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Sources of Short-Term Financing,8,1-2,Chapter 8-Outline,Sources of Short-Term FinancingTrade CreditNet Credit PositionTypes of Bank LoansCorporate and Foreign Borrowing Accounts Receivable FinancingInventory FinancingLonger-term Loans,1-3,Sources of Short-Term Financing,There are various sources of short-term funds available to a firm:Trade Credit from SuppliersBank LoansCorporate Promissory NotesBankers AcceptancesForeign BorrowingLoans Against Receivables and Inventory,1-4,Trade Credit,Approximately 40 percent of short-term financing is in the form of accounts payable or trade creditAccounts payableIs a Spontaneous source of fundsGrows as the business expandsContracts when business declines,1-5,Payment Period,Trade credit is usually extended for 3060 days Extending the payment period to an unacceptable period results in:Alienate suppliers Diminished ratings with credit bureausMajor variable in determining the payment period:The possible existence of a cash discount,1-6,Cash Discount Policy,Allows reduction in price if payment is made within a specified time periodExample:A 2/10,net 30 cash discount means:Reduction of 2%if funds are remitted 10 days after billingFailure to do so means full payment of amount by the 30th day,1-7,Net-Credit Position,Determined by examining the difference between accounts receivable and accounts payablePositive 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),1-8,Bank Credit,Provide self-liquidating loansUse of funds ensures a built-in or automatic repayment schemeChanges in the banking sector today:Centered around the concept of full service bankingExpanded internationally to accommodate world trade and international corporationsDeregulation has created greater competition among other financial institutions,1-9,Prime Rate and LIBOR,Prime rateRate a bank charges to its most creditworthy customersIncreases as a customers credit risk increasesLIBOR(London Interbank Offered Rate)Rate offered to companies:Having an international presenceAbility to use the London Eurodollar market for loans,1-10,Prime Rate versus LIBOR on U.S.Dollar Deposits,1-11,Compensating Balances,A fee charged by the bank for services rendered or an average minimum account balanceWhen interest rates are lower,the compensating balance risesRequired account balance computed on the basis of:Percentage of customer loans outstandingPercentage of bank commitments towards future loans to a given account,1-12,Maturity Provisions,Term loanCredit is extended for one to seven yearsLoan is usually repaid in monthly or quarterly installmentsOnly superior credit applicants,qualifyInterest rate fluctuates with market conditionsInterest rate may be tied to the prime rate or LIBOR,1-13,Cost of Commercial Bank Financing,Effective interest on a loan is based on the:Loan amountDollar interest paidLength of the loanMethod of repaymentDiscounted loan interest is deducted in advance effective rate increasesEffective rate=Interest Days in the year(360)Principal-interest Days loan is outstanding,1-14,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 aEffective rate with=Interest year(360)compensating balances Principal Compensating Days loan is balance in dollars outstanding,1-15,Rate on Installment Loans,Installment loans require a series of equal payments over the period of the loanFederal legislation prohibits a misrepresentation of interest rates,however this may be misused,Effective rate on installment loan=2 Annual no.of payments Interest(Total no.of payments+1)Principal,1-16,Annual Percentage Rate,Truth in Lending Act of 1968 requires the actual APR to be given to the borrowerAnnual percentage rule:Protects unwary consumer from paying more than the stated rateRequires the use of the actuarial method of compounded interest during computationLender must calculate interest for the period on the outstanding loan balance at the beginning of the periodIt is based on the assumptions of amortization,1-17,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 ratesIncrease in demand for funds to carry inflation-laden inventory and receivablesMassive withdrawals of savings deposits at banking and thrift institutions,fuelled by the search for higher returnsCredit conditions can change dramatically and suddenly due to:Unexpected defaultsEconomic recessionsChanges in monetary policyOther economic setbacks,1-18,Financing Through Commercial Paper,Short-term,unsecured promissory notes issued to the publicFinance paper/direct paperDealer paperAsset-backed commercial paperBook-entry transactionsComputerized handling of commercial paper,where no actual