1. Short Term Financing FINC5880 Spring 2014 Shanghai- week 7

2. Alternative Current Asset Financing  Self liquidating approach: the useful life time of the asset is matched with its financing  Aggressive approach: the company finances part of its LT assets with short financing (taking the risk of changing r %)  Conservative approach: the company finances LT also ST needs like part of the ST working capital requirements (avoiding any risk of changing r % on short capital) Making the fit…

3. Assignment : Aggressive or conservative  Consider your teams company assets LT and current over the past 5 years  Consider the relation between LT assets and LT financing and ST assets and ST financing  Does your team’s company follow an aggressive approach or conservative  What is your companies’ cost of short term financing? (% and/or USD) In between the market and the company…

4. Short term financing  Advantages: Fast, flexible, ST debt is cheaper then LT  Disadvantages: ST debt is riskier, ST rates vary highly… 3 Month0.820.830.810.79 6 Month0.930.940.930.94 2 Year1.731.821.801.79 3 Year2.152.242.222.27 5 Year3.073.173.143.20 10 Year4.074.164.134.24 30 Year4.914.974.955.07 T Bond rates

5. Sources of ST Financing  Accruals; accrued wages (before salary payments are made), accrued taxes (before payment) This is interest free capital for the firm.  Accounts Payables: average 40% of current liabilities are AP’s; it’s a trade credit the cost depends on discount for earlier payments…this is substantial

6. AP and Financial Statements  Taking more AP extends this financing source  Taking more discounts reduces this source but increases income  What’s better is matter of calculation!

7. ST Bank Loans  66% of bank loans mature within 1 year  This is the second most important source of ST financing  The agreement is signed by promissory note (conditions of the loan)  Sometimes the firm has to keep a compensating balance in account of say 20% of the total loan sum  Informal line of credit; firm can draw on “good for $...” account  Revolving credit; often accompanied by a clean up close (the balance has to be zero once a year at least)  Bank loan rates move with the prime rate; see what the prime rate has been over the past years to understand the differences in loan rates over the years… Where banks invest in….

8. Prime rate is base rate for bank loans 4% 10% High growth Low growth

9. And now…

10. Promissory note conditions  Interest only loan; principal will be paid when the loan matures; the interest rate can be fixed or floating  Collateral: generally accounts receivables or/and inventory  Loan guarantees: by the owner privately  Interest is most likely paid monthly  Maturity for short loans is anywhere in between 30 days and 1 year  Sometimes interest will be paid in advance (so called discount interest)  Auto loans have an add-on character; the interest over the life of the loan is added to the loan amount  Key person (life) insurance guarantees…as collateral for the case something happens to key persons of the firm

11. Banks bank…  Interest paid needs to be paid per month  Interest on your savings you will get per quarter but more likely once per year  Calculate what amount of interest you pay on a 10% loan when you pay per month, quarter or per year (loan $ 10,000)  The monthly rate: 10%/12=0.85%  Compounded:0.85^12= 14,2%!  Quarterly: 10%/4=2.5%  Compounded: 1.025^4= 10,4%

12. Discount loans  Discount the interest up front and deduct it from the amount the borrower gets in hand…  Say 1yr loan 10% of 10.000 RMB would give the borrower RMB 9000 in hand…

13. Ready for the calculus?  10% per annum is the same as …% per quarter.  Is 10% per annum the same if the year is based on 360 days or 365 days?  Is paying interest in advance the same as paying interest at maturity  Is paying interest at the beginning of a period the same as paying interest at the end of that period? Putting it together

14. Your answers…  1.10 per year is the same as (1.10)^ 0.25 =1.02411 per quarter or 2,411%  10% per annum is 10% per annum but the daily interest will be different; 10%/365 days≠10%/360days  Paying interest in advance reduces risk and increases liquidity so the interest amount paid will be different  The same is true for paying interest pre/post period… Money-wise

15. Discounted interest  The bank deducts the interest on the loan up front so the borrower will receive the face value of the loan less the total interest to be paid  The borrower can only default on the pay back of the loan…  If a loan of $ 10,000 has a 10% interest you will get $ 9,000  The effective rate will be? Magic Box

16. Discounted rates  Interest $ 1000  Money in hands: $ 9000  Effective rate: $1000/$9000*100%= 11,11% much higher then the nominal rate of 10% Testing your computer…

17. SOME BANKS ASK FOR COMPENSATING BALANCES  Say loan is $ 10,000 and interest is 10% and the bank wants a 20% compensating balance  The bank takes $1000 interest in advance and asks for a $ 2000 balance during the period of the loan  You will get $ 7000, $ 2000 stays in the bank and $ 8000 needs to be repaid at maturity  Effective rate? Experiments…

18. Your answer  $ 1000 interest  $ 7000 in hand  $ 1000/$ 7000*100%= 14,29% much much higher then the nominal rate of 10% Money is costly…

19. Add on interest loans (installment loans like for cars)  A 10% loan of $ 10,000 to be repaid in 1 year in monthly installments  You pay $ 1000 interest  But after the first month 11/12 of the loan will be outstanding etc.  On average $ 5000 will be outstanding during the year  The effective rate is now? Calculating…

20. Your staggering answer  Average outstanding $ 5000  Interest paid $ 1000  Thus $1000/$5000*100%=20%!  Twice as high as the nominal rate!  You pay $ 11000 in 12 installments being $ 916,67 per month  The IRR% of this stream of cash is ? Got it!

21. Your answers…  The IRR% of these monthly installments is 1,50% (rounded *) per month  The effective annual rate is: (1+1,5%)^12-1= 19,53%  The annual percentage rate is:  1,5%*12= 17,97% (*) Pealing the Orange

22. How to chose a bank  Willingness to accept risk  Based on the portfolio (risk spread) of the loans of the bank…  Degree of loyalty of the bank; some bank’s rather leave their customers in bad times  Some banks specialize in some sorts of credit or/and sectors  The bank can not give loans higher then 15% of its capital to 1 customer (by law)

23. Commercial Paper  Only issued by large and strong firms  Maturity 1 day-9 months  Interest rate fluctuates with supply and demand  Rates vary in between 1,5-3% below the prime rate and about 0,125-0,5% above T- bill rate!

24. ST securities for financing  Commercial Paper is never secured  Loans can be secured  Collateral can also be given in marketable stocks or bonds…  This reduces credit risk and lowers interest on the loan…

25. Many companies have strong seasonal financing needs…. Qtr 1Qtr 2Qtr 3Qtr 4 13920162371682720361 17690199422041824448 20440227232291327550 22772255872564430856 25409283662877735386 29819335213350940785 34717381704043251394 42985461124567656556 48565532695175464211

26. Companies like this will negotiate an informal line of credit with their bank  Informal agreement between the bank and the company  The bank will assess the company’s credit line maximum  The company will draw on this line during the year “taking down” of the line of credit  The bank does not get a formal fee and the bank does not have any legal obligations to extend the line of credit in amount or time… Bird flue..egg sales and financing effects…

27. Revolving credit agreement  Formal line of credit  Based on contract and legal obligations  Bank receives a commitment fee  Companies pay a fixed % fee on the unused part of the line of credit…  The rate of the loan is pegged to the T-bill rate for revolvers…. Revolvers are popular….

28. Assignment: WC and short term Financing  Determine the WC by quarter of your company  Is there a seasonal effect ?  How does your company normally Finance the seasonal effect? (look at the current liabilities during the season)  Would you say your company is aggressively, conservatively or at liquidity financed during the season? Show the numbers.  Note: Please use the LATEST financial data! This includes FY2011…

29. Working Capital Management?