Financial Management Test
RockPaper555
315ch8.pdf
Overview, Objectives and Readings Page 1 of 1
Overview
This week we will further explore working capital management by focusing on various sources of short-term financing. These sources can include trade credit, bank loans, commercial paper, the use of accounts receivable and inventory as collateral and hedging interest rate risk.
Practice Problems: Please see the syllabus for assigned homework/practice problems.
Objectives Readings _ _ _ __ .._
Learning objectives: Week 5 lecture materials
1. Trade credit from suppliers is normally the most Project instructions available form of short-term financing.
2. Bank loans are usually short-term in nature and should Chapter 8
be paid off from funds from the normal operations of the firm.
3. Commercial paper represents ashort-term, unsecured promissory note issued by the firm.
4. By using accounts receivable and inventory as collateral for a loan, the firm may be able to borrow larger amounts.
5. Hedging may be used to offset the risk of interest rates rising.
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Financing Working Capital
Content Author: Louise August, CPA, PhD
i n the lectures on Working Capital (WC) we talked about the dollar amounts tied up in assets like Accounts Receivable (AR) and Inventory. Because these accounts often represent substantial balances, we may need to think about how the firm can finance its investment in WC Assets.
The first concept to consider is "Maturity Matching." That means that short-term needs should be financed with short-term debt and vice-versa. You wouldn't finance a building with a 90-day note. So if we're thinking about how to finance the investment in short-term assets like Receivables and Inventory short-term financing is probably the way to go.
~7~t~,tt'I~~/ ~c3~C~'tlt'1 :
Supplying the investment in WC assts with ST sources of Financing
Accounts r~e~eiva~le ~ Accruals
Inver►tory Accounts payable 5T bank loans
There are a number of sources of short-term capital available to the firm and we'll look at each of these in turn:
1. Accruals 2. Accounts Payable 3. Commercial Paper (not available to all firms, so not listed in the graphic above) 4. Short-Term Bank Loans
Accruals
This balance sheet line item usually represents unpaid wages and taxes. These accounts represent the time periods between when a benefit is received and the payment for it is made. An example is payroll (Accrued Wages): an employee works today but the wages earned aren't paid until payday. Accrual accounting requires that the firm recognize the benefit it received from the employee's efforts and the obligation it has to pay the wages. Similarly with taxes, the firm earns a portion of its profits throughout the year but only makes tax payments each quarter.
Not financing in the classic sense, but these accounts do represent a period of time during which payment is deferred. Even better, that period of non-payment has no interest burden associated with it, so in that respect they area "free" source of financing. However they aren't very controllable. There isn't much leeway in when payment must be made —payroll really has to be paid on time.
Accounts Payable
We talked about trade credit in conjunction with Receivables. There, we were offering credit to our customers. Payables is the flip-side of this: now our vendors and suppliers are offering trade credit to us. The firm has the opportunity to buy now and pay later. This is often the single largest source of short-term financing for a firm. We often refer to it as being "spontaneous" because it arises out of the normal course of business without much effort on our part. Accruals are spontaneous, too. IYs a quick and easy source of financing often with little in the way of an application process. This is because vendors want our business and offering trade credit is a standard business practice. Not having to pay an invoice until the end of the month is enormously valuable to the firm —we'll look at just how valuable shortly. IYs "30 days same as cash" and thaYs very attractive. Sometimes there are early payment incentives offered and that makes trade credit even more attractive.
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A 2% discount for.;'..:: .̀ . 4
~ay~nent by the 10"'day ~ Cost of Trade Credit
after- the invoice date Vendors sometimes offer early payment incentives to encourage us to pay before the 30-day time period expires — it speeds up their cash collections and provides a valuable
Abbreviated: 2/10, net 30 incentive to us. A common arrangement is the offer of a 2%discount if the invoice is
'̀~, _. ~_ _.~ ~, paid within 10 days of the invoice date, otherwise the whole invoice amount is due by the 30th day. A discount of 2°/o may not sound like much, but IeYs look at an example:
The list price of an item is $100, but if we pay by day 10 iYs only $98. By waiting the extra 20 days to pay the invoice and
paying the $100 list price, we're foregoing the discount and in effect incurring a "finance charge" of 2%. Here's the formula for
calculating the cost of trade credit and the calculation for the cost of 2/10, net 30:
discount °! X 360
1 -disc % Net days- discount
.02 X~~~~ 360
i-A2 30-10
.02 x ~~o gs ~a
A2(}4 I X 1 18 I= 36.73% I
This is the ( I This is the num (ier of periodic interest paying
interest rate periods per year
This is eq~ii~~alent annual rate fora 2% discount for 20 clays
So, not paying by the 10th day and paying full price on the 30th day will cost us 36.73% on an annual basis. Paying early and
taking the discount is an enormous cost saving, or conversely foregoing the discount is an enormously expensive option. We
would likely be better off borrowing from our bank (presumably they're charging us less than that) in order to take advantage
of the discount.
