CMA P3 Finance 5

© Sameh Y. El lithy CMA , CIA . E-mail: [email protected]

---- 1FinanceFinanceFinanceFinance

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©©©© Sameh Y. El Sameh Y. El Sameh Y. El Sameh Y. El lithylithylithylithy ,,,, CMA, CIA .CMA, CIA .CMA, CIA .CMA, CIA .FinanceFinanceFinanceFinance

FINANCING CURRENT FINANCING CURRENT FINANCING CURRENT FINANCING CURRENT ASSETSASSETSASSETSASSETS

FINANCING CURRENT FINANCING CURRENT FINANCING CURRENT FINANCING CURRENT ASSETSASSETSASSETSASSETS

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FINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETSFINANCING CURRENT ASSETS

�Up until this point, we have discussed the first step in working capital management—determining the optimal level for each type of current asset. Now we turn to the second step—financing those assets. We begin with a discussion of alternative financing policies. Some companies use current liabilities as a major source of financing for current assets, while others rely more heavily on longterm debt and equity



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Financing PoliciesFinancing PoliciesFinancing PoliciesFinancing PoliciesFinancing PoliciesFinancing PoliciesFinancing PoliciesFinancing Policies

�

Financing MixTemp CA:S.T.Debt��ز؛

Margin Of SafetyZERO

Policy

Maturity Matching

Degree Of Risk

Moderate Risk-Return

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ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET FINANCING POLICIESFINANCING POLICIESFINANCING POLICIESFINANCING POLICIES

ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET ALTERNATIVE CURRENT ASSET FINANCING POLICIESFINANCING POLICIESFINANCING POLICIESFINANCING POLICIES



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ALTERNATIVE CURRENT ASSET FINANCING ALTERNATIVE CURRENT ASSET FINANCING ALTERNATIVE CURRENT ASSET FINANCING ALTERNATIVE CURRENT ASSET FINANCING POLICIESPOLICIESPOLICIESPOLICIES


�Most businesses experience seasonal and/or cyclical fluctuations.

� For example,construction firms have peaks in the spring and summer, retailers peak around Christmas, and the manufacturers who supply both construction companies and retailers follow similar patterns.

�Similarly, virtually all businesses must build up current assets when the economy is strong, but they then sell off inventories and reduce receivables when the economy slacks off. Still, current assets rarely drop to zero—companies have some permanent current assets, which are the current assets on hand at the low point of the cycle.

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�Then, as sales increase during the upswing, current assets must be increased, and these additional current assets are defined as temporary current assets.

�The manner in which the permanent and temporary current assets are financed is called the firm’s current asset financing policy.



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LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING DECISIONS

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING DECISIONS

Three different long-termfinancing strategy

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What is the best level of long-term financing relative to the cumulative capital requirement?

What is the best level of long-term financing relative to the cumulative capital requirement?

�It is hard to say. There is no convincing theoretical analysis of this question. We can make practical observations, however.

�First, most financial managers attempt to “match maturities” of assets and liabilities. �That is, they finance long-lived assets like plant and

machinery with long-term borrowing and equity.

�Second, most firms make a permanent investment in net working capital (current assets less current liabilities). This investment is financed from long-term sources.



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The maturity matching, maturity matching, maturity matching, maturity matching, or ““““selfselfselfself----liquidating,liquidating,liquidating,liquidating,””””approachapproachapproachapproach


�The maturity matching, or “self-liquidating,”approach calls for matching asset and liability maturities as shown in Panel a of Figure 15-3.

�This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations.

�A financing policy that matches asset and liability maturities. This is a moderate policy.

�Actually, of course, two factors prevent this exact maturity matching:� (1) there is uncertainty about the lives of assets, and� (2) some common equity must be used, and common equity

has no maturity.

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�Panel b of Figure 15-3 illustrates the situation for a relatively aggressive firm �that finances all of its fixed assets with long-term

capital and part of its permanent current assets with short-term, nonspontaneous credit.

�Note that we used the term “relatively” in the title for Panel b because there can be different degrees of aggressiveness.

�However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice safety for the chance of higher profits.

AGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACHAGGRESSIVE APPROACH

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� For example, the dashed line in Panel b could have been drawn below the line designating fixed assets, indicating that all of the permanent current assets and part of the fixed assets were financed with short-term credit; this would be a highly aggressive, extremely non conservative position, and the firm would be very much subject to dangers from rising interest rates as well as toloan renewal problems.



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CONSERVATIVE APPROACHCONSERVATIVE APPROACHCONSERVATIVE APPROACHCONSERVATIVE APPROACHFlexible Strategy


�Panel c of Figure 15-3 has the dashed line above the line designating permanent current assets, indicating that permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs.

� In this situation, the firm uses a small amount of short-term, nonspontaneous credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities.

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�The humps above the dashed line represent short-term financing, while the troughs below the dashed line represent short-term security holdings. �Panel c represents a very safe, conservative current asset

financing policy.

�where long-term financing covers more than the total asset requirement, even at seasonal peaks.

�The firm will have excess cash available for investment in marketable securities when the total asset requirement falls from peaks. �Because this approach implies chronic short-term cash

surpluses and a large investment in net working capital, it is considered a flexible strategy.



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Several considerations must be included in a proper analysisSeveral considerations must be included in a proper analysis

�Maturity Hedging. Most firms finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent financing and is inherently risky, because short-term interest rates are more volatile than longer rates.

�Term Structure. Short-term interest rates are normally lower than long-term interest rates. This implies that, on average, it is more costly to rely on long-term borrowing than on short-term borrowing.



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ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF SHORTSHORTSHORTSHORT----TERM FINANCINGTERM FINANCINGTERM FINANCINGTERM FINANCING

ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF ADVANTAGES AND DISADVANTAGES OF SHORTSHORTSHORTSHORT----TERM FINANCINGTERM FINANCINGTERM FINANCINGTERM FINANCING

Although short-term credit is generally riskier than long-term

credit, using short-term funds does have some significant advantages

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Significant AdvantagesSignificant Advantages

�SPEED�obtained much faster than long-term credit.

�Lenders will insist on a more thorough financial examination before extending longterm credit, and the loan agreement will have to be spelled out in considerable detail because a lot can happen during the life of a 10- to 20-year loan.�Therefore, if funds are needed in a hurry, the firm should look to the

shortterm markets.



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Significant AdvantagesSignificant Advantages

�FLEXIBILITY�If its needs for funds are seasonal or cyclical, a firm

may not want to commit itself to long-term debt for three reasons:� (1) Flotation costs are higher for longterm debt than for

short-term credit. �(2) Although long-term debt can be repaid early, provided

the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds will diminish in the near future,it should choose short-term debt.

�(3) Long-term loan agreements always contain provisions, or covenants, which constrain the firm’s future actions. Short-term credit agreements are generally less restrictive.

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RISKS OF LONGRISKS OF LONGRISKS OF LONGRISKS OF LONG----TERM VERSUS SHORTTERM VERSUS SHORTTERM VERSUS SHORTTERM VERSUS SHORT----TERM DEBTTERM DEBTTERM DEBTTERM DEBTRISKS OF LONGRISKS OF LONGRISKS OF LONGRISKS OF LONG----TERM VERSUS SHORTTERM VERSUS SHORTTERM VERSUS SHORTTERM VERSUS SHORT----TERM DEBTTERM DEBTTERM DEBTTERM DEBT

�Even though short-term rates are often lower than long-term rates, and is more readily available than long-term credit. short-term credit is riskier for two reasons:

�(1) If a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high.

�(2) If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak financial position, the lender may not extend the loan, which could force the firm into bankruptcy.



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SOURCES OF SHORTSOURCES OF SHORTSOURCES OF SHORTSOURCES OF SHORT----TERM TERM TERM TERM FINANCINGFINANCINGFINANCINGFINANCING

SOURCES OF SHORTSOURCES OF SHORTSOURCES OF SHORTSOURCES OF SHORT----TERM TERM TERM TERM FINANCINGFINANCINGFINANCINGFINANCING

Statements about the flexibility, cost, and riskiness of short-term versus longterm

debt depend, to a large extent, on the type of short-term credit that is actually used.

