Discussion Assignment 2.1

TIME VALUE OF MONEY Part 2: A Case Study at Bank One

Female Small businesses represent the majority of all companies in the U.S. employing more than half of all workers. One of the first relationships a young company forges is with a bank. When evaluating banks, a business will consider the strength of the institution, its services and its reputation. On these accounts, Bank One scores high.

Tonya Lloyd Bank One is the sixth largest holding company in the nation. We have over $270 billion in assets with over 1,800 banking centers nationwide. We are the third largest credit card issuer in the nation.

Female As a large international firm, Bank One serves businesses from sole proprietorships to Fortune 500 companies, but they are especially attractive to small businesses to whom they offer a wide range of services.

Tonya Lloyd We are small enough and local enough to provide services for all types of clients that perhaps some of the smaller community banks are unable to provide. These would include technology service and also international services.

Here at Bank One, we pride ourselves on building relationships with our customers and we always attempt to continue to develop those relationships and whatever services we can provide to the customer.

Female The relationship between a business and a bank is a partnership based on trust which may extend for the life of the business. As the business grows, its needs change and it requires a bank that understands and can meet those needs. Bank One prides itself on its relationship with its clients.

Tonya Lloyd Well, our small business customers are not that different from our retail customers. They both need basically the same products and services it is just that often times, the business banker may require a little bit more on hands-on from perhaps the banking center manager, a relationship manager which would be our partner in the business banking side that could provide services that are not available in a retail banking center.

Female There are a number of services a bank provides to its business customers. At first, a company needs to set up checking and saving accounts. Later, the bank may help them with their insurance needs or with

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cash management. A common reason small businesses turn to a bank is to borrow money for large expenditures or working capital. There are several options available to a business that needs to borrow money. The most common option is a term loan.

David Randazzo Term loans are typically used for fixed asset acquisition like equipment or real estate. The range of the loan will depend on the type of equipment and how it will depreciate. We typically finance equipment over a five or seven-year period. We want to be out of our loan before that equipment exceeds its useful life. The same is true with real estate, we will typically finance real estate with a 15 or 20 year amortization which closely matches the useful life of that building.

Female Term loans are amortized which means the borrower pays back some of the principal and some of the interest in each payment to the bank. Most amortized loans are fixed payment loans in which all payments are equal.

David Randazzo With a fixed payment loan, more of your payment goes towards interest at the beginning. But as the loan progresses, more will go towards principal.

Female In some cases, the borrower may choose to pay equal amounts to the principal in each payment.

David Randazzo Some of our customers will ask us to structure the loans so that they have a set principal payment each month. We will then take the interest and add that on top of that principal payment so their payment will change from month to month.

At the beginning of the loan, their payments will be higher because they will include that interest. But as the principal pays down, their payments will become smaller towards the end of the loan.

Female This benefits the borrower if they can afford the higher payments because they are paying less interest overall. The amount of principal is reduced faster so they are paying less interest to the bank.

A company that borrows $10,000 at 8% interest and chooses to make equal principal payments will save $500 in interest over the 10-year repayment period. On larger loans, this difference can be even more substantial.

Still, most customers prefer the fixed payment loan because it is easier to work into their budget and less jarring to their cash flow. They know their payment will remain the same throughout the life of the loan and that they can pay off additional principal as their cash flow improves.

David Randazzo Any additional reduction of principal to the loan will save you interest overtime because of the future value calculation includes time and interest, those additional principal reductions will actually lead to fewer payments being made on the loan.

Female A term loan is perfect example of the time value of money. Time value of money is the concept that a

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dollar in hand today is worth more than a dollar promised at some time in the future because the dollar in hand has the potential to grow to something larger down the line.

When a bank lends money, it charges interest on the principal or the amount borrowed. The company is willing to pay the interest because they can then invest the money in their business buying equipment or materials.

Another way businesses borrow money is through a line of credit. A line of credit is similar to a credit card for a consumer. The company has a certain amount of money available to them but they are responsible for interest payments only on the amount they actually used.

David Randazzo A line of credit is typically used for working capital needs and it will revolve. Let us say that you have a $100,000 line of credit available to your company. You may need $10,000 to go out and buy material. You then take that material and convert it into your product.