Stretching Accounts Payable is a term that means deliberately paying vendor invoices after the due date. Obviously, it
reduces the cost of trade credit by making the value of foregoing the benefit less attractive. See the box below. But iYs not a
wise practice —vendors and suppliers won't appreciate being made to wait for payment. Your reputation may suffer (iYs a
small world) and if they're sufficiently aggravated, they may impose shorter terms, or no terms at all.
D.d2 X 360 The only change is that the denominator for Q.98 50 the second term becomes the difference
between the discoun# period and the actual
2.049!o X 7.2 = 14.69% payment day {60— 10}
Commercial Paper
We talked earlier about Commercial Paper (CP) as a component of Cash Equivalents or Marketable Securities. Then we were
considering Commercial Paper as a potential investment vehicle for excess cash. Here, we're talking about the firm issuing
(selling) CP as a short-term source of funds.
CP is a type of unsecured note issued by the borrower and purchased by an investor looking for ashort-term, high-quality
investment. CP is unsecured, that is, there is no collateral associated with it, just the firm's good name and promise to pay.
CP is not just short-term, it must have a maturity of less than 270 days. That limitation exempts it from Securities and
Exchange Commission (SEC) registration and oversight, and that gives the issuing company quick, direct access to the
capital market.
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It's also sold in very large denominations of $100,000 or more. The market for Commercial Paper is enormous with over $100 billion issued every day. With no collateral or other security to back it and no SEC oversight, the market for CP is only for large firms with very high credit ratings. High-quality and low-risk mean that the interest rate associated with CP is quite low, often below prime. That and the quick access makes CP an attractive source of ST funding for those firms able to sell it.
Short-Term Bank Loans
A large portion of bank lending is short-term (less than one year) often with terms allowing the notes to be renewed, or rolled over. Longer duration loans are often called Term Loans.
Just like any debt arrangement, short-term loans need to have a controlling document that sets forth the terms and conditions. The loan document is often called a promissory note and will usually describe the following details:
• Principal amount being borrowed • Length of the loan or time to maturity • Interest rate • Repayment method • Collateral, if any • Other terms &conditions
Short-term loans have some advantages over longer term loans or corporate bonds:
• Available in lower dollar amounts — if we need to borrow $100,000, it wouldn't make sense to go to the trouble of registering and issuing a corporate bond (we'll cover Bonds in a later week).
• Speed —because we're borrowing directly from our bank, without the complication of registering a security with the SEC, bank loans can be arranged very quickly.
• Lower rate —primarily because of the shorter term, the rate on these loans will be lower. Consider how many of the factors affecting interest rates are a function of time (default, inflation, etc.).
• One, known lender —we're borrowing from our bank, with whom we ought to have cultivated a cordial business relationship. This allows flexibility in negotiating terms and conditions and coping with special circumstances.
Cost of Bank Loans
The terms and conditions of the loan will always address the rate of interest to be paid and the method and timing of repayment. We'll look at this separately.
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Costof ShortTerm Financing
Cost of Bank Loans
• For each example:
• Principal = $10,000
• Maturity = 1. year
• Nominal interest rate = 7.0%
Srrnple Interest
Borrowergets the whole principal amount
Pays principal + interest at maturity
Effective rate interest paid
proceeds
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10% Simple Intet•est
Effective rate -interest paid
.._proceeds i
5io,o~~iose = sl.000;- Sio,000 = iow
Effective rate =nominal rate!!
Simple interest is the only lending arrangement where this is so.