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Major types of ShortMajor types of ShortMajor types of ShortMajor types of Short----Term FundsTerm FundsTerm FundsTerm FundsMajor types of ShortMajor types of ShortMajor types of ShortMajor types of Short----Term FundsTerm FundsTerm FundsTerm Funds

�Accruals, �Accounts payable (trade credit), �Bank loans, and �Commercial paper.



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AccrualsAccruals

�Firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance sheet will typically show some accrued wages. Similarly, the firm’s own estimated income taxes, Social Security and income taxes withheld from employee payrolls, and sales taxes collected are generally paid on a weekly, monthly, or quarterly basis, hence the balance sheet will typically show some accrued taxes along with accrued wages.

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AccrualsAccruals

�These accruals increase automatically, or spontaneously, as a firm’s operations expand. Further, this type of debt is “free” in the sense that no explicit interest is paid on funds raised through accruals. However, a firm cannot ordinarily control its accruals: The timing of wage payments is set by economic forces and industry custom, while tax payment dates are established by law.

�Thus, firms use all the accruals they can, but they have little control over the levels of these accounts.



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Accounts payable (trade credit)Accounts payable (trade credit)

�Trade credit is spontaneous financing because it arises automatically as part of the purchase transaction. The terms of payment are set by suppliers.�Payment should be made within the discount period if

the cost of not taking the discount exceeds the firm’s cost of capital.

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SHORTSHORTSHORTSHORT----TERM BANK LOANSTERM BANK LOANSTERM BANK LOANSTERM BANK LOANSSHORTSHORTSHORTSHORT----TERM BANK LOANSTERM BANK LOANSTERM BANK LOANSTERM BANK LOANS

�Commercial banks, whose loans generally appear on balance sheets as notes payable, are second in importance to trade credit as a source of short-term financing for nonfinancial corporations.

� The banks’ influence is actually greater than it appears from the dollar amounts because banks provide nonspontaneous funds. As a firm’s financing needs increase, it requests additional funds from its bank. If the request is denied, the firm may be forced to abandon attractive growth opportunities.



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SHORTSHORTSHORTSHORT----TERM BANK LOANSTERM BANK LOANSTERM BANK LOANSTERM BANK LOANSSHORTSHORTSHORTSHORT----TERM BANK LOANSTERM BANK LOANSTERM BANK LOANSTERM BANK LOANS

�The key features of bank loans are�MATURITY�PROMISSORY NOTE�COMPENSATING BALANCES�INFORMAL LINE OF CREDIT�REVOLVING CREDIT AGREEMENT

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Maturity Maturity Maturity Maturity Maturity Maturity Maturity Maturity

�Although banks do make longer-term loans, the bulk of their lending is on a shortterm basis—about two-thirds of all bank loans mature in a year or less. Bank loans to businesses are frequently written as 90-day notes, so the loan must be repaid or renewed at the end of 90 days.

�Of course, if a borrower’s financial position has deteriorated, the bank may refuse to renew the loan. This can mean serious trouble for the borrower.



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Promissory NotePromissory NotePromissory NotePromissory NotePromissory NotePromissory NotePromissory NotePromissory Note

� When a bank loan is approved, the agreement is executed by signing a promissory note.

� The note specifies 1) the amount borrowed; 2) the interest rate; 3) the repayment schedule, which can call for either a lump

sum or a series of installments; 4) any collateral that might have to be put up as security for the

loan; and 5) any other terms and conditions to which the bank and the

borrower have agreed.� When the note is signed, the bank credits the borrower’s

checking account with the funds, so on the borrower’s balance sheet both cash and notes payable increase.

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Compensating BalanceCompensating BalanceCompensating BalanceCompensating BalanceCompensating BalanceCompensating BalanceCompensating BalanceCompensating Balance

�Banks sometimes require borrowers to maintain an average demand deposit (checking account) balance equal to from 10 to 20 percent of the face amount of the loan.

�This is called a compensating balance, and such balances raise the effective interest rate on the loans.

�For example, if a firm needs $80,000 to pay off outstanding obligations, but if it must maintain a 20 percent compensating balance, then it must borrow $100,000 to obtain a usable $80,000. �If the stated annual interest rate is 8 percent, the effective cost

is actually 10 percent: $8,000 interest divided by $80,000 of usable funds equals 10 percent.



