1. Chapter 16 Liability Management and Short/Medium-Term Financing

2. Liability Structure of a Company
Imperfections and incompleteness
Permanent and temporary financing
Maturity of debt
Maturity
The risk involved
The cost trade-off
Agency and signaling issues

3. Imperfections and Incompleteness
Imperfections that most affect debt
Flotation costs
Bankruptcy costs
Costs of information
Restrictions on lenders
The way a firm “packages” its debt financing is important
Most important aspect is maturity

4. Permanent and Temporary Financing
Hedging approach to financing
The borrowing and payment schedule for short-term financing would be arranged to correspond to the expected swings in current assets
Fixed assets and the permanent component of current assets would be financed with long-term debt, equity, and the permanent component of current liabilities

5. Maturity of Debt
Schedule of debt maturities is important in assessing the risk-profitability trade-off
Risk involved
Unable to meet principal and interest payments
Lender may not renew loan at maturity
Uncertainty with interest rate
Possible covariance of short-term interest costs with operating income
Cost trade-off
Reduce the risk of cash insolvency by increasing the maturity schedule of its debt
Longer the maturity schedule, the more costly the financing is likely to be

6. Agency and Signaling Issues
Agency issues in controlling the underinvestment problem
Using short- as opposed to long-term debt
Protective covenants
Secured as opposed to unsecured debt
Signaling effect
Associate the issuance of short-term debt with undervaluation and long-term debt with overvaluation

7. Trade Credit Financing
Largest source of short-term financing
Small companies rely on trade credit
Terms of sale
Cash on delivery (COD)
Cash before delivery (CBD)
Net period-no cash discount
Net period with cash discount
Datings

8. Trade Credit as a Means of Financing
When trade credit is not a discretionary source of financing
Trade credit becomes a built-in source of financing that varies with production
Trade credit as a discretionary form of financing
Do not take the cash discount and pay on the last day of the net period
Pay beyond the net period (stretching)

9. Payment On Final Due Date
If a cash discount is not taken, there is a definite opportunity cost
Trade credit can be very expensive
The longer the time between the discount date and the time of payment, the lower the cost of discount forgone

10. Stretching Accounts Payable
Costs of stretching accounts payable
The cost of the cash discount forgone
Possible deterioration in credit rating
Opportunity cost to a deterioration in a firm’s credit reputation
May be an indirect charge in the form of higher prices

11. Advantages of Trade Credit
Ready availability
Restrictions not likely
Flexible means of financing
The advantages of using trade credit must be weighed against the cost

12. Who Bears the Cost? Suppliers when demand is elastic
In other circumstances suppliers pass on the cost to the buyer
A buyer who is bearing the cost may shop around for a better deal

13. Accrual Accounts as Spontaneous Financing
Most common are wages and taxes
Tend to expand with the scope of the operation
Represent an interest-free source of financing
Usually do not represent discretionary financing
Accruals are a discretionary form of financing with a one time pay period change

14. Unsecured Short-Term Loans
Self-liquidating
Line of credit
Specifying the maximum amount of unsecured credit
Conditions
Creditworthiness
Cleanup period
Does not constitute a legal commitment
Revolving credit agreement
Legal commitment to extend credit
Transaction loans
Short-term funding for only one purpose

15. Determining Interest Rates
Negotiation
Creditworthiness of the borrower
Money market conditions
Bank’s marginal cost of funds
Prime rate for better creditworthiness
Rate above prime for lower creditworthiness
Other business the borrower has with a bank
Cost of servicing a loan
Size of the loan

16. Methods of Computing Interest Rates
Collect basis
Interest is paid at the maturity of the note
Discount basis
Interest is deducted from the initial loan
Add-on basis
Interest is added to the funds distributed in order to determine the face value of the note
Paid on the initial amount of the loan

17. Secured Lending Arrangements
Two sources of loan payments
Cash-flow ability of the firm to service debt
Collateral value of the security
More costly to administer
Cost is passed on to the borrower in the form of fees and higher interest costs
Cash flows are segregated with respect to payments to creditors
Reduce underinvestment problem

18. Collateral Value Marketability Life of the collateral
Basic riskiness associated with collateral

19. Uniform Commercial Code (UCC)
Lenders protect themselves under Article 9 of the UCC
Security interest in the collateral is created by security agreement (security device)
Lender must file a copy of the security agreement with a public office to give public notice

20. Assignment of Accounts Receivable
Firm retains title
Major difficulties
Cost of processing the collateral
Risk of fraud
Analyze the quality of receivables
Higher the quality, the higher the percentage the lender is willing to advance
Size of receivables
Smaller the average size of accounts, the more it costs per dollar of loan to process

21. Procedure for Assignment
Firm sends in a schedule of accounts
Lender requires evidence of shipment, such as an invoice
Borrower signs a promissory note and a security agreement
Firm receives an agreed upon percent of the face value of the receivables
Nonnotification arrangement
Notification arrangement

22. Advantages of the Lending Arrangement
Continuous financing arrangement
New receivables replace old
Security base and amount of loan fluctuate accordingly
Flexible means of secured financing
Permanent source of financing
“Cleanup” not required

23. Factoring Receivables
Sale of receivables to a factor
With or without recourse
Factoring costs
Factoring fee plus an interest charge if the firm draws on its account before the receivables are collected
Flexibility
Agreement is continuous
Borrow on a secured and an unsecured basis
Relieves the company of credit checks, the cost of processing receivables, and collection expenses

24. Inventory Loans Floating lien Chattel mortgage Trust receipt loans
Pledge inventories “in general”
Chattel mortgage
Inventories are specifically identified
Trust receipt loans
Borrower holds in trust for the lender the inventory and the proceeds from its sale
Sometimes known as floor planning
Terminal warehouse receipt loans
Storing inventory with a public, or terminal, warehousing company
Field warehouse receipt loans
Secures the inventory loan on property

25. Intermediate-Term Debt
Typically self-liquidating
Term loans
Repayment in periodic installments
Can be fixed or floating rate
Equipment financing
Lender evaluates the marketability of the equipment
Chattel mortgage is a lien on specific equipment
With a conditional sales contract, the seller retains title

26. Medium-Term Notes (MTN)
Sold to investors through an investment bank
Instrument may be offered continually
Issuers typically are large and creditworthy
Maturity range is 9 months to 10 years
Registered with the SEC under Rule 415
Major advantage to the borrower is flexibility

27. Protective Covenants and Loan Agreements
Remedies under default
General provisions
Working capital requirement
Cash dividend and repurchase of stock restriction
Capital expenditures limitation
Limitation on other indebtedness
Routine provisions found in most loan agreements
Special provisions to achieve a desired total protection

28. Negotiating Restrictions and the Option Pricing Theory
Option pricing can be used to model protective-covenant determination
Equity holding motivation
Lender restraint