certificate is created,1-19,Total Commercial Paper Outstanding,1-20,Advantages of Commercial Paper,May be issued at below the prime interest rateNo associated compensating balance requirements Associated prestige for the firm to float their paper in an elite market,1-21,Disadvantages of Commercial Paper,Many lenders have become risk-averse post a multitude of bankruptciesFirms with downgraded credit rating do not have access to this marketThe funds generation associated with this is less predictableLacks the degree of commitment and loyalty associated with bank loans,1-22,Foreign Borrowing,Eurodollar loanDenominated in dollars and made by foreign bank holding dollar depositsShort-term to intermediate terms in maturityLIBOR is the base interest paid on loans for companies of the highest qualityOne approach borrow from international banks in foreign currencyBorrowing firm may suffer currency risk,1-23,Use of Collateral in Short-Term Financing,Secured credit arrangement when:Credit rating of the borrower is too lowNeed for funds is very highPrimary concern whether the borrower can generate enough cash flow to liquidate the loan when dueUniform Commercial CodeStandardizes and simplifies the procedures for establishing security against a loan,1-24,Accounts Receivable Financing,Includes:Pledging accounts receivablesFactoring or an outright sale of receivablesAdvantage:Permits borrowing to be tied directly to the level of asset expansion at any point of timeDisadvantage:Relatively expensive method of acquiring funds,1-25,Pledging Accounts Receivables,Lending firm decides on the receivables that it will use as a collateralLoan percentage depends on the firms:The financial strengthThe creditworthinessInterest rate is well above the prime rateComputed against the balance outstanding,1-26,Factoring Receivables,Receivables are sold outright to the finance companyFactoring firms do not have recourse against the seller of the receivablesFinance companies may do all or part of the credit analysis to ensure the quality of the accountsFactoring firm is:Absorbing risk for which a fee is collectedActually advancing funds to the seller paid a lending rate,1-27,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 rateThe rate may not be considered high due to factors of risk transfer,as well as early receipt of fundsIt also allows the firm to pass on much of the credit-checking cost to the factor,1-28,Asset Backed Public Offering,There is an increasing trend in public offerings of security backed by receivables as collateralInterest paid to the owners is tax freeAdvantages to the firm:Immediate cash flowHigh credit rating of AA or betterProvides Corporate liquidityShort-term financingDisadvantage to the buyer:Risk associated receivables actually being paid,1-29,Inventory Financing,Factors influencing use of inventory:Marketability of the pledged goodsAssociated price stabilityPerishability of the productDegree of physical control that the lender can exercise over the product,1-30,Stages of Production,Stages of productionRaw materials and finished goods usually provide the best collateralGoods in process may qualify only a small percentage of the loan,1-31,Nature of Lender Control,Provides greater assurance to the lender but higher administrative costsTypes of Arrangements:Blanket inventory liensLender has a general claim against inventoryTrust receipts(floor planning)An instrument the proceeds from sales go to the lenderWarehousing A receipt issue goods can be moved only with the lenders approvalPublic warehousingField warehousing,1-32,Hedging to Reduce Borrowing Risk,Engaging in a transaction that partially or fully reduces a prior risk exposureThe financial futures market:Allows the trading of a financial instrument at a future point in timeNo physical delivery of goods,1-33,Hedging to Reduce Borrowing Risk(contd),In selling a Treasury bond futures contract,the subsequent pattern of interest rates determine if it is profitable or notSales price,June 2006 Treasurybond contract*(sale occurs in January 2006.)$100,000Purchase price,June 2006 Treasury bond contract(purchase occurs in June 2006).$95,000Profit 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,1-34,Hedging to Reduce Borrowing Risk(contd),If interest rates increaseThe extra cost of borrowing money to finance the business can be offset by the profit of the futures contractIf interest rates decreaseA loss is garnered on the futures contract as the bond prices riseThis is offset by the lower borrowing costs of the financing firmThe purchase price of the futures contract is established at the time of the initial purchase transaction,