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� As in the formula below, when there is a compensating balance, the total cash received is calculated as principal amount of the loan minus the amount of cash that is necessary to be added to the normal cash balance in order to maintain the compensating balance. It is very possible that the company already has some cash in the bank and therefore already has some of the compensating balance.

� Therefore, in the calculation of total cash received, we will subtract only the balance that the company needs to add to its account at the bank in order to meet the compensating balance requirement.

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� Assume a loan of $10,000 at 12% that requires a $1,500 compensating balance. The effective interest rate will be calculated as $1,200 / $8,500. We use 8,500 because this is the amount of money that the company actually receives and has available to them since $1,500 needs to be placed in the bank as a compensating balance. As such the effective interest rate is 14.11%.

� If, however, the company already has an average of $1,000 on deposit in the bank, then it would need to add only $500 to this amount and the effective interest rate would be calculated as $1,200 / $9,500, or 12,63%.

� Let us now assume that the bank will pay 4% interest on the money that is deposited in its bank. In this case, the interest expense will be reduced by the amount of interest earned on the money that needed to be deposited in order to meet the compensating balance. The 4% interest on $500 is $20,which reduces the interest expense (the numerator) to $1, 180. This reduces the effective interest rate 12.42% .

� The amount that is held as a compensating balance will reduce the amount that we need to repay to the bank at maturity. In the above example we need to repay only $8,500 to the bank because we have in essence already repaid the $1,500 that is being held by the bank as a compensating balance.



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Line of CreditLine of CreditLine of CreditLine of CreditLine of CreditLine of CreditLine of CreditLine of Credit

�A line of credit is an informal agreement between a bank and a borrower indicating the maximum credit the bank will extend to the borrower. �For example, on December 31, a bank loan officer might

indicate to (tell) a financial manager that the bank regards thefirm as being “good” for up to $80,000 during the forthcoming year, provided the borrower’s financial condition does not deteriorate.

�If on January 10 the financial manager signs a promissory note for $15,000 for 90 days, this would be called “taking down”$15,000 of the total line of credit. �This amount would be credited to the firm’s checking account at the

bank, and before repayment of the $15,000, the firm could borrowadditional amounts up to a total of $80,000 outstanding at any one time.

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Revolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit Agreement

�A revolving credit agreement is a formal line of credit often used by large firms.

�To illustrate, in 2001 Texas Petroleum Company negotiated a revolving credit agreement for $100 million with a group of banks. The banks were formally committed for four years to lend the firm up to $100 million if the funds were needed. Texas Petroleum, in turn, paid an annual commitment fee of 1⁄4 of 1 percent on the unused balance of the commitment to compensate the banks for making the commitment.



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Revolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit AgreementRevolving Credit Agreement

� Thus, if Texas Petroleum did not take down any of the $100 million commitment during a year, it would still be required to pay a $250,000 annual fee, normally in monthly installments of $20,833.33.

� If it borrowed $50 million on the first day of the agreement, the unused portion of the line of credit would fall to $50 million, and the annual fee would fall to $125,000.

� Of course, interest would also have to be paid on the money Texas Petroleum actually borrowed. As a general rule, the interest rate on “revolvers” is pegged to the prime rate, the T-bill rate, or some other market rate, so the cost of the loan varies over time as interest rates change.� Texas Petroleum’s rate was set at prime plus 0.5 percentage point.

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Revolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of Credit

�Note that a revolving credit agreement is very similar to an informal line of credit, but with an important difference: �The bank has a legal obligation to honor a revolving

credit agreement, and it receives a commitment fee. �Neither the legal obligation nor the fee exists under

the informal line of credit.



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Revolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of CreditRevolving Credit Vs. Line of Credit

�Often a line of credit will have a clean-up clause that requires the borrower to reduce the loan balance to zero at least once a year.

� Keep in mind that a line of credit typically is designed to help finance negative operating cash flows that are incurred as a natural part of a company’s business cycle, not as a source of permanent capital.

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ExampleExampleExampleExampleExampleExampleExampleExample

�The red company has a revolving line of credit of $300,000 with a one-year maturity .