Let us say you sell that product for $20,000, you can then take those proceeds, pay back the $10,000 on the line and have that full $100,000 available to you and that is what we mean by revolving line of credit. The revolving line of credit allows you to make sure that you have cash flow to support your working cycle.

Female A line is generally for short-term loans rather than longer terms. They are used when you are expecting an influx of cash which will allow you to payoff the loan. Unlike an amortized loan, a line of credit is an interest-only loan which means the borrower only has to pay interest each period and repays the principal at the end of the term.

David Randazzo A line of credit is almost always used with a seasonal or for contracting work. A contractor may need to use their line of credit at the beginning of their project to hire people and buy a material. However, they may not get paid for 90 to 120 days. Therefore, they can use that working capital on their line to support that job. When they get paid, then they can return the money to the bank and pay down their line of credit.

Female As a company grows, they may have a need to purchase equipment. They are then faced with the question of whether to borrow money to buy the equipment or whether to lease it. That decision will be based in part on the time value of money.

David Randazzo The first consideration on whether to buy or lease equipment is your current cash flow situation. With a term loan, we would ask for a 20% to 25% down payment. However with leasing, it is typically a 100% financing and you do not need that down payment. So depending on the cash flow situation, if they need to conserve that cash for working capital, they may choose to go with the lease option.

Female Because it is 100% financing depending on the type of equipment and length of the lease, leasing can be more expensive than a term loan. If you decide to lease, there are two main types of leases available. The difference stems from who owns the equipment and who benefits from its depreciation.

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David Randazzo One type of lease is called the dollar buyout lease. Unlike a term loan, that is a 100% financing. The business owns the equipment and takes the depreciation expense. However to be considered a lease, there must be some type of consideration so the customer will pay us a dollar at the end of the term.

With a true lease, the bank owns the equipment and takes the depreciation. Because of that depreciation, we can pass along savings to our customer in a lower monthly payment and a lower interest rate. The customer at the end of the lease can choose to buy the equipment or they can turn it back over to the bank for us to resell it.

Customers often use a true lease for specialized or technologically advanced equipment. Let us say the equipment will only be good for three years, they will lease it for that time and then they know that they can turn it back into the bank and go out and buy equipment that is now more modern.

Our leasing experts consider what that equipment will be worth at the end of the lease and that factors into how we structure that transaction.

Female Leases, loans and lines of credit are all based on the time value of money. In each case, interest is charged on the amount borrowed and compounded at a set rate for a certain period of time.

The business needs to consider how much to borrow, how long they need to repay it and what form the financing will take. These decisions will affect how much interest they eventually pay. The future value of their loan is determined by time and rate.

Once the company grows to a certain size, it may confront the issue of employee benefits. Chief among this is a retirement plan. Once again, the company turns to its financial partner for help.

Christine Baim We provide a wide range of retirement plans for large and small businesses. The basic concept of any retirement plan is essentially the same. The employer and the employee contribute to retirement account.

We compound that investment overtime to determine the future value of that account of retirement. The future value of the account is really based on the amount of time the investment grows and the rate of return on the investment.

Since your employees usually retire at age 65, we cannot change the amount of time on the investment so it is our job to help you get the best rate of return on your money.

Female The traditional company retirement plan is called a defined benefit plan. In this plan, the employee receives a set payment every month upon retirement. This amount is usually based on salary and years of service. In order to fund this kind of account, the financial manager calculates how much money to invest now in order to have necessary funds in the future.

Everyone in the banking chain depends upon the time value of money. Banks collect deposits. They then use that money to offer loans. The bank rewards customers for their deposits by offering interest. As long as they charge a higher rate of interest on their loans than they pay on their deposits, they make a profit.

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The customers who have accounts at the bank benefit from the time value of money because they are earning interest on their savings. The customers who take loans have access to funds which they can use to earn more than the interest they are paying so they benefit from the time value of money. And the bank makes its money from the spread between the interest rate they offer depositors and the interest rate they charge borrowers. In this way, everyone in the chain benefits from the time value of money.

L i c e n s e d u n d e r a C r e a t i v e C o m m o n s A t t r i b u t i o n 3 . 0 L i c e n s e .

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