Chapter 15 Short-Term Financing Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts Disbursement < Payable > < Float > Cash Invoice Received Payment Sent Disbursed

Learning Objectives Formulate a short-term financing strategy. Choose the appropriate financing instrument. Compute the effective cost of financing.

Financing and the Cash Flow Timeline A deficit cash position may result from the interaction of inefficient or inappropriate working capital policies Management should first evaluate its working capital policies to ensure the most efficient stream of cash flow from operations Once this is done, then a short-term financing strategy should be developed

Short-Term Financing Strategies Total Assets $ Temporary Current Assets Permanent Current Assets Fixed Assets Time

Short-Term Financing Strategies (Cont.) Aggressive Financing Strategy- financing the new current assets with liabilities having comparable maturities Management relies heavily on short-term financing and minimizes long-term financing Net Working Capital position and Current ratios are reduced, impairing solvency Beneficial when short term financing is cheaper than long term sources Exposes to refinancing risk as credit me tighter in future periods and interest rate risk during inflation

Short-Term Financing Strategies: Aggressive $ Short-Term Financing Total Assets Long-Term Financing Time

Short-Term Financing Strategies (Cont.) Conservative Financing Strategy- use the long term sources of financing to meet working capital requirements Improve solvency as current assets will be higher than current liabilities Expensive because long term sources are more costly than short term sources. Reduced refinancing and interest rate risk.

Short-Term Financing Strategies: Conservative Excess Liquidity $ Long-Term Financing Time

Short-Term Financing Strategies (Cont.) Moderate Financing Strategy- combination of both aggressive and conservative strategies.

SHORT -Term Financing Strategies: Moderate Excess Short-Term Liquidity Financing $ Long-Term Financing Time

Financing Alternatives Lines of Credit: Maximum loan amount a lender is willing to provide to a client upon demand. Borrower can use line whenever they choose, avoiding the loan application process Committed line of credit: formal, written agreement that binds the lender to provide a maximum funds at the borrower’s bequest Such agreement requires a commitment fee to pay Typically have covenants to ensure that the borrower maintains a certain level of financial health Uncommitted Line of Credit: not a binding obligation for the lender Lenders like the flexibility offered by uncommitted lines, which free the bank from providing funds in the event of financial deterioration by the borrower.

Lines of Credit (Cont.) Direct Costs Indirect Costs Interest rate: applied on amounts drawn from the line Commitment fee: only relevant for committed lines and is a stated proportion of the unused portion of the line. Indirect Costs Compensating Balance: restricts fund availability; reduces net loan proceeds and increasing the effective cost of line.

Other types of Short-term Financing Banker’s Acceptance- A time draft drawn against a deposit in a commercial bank but with payment at maturity guaranteed by the bank. Letter of Credit- Promise to make payment to a party upon presentation of a draft or bill. Standby Letter of Credit- guarantees that the bank will make funds available if the company cannot or doesn’t wish to meet a major financial obligation Reverse Repurchase Agreement- Corporate investment manager may negotiate with the bank to sell to the bank a specific dollar amount of marketable securities currently held in the firm’s investment portfolio. Also termed as Reverse Repo.

Commercial Paper Short-term promissory note issued by a corporation for a fixed maturity at a fixed discount rate. Can be issued directly by borrower or through a dealer network. Most commercial papers are sold on a discount, where the paper is sold at a price less than its face value or maturity value. Interest bearing commercial papers are less popular pricing format. Here, the borrower repays the principal and the quoted interest over the amount borrowed.

Effective Cost of Commercial Paper Here Out-of-Pocket Cost - Interest Expense: Calculated by discounting the face value of the paper Fees: Usually the commitment fee that back up the commercial paper, this is based on the unused portion of the line Dealer fee: Compensate the investment banker that underwrites the commercial paper Usable Funds - Represents the net proceed firm receives from the commercial paper, the amount received is reduced by the amount of discounted interest paid. M= Number of days in which funds are borrowed

Effective Cost of Credit Line Here Out-of-Pocket Cost - Interest Expense: based on the stated interest rate and the amount borrowed Fees: Usually the commitment fee for the line of credit, which is based on the unused portion of the line Usable Funds - Represents the net proceed firm receives from the Line of credit, the amount received is less than the amount borrowed if the bank requires a compensating balance. M= Number of days in which funds are borrowed

Summary Short-term financing alternatives in this chapter differ from spontaneous financing sources such as payables and accruals. This is important for maintaining liquidity. The chapter began with a discussion of financing using three financing strategies. Then discussion focused on the major forms of short-term financing available. The chapter concluded with a discussion of calculating the effective cost of financing with commercial paper and credit lines.