�The terms call for a 6% interest rate and a ½% commitment fee on the unused portion of the line of credit .

�The average loan balance during the year was $100,000.

�We can calculate the annual cost of this financing arrangement as follow :



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The annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangementThe annual cost of this financing arrangement

interest rateinterest rateinterest rateinterest rate XXXX Borrowed amountBorrowed amountBorrowed amountBorrowed amount

++++

(Credit line limit(Credit line limit(Credit line limit(Credit line limit---- Borrowed amount)Borrowed amount)Borrowed amount)Borrowed amount) XXXX commitment feecommitment feecommitment feecommitment fee

(6%X$100000)+[(300000(6%X$100000)+[(300000(6%X$100000)+[(300000(6%X$100000)+[(300000----100000)x1/2%]=$7000100000)x1/2%]=$7000100000)x1/2%]=$7000100000)x1/2%]=$7000

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The cost of a bank loancost of a bank loancost of a bank loancost of a bank loanThe cost of a bank loancost of a bank loancost of a bank loancost of a bank loan

�The prime interest rate is the rate charged by commercial banks to their best (the largest and financially strongest) business customers. It is traditionally the lowest rate charged by banks. However, in recent years, banks have been making loans at still lower rates in response to competition from the commercial paper market.



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The cost of a bank loan cost of a bank loan cost of a bank loan cost of a bank loan is calculated based on its terms

The cost of a bank loan cost of a bank loan cost of a bank loan cost of a bank loan is calculated based on its terms

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�For example, if the bank quotes an annual rate of 12 percent on a simple interest loan of $100,000 for 1 month, then at the end of the month you would need to repay $100,000 plus 1 month’s interest. This interest is calculated as

�Your total payment at the end of the month would be Repayment of face value plus interest = $100,000 + $1,000 = $101,000

SIMPLE INTERESTSIMPLE INTEREST



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SIMPLE Versus Compound INTERESTSIMPLE Versus Compound INTEREST

� A $10,000 loan at 12% simple interest would require an interest payment of $1,200 per year.

� The same $10,000 loan, but with12% compounded interest, would have an interest cost of $1,200 for the first year, However, in the second year the interest payment would be calculated on both the $10,000 loan and the $1,200 of unpaid interest from thefirst year, Thus, the interest would be $1,344, or $11,200 * 12%, In the third year the interest payment would be even more because it is calculated from the face amount of the loan plus the unpaid interest from the first two years, Thus the third year's payment would be 12% of $12,544, or $1,505, This pattern will continue until the loan is repaid .

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Discounted InterestDiscounted InterestDiscounted InterestDiscounted InterestDiscounted InterestDiscounted InterestDiscounted InterestDiscounted Interest

� The interest rate on a bank loan is often calculated on a discount basis. Similarly, when companies issue commercial paper, they also usually quote the interest rate as a discount. With a discount interest loan, the bank deducts the interest up front.

� For example, suppose that you borrow $100,000 on a discount basis for 1 year at 12 percent.

� In this case the bank hands you $100,000 less 12 percent, or $88,000. Then at the end of the year you repay the bank the $100,000 face value of the loan. This is equivalent to paying interest of $12,000 on a loan of $88,000 The effective interest rate on such a loan is therefore $12,000/$88,000 = .1364, or 13.64 percent.



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�Assume a $10,000 bank loan with 8% discounted interest. Because the interest of $800 is discounted, this amount will not be transferred to the borrower. So the borrower is paying $800 in interest, but receiving only $9,200 in available proceeds. Thus, the effective interest rate is 8.7% ($800 / $9,200).

�Or .08/(1-.08)=8.7% .

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Discounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirementDiscounted Interest with a compensating balance requirement

�Assume the same loan as in the previous example, but there is also a 10% compensating balance requirement. In this case, the effective rate of interest to be paid on the loan will be 9.8%

�($800 / $8,200). This is because the company is essentially receiving only $8,200, because of the $800 of discounted interest and the $1,000 compensating balance! but they have to pay interest as if they had received all $10,000.

�Or, .08/(1-.08-.1)=9.8%.