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10%Discounted Interest
• Interest is deducted from proceeds
• Proceeds = 10,000 -1,000 = 9,000
Effective rate =interest paid proceeds
$1,000 = $9,000 = 11.1'Yo
Efifective rate> nominal rate
Calculating Face Value
Face = required proceeds _ 10.000 _ 71,111 (1 -interest %} 0.9
Proof:
So actual prxecvl5= $lO.OW
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Compensating Balance Requirement (CBR)
• 10°.6 Simple Interest with a 20% CBR
• Step 1. Face value if funds needed = S70,000
face =funds needed = 10,000 = $12,500
Compensating Balance Requirement (CBR) C~ont~
• 10%Simple Interest with a 20°,G CBR
Step 2. Calculate the effective interest rate
effective = interest paid = 1 52 D = 12.5%
interest proceeds 10,000
10%Discounted Interest with 20% CBR. • Step 1. face value if Funds needed =$10,000
face = funds needed = 10,000 = $14,285
(1 - i%- CBR9L) 1-10%-20%
v~xvum componsanng Interest 6alanee
........ rate requirement
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10~/o Discou~lted Interestwith 20n/o CBR • Step 2: Calculate the effective interest rate
effective = interest paid = ~i 29 = 14.3%
interest proceeds 10,000
1 1
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Secured Financing
Collateral
• Secured or Unsecured
• Secured basis
• Encumbers asset • May +interest rate because loan is safe
• Unsecured basis • Commercial paper
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Collateral
• What is suitable collateral?
• Any asset of value
• The personal guarantee of the owners
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Assets Suitable for Collateral
Property, Plant and Equipment
• Cash
• Marketable Securities
• Accounts Receivable
• Inventory
Receivables Cycle
Write a sales order i
Get credit approval
Make the sale and ship the goods
Wait 30 days
Collect the receivable
Pledgin;and Factorin; nccounts Receivable
That future right to cash is an asset
• Can be used as collateral
• Can be sold
Assume:
The firm needs cash and doesn't want to wait
30 days for the receivables to come due.
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Pledgingand Factoring
Accounts Receivable,~o„~~ _ _
Factor — a person or other financial entity
• Pledging
• Use the accounts receivables as collateral
• Customer pays the firm
• Factoring
• The accounts receivables are sold outright
Customer pays the factor
Pledgingand Factoring
Account~5 Receivable • The factor will provide all or some of these services:
• Credit analysis
• Collodion services
Bearing the risk of collection
• Lending
_. _ _ This may be an especiallyattractrve
alternative for small firms
Lender Protects Itself
Discounting the value of accounts receivables __ __ _ _ _.r~ri~R c': o~ mo dons. . _.._....... ..__....
Accepting only the best receivables __ __.
Skim ing the best receivablesalf the top
Having °recourse who bea s the risk
Wiih recourse= weave liabi~ Without recourse~~-the factor is liable
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Inventory Finaticing
• Use the inventory as collateral for a loan
1. Blanket lien
• Thrown over entire inventory
• Diminishes in value as inventory is sold
Inventory Financing (con't)
1. Blanket lien
2. Trust receipts
• Lien against specific inventory items
• Proceeds from items sold pays off lender
Inventory Financing (coil t)
1. Blanket lien
2. Trust receipts
3. Public warehousing
• Segregate
• Custodial care
• Control— must have release. before inventory can be sold
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Inventory suitable for financing
• Must be non-perishable
• Canned or frozen goods, lumber, paper, ores
• Raw Materials Inventory
• Finished Goods Inventory
• Work in Progress Inventory —almost worthless
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FIN 315 V1 -Spring 2016 Course Project
This project requires you to complete two web exercises from chapters 3 and 7 in our
"Foundations of Financial Management" textbook.
Chapter 3 Web Exercise This exercise requires you to explore the IBM website to gather and comment on some financial
data. Note, the instructions indicate that you are to follow the "Investors" link, that link has
been renamed "Investor Relations." The first part of the instructions also indicates that you are
to select "Financial Snapshot," which has been renamed "Financial Info." You should not have
any problem finding the requested information.
Chapter 7 Web Exercise This exercise requires you to explore the Perfect Commerce website to gather information
about what the company does. The second instruction indicates that you are to click on
"Company" and read the description. The website has changed and you will instead need to
click on "About" and then follow the link to "What we do." Instruction number three should
not present any problems. For instruction number four, click on "Solutions." Read through the
various solutions offered by the company and briefly comment on three of them.
Required
Create your response in a Word document that you will upload to the assignment in Moodle.
Your document should clearly identify your name, the class that you are preparing this for, the
date, and the chapters that the assignment comes from. Be sure to carefully and thoroughly
answer all parts of each question. All submissions should be free of spelling and grammatical
errors. Your response should be easy to read with each answer clearly labeled. Any
commentary that is required should be clear and concise. If any additional research is
conducted to answer the questions, you must cite your source(s).
This project is worth up to 10 points.
Please post any questions that you may have in the Homework Lab forum.
