INTERVIEW

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Chapter

McGraw-Hill/Irwin

Sources of Short-Term Financing

Chapter Outline

Trade credit from suppliers.
Bank loans.
Commercial paper.
Borrowing in foreign markets.
Using collaterals like accounts receivable and inventory for larger loans.

Financing Arrangements

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

Trade Credit

40 percent of short-term financing is in the form of accounts payable or trade credit.
Accounts payable
Spontaneous source of funds.
Growing as the business expands.
Contracting when business declines.

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.

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 30th day.

Net-Credit Position

Determined by examining the difference between accounts receivable and accounts payable.
It is 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).

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.

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.

Prime Rate versus LIBOR on U.S. Dollar Deposits

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.

Compensating Balances - Example

If one needs $100,000 in funds, he/ she must borrow $125,000 to ensure the intended amount will be available. This would be calculated as:

Amount to be borrowed = Amount needed

(1 - c)

= $100,000

(1 – 0.2)

= $125,000

Where ‘c’ is the compensating balance expressed as a decimal.

To check on this calculation, the following can be done:

$125,000 Loan

- 25,000 20% compensating balance requirement

$100,000 Available funds

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.

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 X Days in the year (360)

Principal Days loan is outstanding

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 X year (360)

compensating balances Principal – Compensating Days loan is

balance in dollars outstanding

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.

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.

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.

The Credit Crunch Phenomenon (cont’d)

Credit conditions can change dramatically and suddenly due to:
Unexpected defaults.
Economic recessions.
Other economic setbacks.

Financing Through Commercial Paper

Short-term, unsecured promissory notes issued to the public.
Finance paper/ direct paper
Sold by financial firms, directly to the lender.
Dealer paper
Sold by industrial companies, use of intermediate dealer network for its distribution.
Book-entry transactions
Computerized handling of commercial paper, where no actual certificate is created.

Total Commercial Paper Outstanding

Advantages of Commercial Paper

Fuelled by the rapid growth of money-market mutual funds, and their need for short-term securities for investments.
No associated compensating balance requirements.
Associated prestige for the firm to float their paper in an elite market.

Comparison of Commercial Paper Rate to Prime Rate (annual rate)

Limitations on the Issuance 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.

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.

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.

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.

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.

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 determine and 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.

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 mush of the credit-checking cost to the factor.

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.

Inventory Financing

Factors influencing use of inventory:
Marketability of the pledged goods.
Associated price stability.
Perish-ability of the product.
Degree of physical control that the lender can exercise over the product.

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.

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.

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.

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.

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.

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.