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�Now suppose that you borrow $100,000 on a discount basis for 1 month at 12 percent.

�In this case the bank deducts 1 percent up-front interest and hands you

� At the end of the month you repay the bank the $100,000 face value of the loan, so you are effectively paying interest of $1,000 on a loan of $99,000.

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MCQMCQMCQMCQMCQMCQMCQMCQ

� The Oxford Corporation was recently quoted terms on 7% discounted interest with a 20% compensating balance. The term of the loan is 1 year .The effective cost of borrowing is (rounded ) .

A. 8.75%.B. 9.41%.C. 7.53%.D. 9.59%.

= 0.07/(1-0.07-0.20)



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� A company has a temporary need for funds. Managemen t is trying to decide between not taking cash discounts from one of its t hree biggest suppliers, or a 14.75% per annum renewable discount loan from its b ank for three months. The suppliers' terms are as follows:

� Fort Co, 1/10, net 30� Riley Manufacturing Co. 2/15, net 60� Shad, Inc. 3/15, net 90

Using a 360-day year, the cheapest source of short- term financing in this situation is:A. The bank.B. Fort Co,C. Riley Manufacturing Co.D. Shad, Inc14.75%/(1-14.75%)=17.30,1/99*360/20=18.18%,2/98*360/45=16.32%, /97*360/75=14.84%

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Morton Company needs to pay a supplier's invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating ba lance ,

Question1: The amount Morton Company must borrow to pay the su pplier within the discount period and cover the compensati ng balance is:

A. $55,000.B. $55,056.C. $55,556.D. $54,444.If the invoice is paid within the discount period , the company will pay

50000$*.98=49000$ ,so by requiring a compensating b alance of 10% the company must borrow L which equals 49000+0.10L , th en L=54 444$ .

Or the amount of 49000$ should represent 90% of the loan , so the loan is 49000$*100/90 = 54 444$



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Morton Company needs to pay a supplier's invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating ba lance

Question2: Assuming Morton Company borrows the money on the la st day of the discount period and repays it 30 days later, the effective interest rate on the loan is:

A. 12.00%.B. 13.33%.C. 13.20%.D. 13.48%.

12%/(1-10%)= 13.33%

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Installment LoansInstallment LoansInstallment LoansInstallment LoansInstallment LoansInstallment LoansInstallment LoansInstallment Loans

� Installment loans are usually a longer-term source of financing .

� The calculation for installment loans is more compl ex than others, and it is not presented here because it is not expected th at installment loans will be tested with a numerical question .

� That ‘s it .



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Commercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial Paper

�Unsecured, short-term promissory notes of large firms, usually issued in denominations of $100,000 or more and having an interest rate somewhat below the prime rate.

�The interest rate on commercial paper fluctuates with supply and demand conditions—it is determined in the marketplace, varying daily as conditions change.

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Commercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial PaperCommercial Paper

�On the other hand, using commercial paper permits a corporation to tap a wide range of credit sources, including financial institutions outside its own area and industrial corporations across the country, and this can reduce interest costs.



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SECURED LOANSSECURED LOANSSECURED LOANSSECURED LOANSSECURED LOANSSECURED LOANSSECURED LOANSSECURED LOANS

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�Many short-term loans are unsecured, but sometimes the company may offer assets as security.

�Since the bank is lending on a short-term basis, the security generally consists of liquid assets such as receivables, inventories, or securities. �For example, a firm may decide to borrow short-term

money secured by its accounts receivable. When its customers pay their bills, it can use the cash collected to repay the loan.



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�Banks will not usually lend the full value of the assets that are used as security. �For example, a firm that puts up $100,000 of

receivables as security may find that the bank is prepared to lend only $75,000.

�The safety margin (or haircut, as it is called) is likely to be even larger in the case of loans that are secured by inventory.

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Pledging receivablesWarehouse financing uses inventory

Chattel mortgages are loans secured by movable personal property (e.g., equipment or

livestock).



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�Several different kinds of collateral can be employed, including marketable stocks or bonds, land or buildings, equipment, inventory, and accounts receivable.