Learning Objectives
~ ~. ! ~
~~~c~~
Block, Hirt, and Danielsen
Foundations of Financial Management
16tf' edition
Trade Credit
p Approximately 40 percent of short-term
financing is in form of accounts payable or
trade credit
Accounts payable
Spontaneous source of funds
Grows as business expands
v Contracts when business declines
Cash Discount Policy
Allows reduction in price if payment is made within a specified time period
Example: 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~h day
Cost of failing to take a cash discount = Discount percent x
100% -Discount percent
Final due date —Discount period
Trade credit from suppliers is the most
available short-term financing
g Bank loans are short term, should be paid from normal operations
Commercial paper is a short-term, unsecured
promissory note issued by the firm
Using accounts receivable and inventory as
collateral for a larger loan
Hedging used to offset risk of rising interest rates
Payment Period
Trade credit usually extended for 30-60 days
Extending payment period to unacceptable
length may
Alienates suppliers
g Diminishes ratings with Dun &Bradstreet and
local credit bureaus
Major variable in determining payment period
Possible existence of cash discount
Net-Credit Position
Determined by examining difference between
accounts receivable and accounts payable
A Positive when accounts receivable are greater
than accounts payable and vice versa
Larger firms tend to be net providers of trade
credit (relatively high receivables)
Smaller firms typically in user position (relatively
high payables)
Bank Credit
Provide self-liquidating loans
ffi Use of funds ensures built-in or automatic
repayment scheme
• Changes in banking sector today
Centered around concept of ̀full service banking'
Expanded internationally to accommodate world
trade and international corporations
ro Largest international banks expanding into the
U nited States through bank acquisitions and
branch offices
Bank Credit
Recession of 2007-2009
• Longest on record since Great Depression of
1930s
• Forced many large banks to verge of collapse
With enactment of Gramm-Leach-Bliley Act in
1999, commercial banks and investment banks
were allowed to merge
• Mergers allowed banks to take excess risk which
led to credit problems that started to show up in
2007
Prime Rate and LIBOR Figure 8-1 Prime Rate versus LIBOR
on U.S. Dollar Deposits
Prime rate
Rate bank charges to the most creditworthy
customers
I ncreases as customer's credit risk increases
• London Interbank Offered Rate (LIBOR)
e Rate offered to companies with
I nternational presence
Ability to use London Eurodollar market for
loans
Compensating Balances
Average minimum account balance maintained
as alternative to fee charged by bank for services
rendered
When interest rates are lower, compensating balance
rises
When compensating balances are required to obtain
a loan
Computed as a percentage of customer loans outstanding
Computed as a percentage of bank commitments towards
future loans to given account
Percent~o 9
6
6
5
0
3
z
Compensating Balances
Amount that must be borrowed is calculated by taking
needed funds and dividing by (1 — c), where c is
compensating balance expressed as decimal
For example, if $100,000 is needed, amount borrowed must
be $125,000 considering 20% of amount borrowed as
compensating balance, computed as:
Amount to be borrowed =Amount needed = 100 000
(1 — c) (1 — 0.2)
_ $125,000
.x.-rtiamdsaakst.~- ma~ate~, 8-12
o :.::,,. ..,,.:.,. ... ..,,. ,:,. ., .. , ., ,::... , .:,.. 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Maturity Provisions
Term loan
A Credit extended for one to seven years
• Loan usually repaid in monthly or quarterly installments
Only superior credit applicants qualify
• Interest rate fluctuates with market conditions
• Interest rate may be tied to prime rate or LIBOR
Cost of Commercial Bank Financing
Effective interest rate on is based on
Loan amount
Dollar interest paid
• Length of loan
Method of repayment
Effective rate = Interest x Days in year (360)
Principal Days loan is outstanding
.., . ~-, ,
Cost of Commercial Bank Financing
o Incase of a discounted loan, interest is deducted in advance and the effective rate of i nterest increases
• For example:
A $1,000 one-year loan with $60 of interest deducted in
advance represents the payment of interest on only
$940, or an effective rate of 6.38 percent.
