1. © 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

2. © 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

3. © 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

4. © 2003 McGraw-Hill Ryerson Limited Figure 8-1 Structure of corporate debt, 2000 PPT 8-4

5. © 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)

6. © 2003 McGraw-Hill Ryerson Limited Figure 8-2 Prime interest rate movements PPT 8-10

7. © 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

8. © 2003 McGraw-Hill Ryerson Limited Timing and Cash Discount

9. © 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.

10. © 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

11. © 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

12. © 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

13. © 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

14. © 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

15. © 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

16. © 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

17. © 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

18. © 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

19. © 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