1. Chapter 08 Sources of Short-Term Financing 8-1

2. 8-2 Chapter Outline Trade credit from suppliers Bank loans Commercial paper Borrowing larger amounts Using hedging to offset the risk

3. 8-3 Financing Arrangements Lines of credit are sometimes referred to as a revolving credit facility where interest cost: –Is based on LIBOR (the London Interbank Offered Rate) –Is based on the company’s senior unsecured credit rating – a percentage margin Primary aim of the borrowing firms: –Minimize cost

4. 8-4 Trade Credit Approximately 40 percent of short-term financing is in the form of accounts payable or trade credit –Accounts payable Is a Spontaneous source of funds Grows as the business expands Contracts when business declines

5. 8-5 Payment Period Trade credit is usually extended for 30–60 days Extending the payment period to an unacceptable period results in: –Alienate suppliers –Diminished ratings with credit bureaus Major variable in determining the payment period: –The possible existence of a cash discount

6. 8-6 Cash Discount Policy Allows reduction in price if payment is made within a specified time period –Example: A 2/10, net 30 cash discount means: Reduction of 2% if funds are remitted 10 days after billing Failure to do so means full payment of amount by the 30 th day

7. 8-7 Net-Credit Position Determined by examining the difference between accounts receivable and accounts payable –Positive if accounts receivable is greater than accounts payable and vice versa –Larger firms tend to be net providers of trade credit (relatively high receivables) –Smaller firms in the relatively user position (relatively high payables)

8. 8-8 Bank Credit Provide self-liquidating loans –Use of funds ensures a built-in or automatic repayment scheme Changes in the banking sector today: –Centered around the concept of ‘full service banking’ –Expanded internationally to accommodate world trade and international corporations –Deregulation has created greater competition among other financial institutions

9. 8-9 Prime Rate and LIBOR Prime rate –Rate a bank charges to its most creditworthy customers –Increases as a customer’s credit risk increases LIBOR (London Interbank Offered Rate) –Rate offered to companies: Having an international presence Ability to use the London Eurodollar market for loans

10. 8-10 Prime Rate versus LIBOR on U.S. Dollar Deposits

11. 8-11 Compensating Balances A fee charged by the bank for services rendered or an average minimum account balance –When interest rates are lower, the compensating balance rises –Required account balance computed on the basis of: Percentage of customer loans outstanding Percentage of bank commitments towards future loans to a given account

12. 8-12 Maturity Provisions Term loan –Credit is extended for one to seven years –Loan is usually repaid in monthly or quarterly installments –Only superior credit applicants, qualify –Interest rate fluctuates with market conditions Interest rate may be tied to the prime rate or LIBOR

13. 8-13 Cost of Commercial Bank Financing Effective interest on a loan is based on the: –Loan amount –Dollar interest paid –Length of the loan –Method of repayment –Discounted loan – interest is deducted in advance – effective rate increases Effective rate = Interest × Days in the year (360) Principal-interest Days loan is outstanding

14. 8-14 Interest Costs with Compensating Balances Assuming that 6% is the stated annual rate and that 20% compensating balance is required; Effective rate with = Interest compensating balances (1 – c) = 6% = 7.5% (1 – 0.2) When dollar amounts are used and the stated rate is not known, the following can be used for computation: Days in a Effective rate with = Interest × year (360) compensating balances Principal – Compensating Days loan is balance in dollars outstanding

15. 8-15 Rate on Installment Loans Installment loans require a series of equal payments over the period of the loan –Federal legislation prohibits a misrepresentation of interest rates, however this may be misused Effective rate on installment loan = 2 × Annual no. of payments × Interest (Total no. of payments + 1) × Principal

16. 8-16 Annual Percentage Rate Truth in Lending Act of 1968 requires the actual APR to be given to the borrower Annual percentage rule: –Protects unwary consumer from paying more than the stated rate –Requires the use of the actuarial method of compounded interest during computation Lender must calculate interest for the period on the outstanding loan balance at the beginning of the period –It is based on the assumptions of amortization

17. 8-17 The Credit Crunch Phenomenon The Federal Reserve tightens the growth in the money supply to combat inflation – the affect: –Decrease in funds to be lent and an increase in interest rates –Increase in demand for funds to carry inflation-laden inventory and receivables –Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns Credit conditions can change dramatically and suddenly due to: –Unexpected defaults –Economic recessions –Changes in monetary policy –Other economic setbacks

18. 8-18 Financing Through Commercial Paper Short-term, unsecured promissory notes issued to the public –Finance paper / direct paper –Dealer paper –Asset-backed commercial paper Book-entry transactions –Computerized handling of commercial paper, where no actual certificate is created