Interest Costs with Compensating Balances
m 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:
Effective rate = 60 x 360 = 60 = 6.38%
$1,000 - $60 360 $940
Effective rate with - Interest x Days in a vear (360) compensating balances (Principal -Compensating Days loan is
balance in dollars) outstanding
,. , _.. ,.:: .M . t ,,.:: .! ... ~ ~,. - .~ ~~- ~ "~ .,~ ~,~- eras,
Rate on Installment Loans
4 Installment loans require a series of equal payments over the life of the loan
a Effective rate of interest on installment loans would be almost double quoted rate of interest
Effective rate on installment loan
= 2 x Annual no. of payments x Interest
(Total no. of payments + 1) x Principal
=2x12x$60 = 1440 =11.08%
13 x $1,000 $13,000
Annual Percentage Rate
Truth in Lending Act of 1968 requires actual annual percentage rate (APR) given to borrower
f Annual percentage rate
y Requires use of actuarial method of compounded i nterest during computation of APR
Lender must calculate interest for period on outstanding loan balance at beginning of period
~° Based on assumptions of amortization
According to the law, a loan amortization schedule is the final authority in the calculation of APR
The Credit Crunch Phenomenon Financing through Commercial Paper
Federal Reserve tightens growth in money supply to combat inflation causing
Decrease in lendable funds and increase in interest rates
• Increases demand for funds to carry inflation-laden inventory and receivables
Massive withdrawals of savings deposits at banking and thrift institutions, fueled by search for higher returns
s Credit conditions can change dramatically and suddenly due to
Unexpected defaults
• Economic recessions
Changes in monetary policy
Other economic setbacks
Figure 8-2 Total Commercial
Pacer Outstandin
Commercial paper represents
Short-term, unsecured promissory note
Usually issued to public in minimum units of $25,000
Forms of commercial paper
Finance paper or direct paper (paper sold by financial
firms directly to lender)
Dealer paper (paper sold by companies through dealer
network)
x Asset-backed commercial paper
ffi Book-entry transactions
Computerized handling of commercial paper where no
actual certificate created
a,a- ~~; ,~~.~4 ~e-za
Billions of dollars Billions of dollars
1,400 r 300
--Financial pek scale)
1,200 ~ -~-Asset-backed (left scale)
F-Nonfinancial f right scale) 250
~,000 zoo
800
._. ,^,,v ..._.-d" a 150
600 i s~
r-` - goo coo `ti-i'e sa
200 5~
Advantages of Commercial Paper
May be issued at below prime interest rate, rate
Rate differential is normally 2 to 3 percent
No associated compensating balance requirements with issuance
g Associated prestige for firm to float paper in "snobbish market" for funds
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
e ,~3-xxei' ~ - ~ +«~~'e:' ~C~k"~
:-., .. ,_,mot.,
Table 8-1 Comparison of Commercial Paper Limitations on the Issuance of
Rate to Prime Rate (Annual Rate) Commercial Paper
~~~~~ c~ i~~~;~4~ f~~lYR~atedl3-'.
. _Alonfhs . _.„
~ ~ ~ .aveiage9sn
>~~Rife k ~
..
.; rime RateMtnus : Pinadceraper
• .....2.78 .1997 5.72 8:5
1998 4.94 7.75 2.61
1999 5.73 8.5 2.77
2000 634 9S 3.16
2001 1.61 4.75 2.94
2002 1.31 4.Z5 2.94
2003 1.07 4.00 2.93
2004 2.48 5.25 2.77
2005 4.46 7.25 2.79
2006 5.31 8.25 2.94
2007 4.82 7.25 2.43
2008 1.54 3.25 1.71
2009 0.24 3.25 3.01
2010 0.37 3.25 2.88
2011 0.58 3.25 2.67
2012 0.35 3.25 2.9
zois o.zo s.zs a.os 2014 0.23 3.25 3.02
Avera e 2.64 5.44 2.81
Many lenders have become risk-averse after multitude of bankruptcies, corporate fraud and other events
Firms with downgraded credit rating do not have access to market
Associated funds are less predictable
t Lacks degree of commitment and loyalty as is associated with more expensive bank loans
Foreign Borrowing Use of Collateral in Short-Term Financing
• Eurodollar loan °Secured credit arrangement when • Denominated in dollars and made by foreign bank holding ~ Credit rating of borrower is too low
dollar deposits Need for funds very high
Short-term to intermediate term in maturity
LIBOR is the base interest paid on loans for companies of 'Primary concern is whether borrower can generate
highest quality enough cash flow to liquidate loan when due
m Borrow from international banks in foreign currency ~ Uniform Commercial Code Directly or through foreign subsidiary ~ Adopted by all states
Converts foreign currency into dollars and sent to parent Standardizes and simplifies procedures
company
• Borrowing firm may suffer currency risk ~ Establishes security against loan
Accounts Receivable Financing Pledging Accounts Receivables
• Includes
• Pledging accounts receivable as collateral for loan
• Factoring or outright sale of receivables
Advantage
• Permits borrowing to be tied directly to level of
asset expansion at any point in time
A Disadvantage
• Relatively expensive method of acquiring funds
Lending firm decides on which of the account receivables it will use as collateral for a loan
Loan percentage depends on firm's
m Financial strength of borrowing firm
Creditworthiness of its accounts
s Interest rate well above prime rate
Computed against balance outstanding
-: ~ - ...., _ . ~ .. a~sz.~~ ._. . r ~..._. , _,.:r ~ , ,.
