be financed with short-term debt and
long-term needs should be financed with long-term sources of
funds.
20.2 The Matching Principle

Permanent working capital


The amount that a firm must keep invested in short-term
assets to support continuing operations.
Temporary working capital

The difference between the actual level of investment in shortterm assets and the permanent working capital investment.
Table 20.6 Projected Levels of Working Capital
for Springfield Snowboards, 2013, Assuming
Seasonal Sales
20.2 The Matching Principle

Aggressive Financing Policy



Financing part or all of the permanent working capital with
short-term debt
Funding risk
Conservative Financing Policy


Financing short-term needs with long-term debt
Nonproductive use of cash
Figure 20.1 Financing Policy Choices for
Springfield Snowboards
Figure 20.1 Financing Policy Choices for
Springfield Snowboards (cont.)
20.3 Short-Term Financing with Bank
Loans

Promissory note

Single, End of Period Payment Loan


Benchmark rate, such as prime rate or LIBOR
Line of Credit




Uncommitted
Committed
Revolving
Evergreen
20.3 Short-Term Financing with Bank
Loans

Promissory note

Bridge Loan


Often discount loan with fixed interest rate
With a discount loan, borrower pays interest at the beginning of the
loan period.
20.3 Short-Term Financing with Bank
Loans

Common Loan Stipulations



Commitment Fees
Loan Origination Fee
Compensating Balance Requirements
20.3 Short-Term Financing with Bank
Loans

Commitment Fees

Example: $1 million committed line of credit with 10% EAR and
0.5% EAR commitment fee. Firm borrows $800,000 and repays
at year-end.
Interest on borrowed funds = 0.10($800,000)
= $80,000
Commitment fee paid on unused portion = 0.005($200,000)
= $ 1,000
Total cost
$81,000
20.3 Short-Term Financing with Bank
Loans

Loan Origination Fee:

Timmons Towel and Diaper Service is offered a $500,000 loan
for three months at an APR of 12% with a loan origination fee
of 1%. The origination fee is charged on the principal, so the fee
is 0.01  $500,000 = $5000, so the actual amount borrowed is
$495,000. The interest payment for three months is $500,000
(0.12/4) = $15,000.
20.3 Short-Term Financing with Bank
Loans

Loan Origination Fee:


Putting these cash flows on a timeline:
Thus the actual three-month interest rate paid is
515, 000
 1= 4.04%
495,000
20.3 Short-Term Financing with
Compensating Balances

Compensating Balance Requirement

Timmons Towel and Diaper Service’s keeps 10% of the loan
principal in a non-interest-bearing account with the bank. The
loan was for $500,000, so this means that Timmons must hold
0.10  500,000 = $50,000 in an account at the bank. Thus the
firm has only $450,000 of the loan proceeds actually available
for use, although it must pay interest on the full loan amount.
20.3 Short-Term Financing with
Compensating Balances

Compensating Balance Requirement

At the end of the loan period, the firm owes $500,000  (1 +
0.12/4) = $515,000, and so must pay $515,000 – 50,000 =
$465,000 after using its compensating balance. Putting these
cash flows on a timeline:
20.3 Short-Term Financing with
Compensating Balances

Compensating Balance Requirement

Thus the actual three-month interest rate paid is
465,000
 1 = 3.33%
450, 000
Example 20.1 Compensating Balance
Requirements and the Effective Annual Rate
Problem:

Assume that Timmons Towel and Diaper Service’s bank pays 1% (APR with
quarterly compounding) on its compensating balance accounts. What is the
EAR of Timmons’ three-month loan?
Example 20.1 Compensating Balance
Requirements and the Effective Annual Rate
Solution:
Plan:

The interest earned on the $50,000 will reduce the net payment Timmons
must make to pay off the loan. Once we compute the final payment, we can
determine the implied three-month interest rate and then convert into an
EAR.
Example 20.1 Compensating Balance
Requirements and the Effective Annual Rate
Execute:

The balance held in the compensating balance account will grow to
50,000(1 + 0.01/4) = $50,125. Thus the final loan payment will be 500,000 +
15,000 – 50,125 = $464,875. Notice that the interest on the compensating
balance accounts offsets some of the interest that Timmons pays on the
loan. Putting the new cash flows on a timeline:
Example 20.1 Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):
The actual three-month interest rate
paid is:
464, 875
450, 000
 1 = 3.31%
Expressing this as an EAR gives 1.03314 – 1 =
13.89%.
Example 20.1 Compensating Balance
Requirements and the Effective Annual Rate
Evaluate:

As expected, because the bank allowed Timmons to deposit the
compensating balance in an interest-bearing account, the interest earned on
the compensating balance reduced the overall interest cost of Timmons for
the loan.
Example 20.1a Compensating Balance
Requirements and the Effective Annual Rate
Problem:

Assume that Timmons Towel and Diaper Service’s bank pays 1.5% (APR with
monthly compounding) on its compensating balance accounts. What is the
EAR of Timmons’ three-month loan?
Example 20.1a Compensating Balance
Requirements and the Effective Annual Rate
Solution:
Plan:

The interest earned on the $50,000 will reduce the net payment Timmons
must make to pay off the loan. Once we compute the final payment, we can
determine the implied three-month interest rate and then convert into an
EAR.
Example 20.1a Compensating Balance
Requirements and the Effective Annual Rate
Execute:

The balance held in the compensating balance account will grow to
$50,000(1 + 0.015/12)3 = $50,188. Thus the final loan payment will be
$500,000 + $15,000 – $50,188 = $464,812. Notice that the interest on the
compensating balance accounts offsets some of the interest that Timmons
pays on the loan. Putting the new cash flows on a timeline:
Example 20.1a Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):
The actual three-month interest rate
paid is:
$464,812
$450,000
 1 = 3.29%
Expressing this as an EAR gives 1.03294 – 1 =
13.82%.
Example 20.1a Compensating Balance
Requirements and the Effective Annual Rate
Evaluate:

As expected, because the bank allowed Timmons to deposit the
compensating balance in an interest-bearing account, the interest earned on
the compensating balance reduced the overall interest cost of Timmons for
the loan.
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Problem:

Bills, Inc. has a 3-month $750,000 loan from its bank. The interest payable on
the loan is 8% (APR with quarterly compounding) and the bank requires a
10% compensating balance. Assume Bills, Inc.’s bank pays 1% (APR with
quarterly compounding) on its compensating balance accounts. What is the
EAR of Bills’ $750,000 3-month loan?
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Solution:
Plan:

The interest earned on the $75,000, will reduce the net payment Bills must
make to pay off the loan. Once the final payment is computed, you can
determine the implied three-month interest rate and convert to EAR. Bills,
Inc. must maintain a $75,000 compensating balance ($750,000 x 10%)
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Execute:



The balance held in the compensating balance account will grow to
(75,000)(1 + 0.01/4) = $75,187.50.
The interest Bills owes on the loan at the end of the 3-month period is
$15,000 ($750,000 x (0.08/4)).
The final loan payment will be 750,000 + 15,000 – 75,187.50 = $689,812.50.
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):


Since Bills only has the use of $675,000 ($750,000 - $75,000), the actual 3
month rate paid is (689,812.50 / 675,000) – 1 = 2.19%.
EAR is 1.02194 – 1 = 9.05%
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):



If Bills’ bank had not paid interest on the compensating balance, Bills would
have paid back $765,000 - $75,000 = $690,000 on the $675,000 loan.
So the 3 month rate would have been $690,000/$675,000-1=2.22%
EAR is 1.02224-1=9.19%
Example 20.1b Compensating Balance
Requirements and the Effective Annual Rate
Evaluate:

The interest earned on the compensating balance reduced the overall
interest cost for the loan.
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Problem:

WiseGuy, Inc. has a 3-month $1,000,000 loan from its bank. The interest
payable on the loan is 6% (APR with quarterly compounding) and the bank
requires a 15% compensating balance. Assume WiseGuy, Inc.’s bank pays
0.75% (APR with quarterly compounding) on its compensating balance
accounts. What is the EAR of WiseGuy’s $1,000,000 3-month loan?
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Solution:
Plan:

The interest earned on the $150,000 will reduce the net payment WiseGuy
must make to pay off the loan. Once the final payment is computed, you can
determine the implied three-month interest rate and convert to EAR.
WiseGuy, Inc. must maintain a $150,000 compensating balance ($1,000,000
x 15%)
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Execute:



The balance held in the compensating balance account will grow to
(150,000)(1 + 0.0075/4) = $150,281.25
The interest WiseGuy owes on the loan at the end of the 3-month period is
$15,000 ($1,000,000 x (0.06/4)).
The final loan payment will be $1,000,000 + 15,000 – 150,281.25 =
$864,718.75.
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):


Since WiseGuy only has the use of $850,000 ($1,000,000 - $150,000), the
actual 3 month rate paid is ($864,718.75/ $850,000) – 1 = 1.73%.
EAR is 1.01734 – 1 = 7.10%
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Execute (cont’d):



If WiseGuy’s bank had not paid interest on the compensating balance, the
company would have paid back $1,000,000+15,000-150,000 = $865,000 on
the $850,000 loan.
So the 3 month rate would have been $865,000/$850,000-1=1.76%
EAR is 1.01764-1=7.25%
Example 20.1c Compensating Balance
Requirements and the Effective Annual Rate
Evaluate:

The interest earned on the compensating balance reduced the overall
interest cost for the loan.
20.4 Short-Term Financing with
Commercial Paper

Commercial paper





Short-term, unsecured debt used by large corporations
Usually cheaper than a short-term bank loan.
Minimum face value is $25,000
Most has a face value of at least $100,000.
Interest on commercial paper is typically paid by selling it at an
initial discount.
20.4 Short-Term Financing with
Commercial Paper

Direct paper


Firm sells directly to investors
Dealer paper


Dealers sell to investors in exchange for a spread (or fee) for
their services.
The spread decreases the proceeds that the issuing firm
receives, increasing the effective cost.
Example 20.2 The Effective Annual Rate
of Commercial Paper
Problem:

A firm issues three-month commercial paper with a $100,000 face value and
receives $98,000. What effective annual rate is the firm paying for its funds?
Example 20.2 The Effective Annual Rate
of Commercial Paper
Solution:
Plan:

First put the firm’s cash flows on a timeline :

The three-month rate can be computed by comparing the present value
received ($98,000) with the future value paid ($100,000). From there, we
can convert it into an EAR using Eq 5.1:
EAR = equivalent one-year rate = (1 + r)n − 1,
where n is the number of 3-month periods in a year.
Example 20.2 The Effective Annual Rate
of Commercial Paper
Execute:

The actual three-month interest rate paid is:
100, 000
 1 = 2.04%
98,000

Expressing this as an EAR gives:
1.0204  1= 8.42%.
4
Example 20.2 The Effective Annual Rate
of Commercial Paper
Evaluate:

The financial manager needs to know the EAR of all of the firm’s funding
sources to be able to make comparisons across them and choose the leastcostly way to finance the firm’s short-term needs.
Example 20.2a The Effective Annual Rate
of Commercial Paper
Problem:

A firm issues six-month commercial paper with a $1,000,000 face value and
receives $975,000. What effective annual rate is the firm paying for its funds?
Example 20.2a The Effective Annual Rate
of Commercial Paper
Solution:
Plan:

First put the firm’s cash flows on a timeline :

