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**Short-Term Financial Planning**

Chapter 20 Short-Term Financial Planning

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**Short-Term Financial Planning**

Chapter 20 Short-Term Financial Planning

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**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

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**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

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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

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**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?

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**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?

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**Table 20.1 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Level Sales**

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**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.

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**20.1 Forecasting Short-Term Financing Needs**

Three reasons for short-term financing Negative cash flow shocks Positive cash flow shocks Seasonalities

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**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.

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**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.

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**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.

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**Table 20.2 Projected Financial Statements for Springfield Snowboards, 2013, Assuming Seasonal Sales**

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**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.

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**Table 20.3 Projected Cash Receipts for Springfield Snowboards, Assuming Seasonal Sales**

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**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

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**Table 20.4 Projected Cash Disbursements for Springfield Snowboards, Assuming Seasonal Sales**

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**20.1 Forecasting Short-Term Financing Needs**

The Cash Budget

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**20.2 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.

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**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 short- term assets and the permanent working capital investment.

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Table Projected Levels of Working Capital for Springfield Snowboards, 2013, Assuming Seasonal Sales

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**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

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**Figure 20.1 Financing Policy Choices for Springfield Snowboards**

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**Figure 20. 1 Financing Policy Choices for Springfield Snowboards (cont**

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**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

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**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.

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**20.3 Short-Term Financing with Bank Loans**

Common Loan Stipulations Commitment Fees Loan Origination Fee Compensating Balance Requirements

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**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

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**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.

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**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

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**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 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.

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**20.3 Short-Term Financing with Compensating Balances**

Compensating Balance Requirement At the end of the loan period, the firm owes $500,000 ( /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:

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**20.3 Short-Term Financing with Compensating Balances**

Compensating Balance Requirement Thus the actual three-month interest rate paid is

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**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?

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**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.

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**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( /4) = $50,125. Thus the final loan payment will be 500, ,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:

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**Example 20.1 Compensating Balance Requirements and the Effective Annual Rate**

Execute (cont’d): The actual three-month interest rate paid is: Expressing this as an EAR gives – 1 = 13.89%.

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**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.

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**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?

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**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.

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**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( /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:

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**Example 20.1a Compensating Balance Requirements and the Effective Annual Rate**

Execute (cont’d): The actual three-month interest rate paid is: Expressing this as an EAR gives – 1 = 13.82%.

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**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.

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**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?

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**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%)

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**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)( /4) = $75, 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 – 75, = $689,

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**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, / 675,000) – 1 = 2.19%. EAR is – 1 = 9.05%

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**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 =9.19%

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**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.

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**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?

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**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%)

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**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)( /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 – 150, = $864,

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**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 = 7.10%

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**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 = $865,000 on the $850,000 loan. So the 3 month rate would have been $865,000/$850,000-1=1.76% EAR is =7.25%

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**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.

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**20.4 Short-Term Financing with 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.

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**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.

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**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?

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**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.

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**Example 20.2 The Effective Annual Rate of Commercial Paper**

Execute: The actual three-month interest rate paid is: Expressing this as an EAR gives:

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**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 least- costly way to finance the firm’s short-term needs.

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**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?

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**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 6- month periods in a year.

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**Example 20.2a The Effective Annual Rate of Commercial Paper**

Execute: The actual six-month interest rate paid is: Expressing this as an EAR gives:

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**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.

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**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?

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**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

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**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%

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**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.

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**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

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**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.

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**20.5 Short-Term Financing with Secured Financing**

Inventory as Collateral Floating lien, general lien, or blanket lien All of the inventory is used to secure the loan. Trust receipts loan or floor planning 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.

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**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.

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**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.

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**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: Expressing this as an EAR gives:

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**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%!

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**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.

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**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.

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**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 = $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: Expressing this as an EAR gives: – 1 = or 11.46%

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**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 %.

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**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.

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**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.

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**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 = $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 = 17.18%

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**Example 20.3b Calculating the Effective Annual Cost of Warehouse Financing**

Evaluate: The warehouse arrangement is expensive, the EAR on the loan itself is % but the warehouse arrangement raises it to 17.18%

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**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

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**Table 20.7 Projected Cash Balance and Short-term Financing at Springfield Snowboards**

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**Chapter Quiz 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?

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**Chapter Quiz 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?

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