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© 2003 McGraw-Hill Ryerson Limited 8 8 Chapter Sources of Short-Term Financing McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised by: PChua Ref: Block et al Gitman et al
© 2003 McGraw-Hill Ryerson Limited Chapter 8 – Outline Sources of Short-Term Financing Interest Rates Terminology Trade Credit from Suppliers Short-term Bank Loans – Types, Characteristics and Features Corporate and Foreign Borrowing Accounts Receivable Financing Inventory Financing Summary and Conclusions PPT 8-2
© 2003 McGraw-Hill Ryerson Limited Sources of Short-Term Financing Unsecured Sources of Short-Term Financing - Spontaneous - Accounts Payables, Accruals - Negotiated - Bank Loans: Promissory Notes, Lines of Credit, Revolving Lines of Credit, Letter of Credit - Commercial Paper - EuroDollar Loans Secured Sources of Short-Term Financing - Pledging Accounts Receivables - Factoring Accounts Receivables - Using Inventory as Collateral
© 2003 McGraw-Hill Ryerson Limited Figure 8-1 Structure of corporate debt, 2000 PPT 8-4
© 2003 McGraw-Hill Ryerson Limited Primer on Interest Rates Prime Rate: the interest rate charged to a bank’s best customers is scaled up proportionally according to customer’s credit rating (1-3% above prime) is based on Bank of Canada Rate, usually 150 basis points above it Bank of Canada Rate: the rate Bank of Canada uses to control inflation and the value of Canadian dollar in relation to other currencies Bank Rate: the rate at which Chartered Banks can borrow from Bank of Canada Effective Interest Rate: the actual interest rate or “true” cost of a loan, including interest on interest (compounding)
© 2003 McGraw-Hill Ryerson Limited Figure 8-2 Prime interest rate movements PPT 8-10
© 2003 McGraw-Hill Ryerson Limited Accounts Payables Provided by sellers of goods or services Major source of short-term financing for over 50% of firms No need to formally negotiate; invoice will serve as the credit agreement Spontaneous -expands or contracts as sales rises or falls No explicit cost (interest-free) No collateral to pledge It is usually a 30-60 day grace period before a bill is due A cash discount is often given if payment is made within a specified time Ex., 2/10 net 30 means a 2% discount is given if paid in 10 days; if not, the full amount is due in 30 days
© 2003 McGraw-Hill Ryerson Limited Timing and Cash Discount
© 2003 McGraw-Hill Ryerson Limited Managing Accounts Payable Goal: save cash without damaging credit Analyzing Credit Terms: Taking the Cash Discount Giving up the Cash Discount Delaying payment beyond the credit terms if possible CGUCD = [d%/(100%-d%)]*(365/(N) CGUCD = Cost of Giving Up Cash Discount; d% = Cash Discount; N = Number of days payment can be delayed by giving up discount.
© 2003 McGraw-Hill Ryerson Limited Net Credit Position Net Credit Position: a firm’s Accounts Receivable (A/R) minus its Accounts Payable (A/P) if A/R is greater than A/P, it is a net provider of trade credit (positive number) if A/P is greater than A/R, it is a net user of trade credit (negative number) larger firms tend to be net providers of trade credit, while smaller firms are net users PPT 8-6
© 2003 McGraw-Hill Ryerson Limited Short-term Bank Loans - Characteristics Major source of unsecured loans Negotiated; results from actions taken by the Financial Manager More Popular than Commercial Paper; available to all sizes of firms Its intends to carry firms through seasonal peaks in financing needs due to inventory and A/Rs build-up ; hence self-liquidating, that is, the use to which borrowed money is put provides the mechanism through which loan is repaid Major Types of bank loans are: - Promissory Notes - Lines of Credit - Revolving Lines of Credit - Letter of Credit
© 2003 McGraw-Hill Ryerson Limited Short-term Bank Loans – Common Features Can be Fixed-Rate or Floating Rate, rates based on Prime Interest Rates - Fixed Rate Loan is when the interest rate is set at the time loan is negotiated - Floating Rate Loan is when the Interest rate can vary based on the changes in Prime rates during the life of a loan - Interest Rate is prime rate + premium Can be Discounted Loan or not - Discounted Loan is when Interest is paid at the beginning of the loan period May have Compensating Balance Requirement - a bank requires a minimum average account balance in order to qualify for a loan May Require Commitment Fees Payment can be on Installments
© 2003 McGraw-Hill Ryerson Limited Types of Short-term Bank Loans Promissory Note: a note signed by the borrower, stating loan terms, loan maturity and interest rate short-term loan for a specific purpose discounted loan or not Fixed or variable interest rate may require compensating balance Line of Credit: Agreement between a commercial bank and firm on a pre-approved maximum amount of money to be made available to the firm at any point in time over the life of the loan, typically 1 year Loan amount available is not guaranteed but is subject to funds availability Very similar to credit card agreement Fixed or variable interest rate may require compensating balance PPT 8-8
© 2003 McGraw-Hill Ryerson Limited Types of Short-term Bank Loans - continued Revolving Line of Credit: Bears all the features of a Line of Credit EXCEPT that it is guaranteed Commitment Fees is usually required Fixed or variable interest rate may require compensating balance Letter of Credit Purpose is to finance goods in transit (usually imports) A letter from a company’s bank to the company foreign supplier, stating that the company’s bank guarantees payment of the invoiced amount issued by the foreign supplier if all underlying agreements are met PPT 8-8
© 2003 McGraw-Hill Ryerson Limited Chartered Banks in Canada http://www.rbc.com/ http://www.cibc.com/index.html http://www.bmo.com/ http://www.scotiabank.com/ http://www.tdbank.ca/index.html http://www.nbc.ca PPT 8-7
© 2003 McGraw-Hill Ryerson Limited Corporate and Foreign Borrowing Commercial Paper: a short-term unsecured promissory note in minimum units of $50,000 sold (at a discount) by finance companies, other large corporations cheaper than bank loans total amount of commercial paper outstanding has increased greatly in recent years Eurodollar Loans: loans from foreign banks are called Eurodollar loans (U.S Eurodollars predominate) Subject to exchange rate fluctuations PPT 8-11
© 2003 McGraw-Hill Ryerson Limited Accounts Receivable Financing A/R financing includes 3 choices: pledging accounts receivable as collateral for a loan an outright sale (factoring) of receivables to a factoring company Asset-backed Securities: sale of receivables by large corporations in public offerings Tends to be a relatively expensive source of financing PPT 8-14
© 2003 McGraw-Hill Ryerson Limited Inventory Financing Inventory may be assigned as collateral security against an operating loan For example, in a Trust Receipt Is an instrument acknowledging that the borrower holds the inventory and proceeds from sale in trust for the lender when goods are sold, loan is repaid used by auto dealers, industrial equipment dealers, television and home appliance dealers PPT 8-15
© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions Short-term financing options include: trade credit from suppliers bank operating loans commercial paper for large companies Eurodollar or foreign currency loans financing secured by accounts receivable or inventory Bank operating loans move up or down based upon the borrower’s need for working capital, and incur interest based upon the prime rate PPT 8-16
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