The six-month rate can be computed by comparing the present value
($975,000) with the future value ($1,000,000). From there, we can convert
it into an EAR using Eq 5.1: EAR= (1 + r)n − 1, where n is the number of 6month periods in a year.
Example 20.2a The Effective Annual Rate
of Commercial Paper
Execute:

The actual six-month interest rate paid is:
$1,000,000
 1 = 2.56%
$975,000

Expressing this as an EAR gives:
1.0256 2  1 = 5.19%
Example 20.2a The Effective Annual Rate
of Commercial Paper
Evaluate:

The financial manager needs to know the EAR of all of the firm’s funding
sources to be able to make comparisons across them and choose the least
costly way to finance the firm’s short-term needs.
Example 20.2b The Effective Annual Rate
of Commercial Paper
Problem:

Bills, Inc’s bank issues three-month commercial paper with a 100,000 face
value and receives 97,000. What EAR is the firm paying for the funds?
Example 20.2b The Effective Annual Rate
of Commercial Paper
Solution:
Plan:

The three-month rate can be computed by comparing the present value
with the future value.You can then convert it into an EAR using equation 5.1:
EAR= (1 + r)n − 1
Example 20.2b The Effective Annual Rate
of Commercial Paper
Execute:


The actual three-month interest rate paid is
100,000/97,000 – 1 = 3.09%
Converting to EAR gives:
(1.0309)4 – 1 = 12.94%
Example 20.2b The Effective Annual Rate
of Commercial Paper
Evaluate:

The manager needs to know the EAR of all Bills’ funding sources to make
valid comparisons across them and choose the cheapest way to finance.
20.5 Short-Term Financing with Secured
Financing

Secured loans

Loans collateralized with short-term assets


Usually accounts receivables or inventory.
Most common sources:



Commercial banks
Finance companies
Factors

firms that purchase the receivables of other companies
20.5 Short-Term Financing with Secured
Financing

Accounts Receivable as Collateral

Pledging of Accounts Receivable


lender reviews the invoices and decides which credit accounts it will
accept as collateral, based on its own credit standards.
Factoring of Accounts Receivable


Firm sells receivables to the lender (i.e., the factor)
Lender pays the firm the amount due from its customers at the end of
the firm’s payment period less a factor’s fee.
20.5 Short-Term Financing with Secured
Financing

Inventory as Collateral

Floating lien, general lien, or blanket lien


Trust receipts loan or floor planning


All of the inventory is used to secure the loan.
Distinguishable inventory items are held in a trust as security for the
loan.
Warehouse arrangement

inventory that serves as collateral is stored in a separate warehouse.
Example 20.3 Calculating the Effective Annual
Cost of Warehouse Financing
Problem:

The Row Cannery wants to borrow $2 million for one month. Using its
inventory as collateral, it can obtain a 12% (APR with monthly compounding)
loan. The lender requires that a warehouse arrangement be used. The
warehouse fee is $10,000, payable at the end of the month. Calculate the
effective annual rate of this loan for Row Cannery.
Example 20.3 Calculating the Effective Annual
Cost of Warehouse Financing
Solution:
Plan:

The monthly interest rate is 12% / 12 = 1%. We need to compute the total
cash flows Row will owe at the end of the month (including interest and
warehouse fee). By scaling those cash flows by the amount of the loan, we
will have a total monthly cost for the loan, which we can then convert to an
EAR.
Example 20.3 Calculating the Effective Annual
Cost of Warehouse Financing
Execute:

At the end of the month, Row will owe $2,000,000  1.01 = $2,020,000
plus the warehouse fee of $10,000. Putting the cash flows on a timeline
gives:
The actual one-month interest rate paid is:
2, 030, 000
 1 = 1.5%
2, 000, 000
Expressing this as an EAR gives:
1.01512  1 = 0.196, or 19.6%.
Example 20.3 Calculating the Effective Annual
Cost of Warehouse Financing
Evaluate:

The warehouse arrangement is quite costly: the EAR on the loan itself is
(1.01)12-1=0.1268, or 12.68%, but the warehouse arrangement raises it to
19.6%!
Example 20.3a Calculating the Effective Annual
Cost of Warehouse Financing
Problem:

The Row Cannery wants to borrow $5 million for three months. Using its
inventory as collateral, it can obtain a 9% (APR with quarterly compounding)
loan. The lender requires that a warehouse arrangement be used. The
warehouse fee is $25,000, payable at the end of the three months. Calculate
the effective annual rate of this loan for Row Cannery.
Example 20.3a Calculating the Effective Annual
Cost of Warehouse Financing
Solution:
Plan:

The quarterly interest rate is 9%/4 = 2.25%. We need to compute the total
cash flows Row will owe at the end of the three months (including interest
and warehouse fee). By scaling those cash flows by the amount of the loan,
we will have a total three month cost for the loan, which we can then
convert to an EAR.
Example 20.3a Calculating the Effective Annual
Cost of Warehouse Financing
Execute:

At the end of the three months, Row will owe $5,000,000  1.0225 =
$5,112,500 plus the warehouse fee of $25,000. Putting the cash flows on a
timeline gives:
The actual three-month interest rate paid is:
$5,137,500
 1 = 2.75%
$5,000,000
Expressing this as an EAR gives: 1.02754 – 1 = 0.1146 or
11.46%
Example 20.3a Calculating the Effective Annual
Cost of Warehouse Financing
Evaluate:

The warehouse arrangement is not inexpensive: the EAR on the loan itself is
(1.0225)4-1=0.0931, or 9.31%, but the warehouse arrangement raises it to
11.46%.
Example 20.3b Calculating the Effective Annual
Cost of Warehouse Financing
Problem:

Bills, Inc needs to borrow $2,000,000 for one month. Using its Inventory as
collateral, it can obtain a 10% (APR) loan. The lender requires a warehouse
arrangement be used. The warehouse fee is $10,000 payable at the end of
the month. Calculate the EAR of this loan.
Example 20.3b Calculating the Effective Annual
Cost of Warehouse Financing
Solution:
Plan:

The monthly interest rate is 10%/12 = 0.833%. We need to compute the
total cash flows owed at the end of the month. By scaling those cash flows
by the amount of the loan, we will have a total monthly cost for the loan,
convertible to an EAR.
Example 20.3b Calculating the Effective Annual
Cost of Warehouse Financing
Execute:



At the end of the month, Bills will owe $2,000,000 x 1.00833 = $2,016,667
plus the warehouse fee of $10,000
The actual one month rate paid is ($2,026,667/$2,000,000) – 1 = 1.33%
Converting to EAR gives 1.013312 – 1 = 17.18%
Example 20.3b Calculating the Effective Annual
Cost of Warehouse Financing
Evaluate:

The warehouse arrangement is expensive, the EAR on the loan itself is
10.47% but the warehouse arrangement raises it to 17.18%
20.6 Putting It All Together: Creating a
Short-Term Financial Plan

Back to Springfield Snowboards


Due to seasonal sales, there will be wide swings in forecasted
cash flows
Analysis identifies two decisions:


What to do with the excess cash in the first quarter
How to finance the third quarter deficit
Table 20.7 Projected Cash Balance and Shortterm Financing at Springfield Snowboards
Chapter Quiz
1.
2.
3.
4.
5.
How do we forecast the firm’s future cash requirements?
What is the effect of seasonalities on short-term cash flows?
What is the matching principle?
What is the difference between permanent and temporary
working capital?
What is the difference between an uncommitted line of credit
and a committed line of credit?
Chapter Quiz
6.
7.
8.
9.
10.
Describe common loan stipulations and fees.
What is commercial paper?
What is the maximum maturity of commercial paper?
What is factoring of accounts receivable?
What is the difference between a floating lien and a trust
receipt?