�Marketable securities make excellent collateral, but few firms that need loans also hold portfolios of stocks and bonds. Similarly, real property (land and buildings) and equipment are good forms of collateral, but they are generally used as security for long-term loans rather than for working capital loans.

�Therefore, most secured short-term business borrowing involves the use of accounts receivable and inventories as collateral.

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Pledging ReceivablesPledging ReceivablesPledging ReceivablesPledging ReceivablesPledging ReceivablesPledging ReceivablesPledging ReceivablesPledging Receivables

�When you pledge your receivables as collateral for a loan, you remain responsible for collecting the debt and you suffer if a customer is delinquent.

�Loans can be secured by pledging receivables , i.e., committing the proceeds of the receivables to paying off the loan. A bank will often lend up to 80% of outstanding receivables.



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Inventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory Financing

�As the name implies, an inventory loan uses inventory as collateral. Some common types of inventory loans are

�Blanket Inventory Lien.� The blanket inventory lien gives the lender a lien against all

the borrower’s inventories.

�Trust Receipt. �Under this arrangement, the borrower holds the inventory in

trust for the lender. �The document acknowledging the loan is called the trust

receipt. Proceeds from the sale of inventory are remitted immediately to the lender.

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Inventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory FinancingInventory Financing

�Field-Warehouse Financing. �In field-warehouse financing, a public warehouse

company supervises the inventory for the lender.

�A third party, such as a public warehouse, holds the collateral and serves as the creditor’s agent, and the creditor receives the terminal warehouse receipts evidencing its rights in the collateral.



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Accounts Receivable Accounts Receivable Accounts Receivable Accounts Receivable FinancingFinancingFinancingFinancing

Accounts Receivable Accounts Receivable Accounts Receivable Accounts Receivable FinancingFinancingFinancingFinancing

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Accounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable AssignmentAccounts Receivable Assignment

�When a loan is secured by receivables, the firm assignsthe receivables to the bank.

�If the firm fails to repay the loan, the bank can collect the receivables from the firm’s customers and use the cash to pay off the debt.

�However, the firm is still responsible for the loan even if the receivables ultimately cannot be collected. The risk of default on the receivables is therefore borne by the firm.

�Thus ,under assignment, the lender not only has a lien on the receivables but also has recourse to the borrower.



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Factoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring Receivables

�An alternative procedure is to sell the receivables at a discount to a financial institution known as a factor and let it collect the money. �In other words, some companies solve their financing problem

by borrowing on the strength of their current assets; others solve it by selling their current assets.

�Once the firm has sold its receivables, the factor bears all the responsibility for collecting on the accounts. �Therefore, the factor plays three roles:

�it administers collection of receivables,

�takes responsibility for bad debts assumes the full risk of default , and

�provides finance.

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Factoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring ReceivablesFactoring Receivables

� The seller of the receivables receives money immediately to reinvest in new inventories.

� The financing cost is usually high about two points or more above prime, plus a fee for collection.�A firm that uses a factor can eliminate its credit department and accounts

receivable staff. Also, bad debts are eliminated. These reductions in costs can more than offset the fee charged by the factor.

� The factor can often operate more efficiently than its clients because of the specialized nature of its service.



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The formula to calculate the cash received from factoring is as follows:

The formula to calculate the cash received from factoring is as follows:

Face amount of the receivables .

Minus :The amount of the reserve (calculated from the face amount of receivables if applicable) .

Minus :The factor's fee (this is also calculated from the face amount)

= Amount that the seller needs to pay interest on

Minus :Interest for the time period before the collection of the receivables .

Cash to be received by the Seller .

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ExampleExampleExampleExampleExampleExampleExampleExample

� Assume a factor charges a 4% fee and 12% interest on all monies that are advanced to the seller. Additionally, the factor reserves a 7% reserve. The amount of the receivables to be sold is $150,000 and it is due for collection in 120 days. The amount of cash that will be received by the seller is calculated as follows:

Amount of receivables submitted $150,000

Minus: 7% reserve ( % of face ) (10,500)

Minus: 4% factor's fee ( % of Face ) (6,000)

Amount accruing to the company $133,500Minus: 12% interest for 120 days (on $133,500) (5,340)Amount to be received immediately 128.160

Documents

CMA P3 Finance 5