Table 8-2 Receivables Loan Balance Factoring Receivables
S'~ S 3 ~'~F ~. '~ ~ ~,
P l~
Total accounts receivable .......................... $71,000 515,700 $19,400 $76,300
Acceptable accounts receivable (to finance company) ............................. 70,000 14,000 18,000 15,000
Loan balance (80%) .................................. 8:000 11.200 14,400 12.000
Interest 12%annual-7%per month ........ 80 112 144 120
_. _ __
• Receivables are sold outright to finance company
Factoring firms do not have recourse against seller of receivables
Finance companies may do all or part of credit analysis to ensure quality of accounts
d Factoring firm
Absorbs risk
Actually advances funds to seller at lending rate
Factoring Receivables —Example Asset-Backed Public Offerings
If $100,000 a month is processed at 1% commission,
and 12% annual borrowing rate, total effective cost is
computed on annual basis 1%......Commission
1%......Interest for one month (12%annual/12)
2%......Total fee monthly
2%......Monthly X 12 = 24%annual rate
Rate may not be considered high due to factors of risk
transfer, as well as early receipt of funds
Also allows firm to pass on much of credit-checking cost
to factor
Increasing trend in public offerings of security backed by receivables as collateral A Interest paid to owners is tax free
• Advantages to firm • Trade future cash flows for immediate cash
• Carries a high credit rating of AA or better
• Provides
• Corporate liquidity
• Short-term financing
a Disadvantage to buyer Risk associated —receivables actually being paid
_ ~., „ ,~..~~ " - - ~ ~ -- a~....~ x.a-ate: ~.«~ sue: ,r,r~r ~ .~:. ~ - F~ aa2.:
I nventory Financing
Factors influencing use of inventory for financing:
Marketability of pledged goods
a Associated price stability
A Perishability of product
Degree of physical control that lender can exercise
over product
Stages of Production
a Stages of production
• Raw materials and finished goods usually provide best collateral
Goods in process may qualify only small
percentage of loan
<:~.:, , . .... :~~a,,,.~ ,;.~.~'~,a&~
:-:. . .. >. ,::: .. -:~.. 833.: .:: , ~ •, .,. 1 .. .:>:: .- r.r, .~,. _ .8.34:.;
Nature of Lender Control
°~ Provides greater assurance to lender but higher
administrative costs
Types of Arrangements
Blanket inventory liens -Lender has general claim against
inventory
x Trust receipts (floor planning) — an instrument acknowledges
that borrower holds inventory and proceeds from sales in
trust for the lender
Warehousing -Receipt issued and goods can be moved only
with lender's approval
• Public warehousing (with warehousing firm)
• Field warehousing (on borrower's premises)
Appraisal of Inventory Control Devices
Well-maintained control measures involve
Substantial administrative expenses
x Raising overall cost of borrowing
N Extension of funds well synchronized with needs
Hedging to Reduce Borrowing Risk
Engaging in transaction that partially or fully
reduces prior risk exposure
The financial futures market
• Allows trading of financial instrument at future point
i n time
e No physical delivery of goods but execute a later
transaction that reverses initial position
For example: initially sells a futures contract, then later
buys a contract that covers initial sale and vice versa
Hedging to Reduce Borrowing Risk
I n selling Treasury bond futures contract, subsequent pattern of interest rates determines if profitability
Purchase price of futures contract is established at time of initial purchase transaction
Sales price, June 2016 Treasury
bond contract* (sale occurs in January 2016.) ...............$100,000
Purchase price, June 2016 Treasury
bond contract (purchase occurs in June 2016) ................ 95 000
Profit on futures contract ......................................................$5,000
* Only small percentage of actual dollars involved must be invested to initiate contract; this is known as margin.
,.<,F _
Hedging to Reduce Borrowing Risk
g If interest rates increase:
Extra cost of borrowing money to finance business
can be offset by profit of futures contract
If interest rates decrease:
Loss on futures contract as bond prices rise
m Offset by lower borrowing costs of financing firm
.... ... :.... .. ..8.39.'.