19. 8-19 Total Commercial Paper Outstanding

20. 8-20 Advantages of Commercial Paper May be issued at below the prime interest rate No associated compensating balance requirements Associated prestige for the firm to float their paper in an elite market

21. 8-21 Disadvantages of Commercial Paper Many lenders have become risk-averse post a multitude of bankruptcies Firms with downgraded credit rating do not have access to this market The funds generation associated with this is less predictable Lacks the degree of commitment and loyalty associated with bank loans

22. 8-22 Foreign Borrowing Eurodollar loan –Denominated in dollars and made by foreign bank holding dollar deposits –Short-term to intermediate terms in maturity –LIBOR is the base interest paid on loans for companies of the highest quality One approach – borrow from international banks in foreign currency –Borrowing firm may suffer currency risk

23. 8-23 Use of Collateral in Short-Term Financing Secured credit arrangement when: –Credit rating of the borrower is too low –Need for funds is very high –Primary concern – whether the borrower can generate enough cash flow to liquidate the loan when due Uniform Commercial Code –Standardizes and simplifies the procedures for establishing security against a loan

24. 8-24 Accounts Receivable Financing Includes: –Pledging accounts receivables –Factoring or an outright sale of receivables Advantage: –Permits borrowing to be tied directly to the level of asset expansion at any point of time Disadvantage: –Relatively expensive method of acquiring funds

25. 8-25 Pledging Accounts Receivables Lending firm decides on the receivables that it will use as a collateral Loan percentage depends on the firms: –The financial strength –The creditworthiness Interest rate is well above the prime rate –Computed against the balance outstanding

26. 8-26 Factoring Receivables Receivables are sold outright to the finance company –Factoring firms do not have recourse against the seller of the receivables –Finance companies may do all or part of the credit analysis to ensure the quality of the accounts –Factoring firm is: Absorbing risk – for which a fee is collected Actually advancing funds to the seller – paid a lending rate

27. 8-27 Factoring Receivables – Example If $100,000 a month is processed at a 1% commission, and a 12% annual borrowing rate, the total effective cost is computed on an annual basis 1%......Commission 1%......Interest for one month (12% annual/12) 2%......Total fee monthly 2%......Monthly X 12 = 24% annual rate The rate may not be considered high due to factors of risk transfer, as well as early receipt of funds It also allows the firm to pass on much of the credit-checking cost to the factor

28. 8-28 Asset Backed Public Offering There is an increasing trend in public offerings of security backed by receivables as collateral –Interest paid to the owners is tax free –Advantages to the firm: Immediate cash flow High credit rating of AA or better Provides –Corporate liquidity –Short-term financing –Disadvantage to the buyer: Risk associated – receivables actually being paid

29. 8-29 Inventory Financing Factors influencing use of inventory: –Marketability of the pledged goods –Associated price stability –Perishability of the product –Degree of physical control that the lender can exercise over the product

30. 8-30 Stages of Production Stages of production –Raw materials and finished goods usually provide the best collateral –Goods in process may qualify only a small percentage of the loan

31. 8-31 Nature of Lender Control Provides greater assurance to the lender but higher administrative costs Types of Arrangements: –Blanket inventory liens Lender has a general claim against inventory –Trust receipts (floor planning) An instrument – the proceeds from sales go to the lender –Warehousing A receipt issue – goods can be moved only with the lender’s approval Public warehousing Field warehousing

32. 8-32 Appraisal of Inventory Control Devices Well-maintained control measures involves: –Substantial administrative expenses –Raise overall cost of borrowing –Extension of funds is well synchronized with needs

33. 8-33 Hedging to Reduce Borrowing Risk Engaging in a transaction that partially or fully reduces a prior risk exposure The financial futures market: –Allows the trading of a financial instrument at a future point in time –No physical delivery of goods

34. 8-34 Hedging to Reduce Borrowing Risk (cont’d) –In selling a Treasury bond futures contract, the subsequent pattern of interest rates determine if it is profitable or not Sales price, June 2006 Treasury bond contract* (sale occurs in January 2006.)……………$100,000 Purchase price, June 2006 Treasury bond contract (purchase occurs in June 2006)……………. $95,000 Profit on futures contract………….…………………………….$5,000 * Only a small percentage of the actual dollars involved must be invested to initiate the contract. This is known as the margin

35. 8-35 Hedging to Reduce Borrowing Risk (cont’d) –If interest rates increase The extra cost of borrowing money to finance the business can be offset by the profit of the futures contract –If interest rates decrease A loss is garnered on the futures contract as the bond prices rise This is offset by the lower borrowing costs of the financing firm –The purchase price of the futures contract is established at the time of the initial purchase transaction

36. Q End 8-36

37. Q & A 8-37

38. Thank You. 8-38