Copy of Short-term Fiannce

8/8/2019 Copy of Short-term Fiannce

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Short TermShort TermFinancingFinancingDecisionDecision


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Learning Objectives

The need for short-term financing. The advantages and disadvantages of

short-term financing.

Three types of short-term financing. Computation of the cost of trade credit,

commercial paper, and bank loans.

How to use accounts receivable andinventory as collateral for short-termloans.


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Why Do Firms Need Short-term Financing? Cash flow from operations may not be sufficient

to keep up with growth-related financing needs.

Firms may prefer to borrow now for theirinventory or other short term asset (current

asset) needs rather than wait until they havesaved enough.

Firms prefer short-term financing instead of

long-term sources of financing due to: easier availability

usually has lower cost

matches need for short term assets, like inventory


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Sources of Short-term Financing Short-term loans / Overdrafts.

borrowing from banks and other financialinstitutions for one year or less.

Trade Credit.

borrowing from suppliers

Commercial Paper.

Issued by large credit- worthy businesses.

Bankers Acceptance

An agreement by a bank to pay a sum of money.


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TYPES OF SHORT-TERM LOANS: Promissory note

A legal IOU that spells out the terms ofthe loan agreement, usually the loanamount, the term of the loan and the

interest rate.Often requires that loan be repaid in full

with interest at the end of the loan

period.Usually with a Bank or FinancialInstitution; occasionally with suppliers orequipment manufacturers


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TYPES OF SHORT-TERM LOANS: Line of Credit

The borrowing limit that a bank sets for afirm after reviewing the cash budget.

The firm can borrow up to that amount of

money without asking, since it is pre-approved

Usually informal agreement and may

change over time Usually covers peak demand times, growth

spurts, etc.


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Estimation of Cost of Short-Term Loan /Credit

Calculation is easiest if the loan is for a oneyear period:

Effective Interest Rate is used to determinethe cost of the credit to be able to comparediffering terms.

Effective AnnualInterest Rate

Interest you payAmount you get to use

=

Example:Example: You borrow $10,000 from a bank, at a statedrate of 10%, and must pay $1,000 interest at the end ofthe year. Youreffective annual rate is the same as thestated rate: $1,000/$10,000= .10 = 10%


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Variations in Loan Terms

A discount loan requires that interest bepaid up front when the loan is given.

This changes the effective cost in the

previous example since you only get touse:

($10,000 - $1,000) = $9,000.

Effective annual rate (APR) =$1,000/$9,000 = .1111 = 11.11%.


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Variations in Loan Terms Sometimes lenders require that a minimum

amount, called a compensating balance be keptin your bank account. It is taken from theamount you want to borrow.

If your compensating balance requirement is$500, then the amount you can use is reducedby that amount.

Effective Annual Rate (APR) for a $10,000simple interest 10% loan with a $500compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.


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Variations in Loan Terms :Both DiscountInterest and Compensating Balance

Sometimes, lenders will require bothdiscount interest (paid in advance) and a

compensating balance. If the interest is $1,000 and the

compensating balance is $500, then the

effective annual rate (APR) becomes: $1,000 / ($10,000 - $1,000 - $500)

$1,000 / $8,500 = 11.76%


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Calculating (Effective Annual Rate ) APR $1000 loan is extended @6% for 90 days? What

would be APR?


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TRADE CREDIT Trade credit is the act of obtaining funds by

delaying payment to suppliers, who typicallygrant 30 days to pay.

The cost of trade credit may be some interest

that the supplier charges on the unpaidbalance.

More often, it is in the form of a lost discountthat would be given to firms who pay earlier.

Credit has a cost. That cost may be passedalong to the customer as higher prices, or borneby the seller as lower profits, or some of both.


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Cost of Trade Credit

Cost of Trade Credit

Typically receive a discount if you payearly.

Stated as: 2/10, net 60

Purchaser receives a 2% discount ifpayment is made within 10 days of theinvoice date, otherwise payment is due

within 60 days of the invoice date.

The cost is in the form of the lostdiscount (2%)if you dont take it.


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Cost of Trade Credit 2/10 net 60 QS:Assume your purchase is $100 list price.

If you take the discount, you pay $98. If you dont takethe discount, you pay $100. what would be APR?

SOLUTION: Therefore, you (buyer) are paying $2 forthe privilege of borrowing $98 for the additional 50

days. (Note: the first 10 days are free in this example).

APR = $2/$98 x 360/50 = 14.7% (If you pay in 60 days)

What if 2/10, net 30 (list price is same $100). Whatwould be the APR?

APR = $2/$98 x 360/20 = 36.7% (If you pay in 30 days)


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COMMERCIAL PAPERCommercial paper consists of short-term notes issuedby large and highly rated firms. Typically these notes areof short maturity, ranging up to 270 days.

CP trades in the market at rates just above T-bill rate.

CP is bought with surplus cash by banks and othercompanies, then held as a marketable security forliquidity purposes.


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COMMERCIAL PAPER

Commercial paper is quoted on a discount basis,meaning that the interest is subtracted from theface value to arrive at the price. See 3 stepsbelow for calculation:

Step 1: Compute the discount (D) from face value

of the commercial paper Discount (D) = Discount rate x par value x DTG/360

DTG = days to go (to maturity)

Step 2: Compute the price = Face value - Discount

Step 3: Compute Effective Annual Rate (APR):


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Cost of Commercial Paper QS:A company issued 90 day commercial paper with

face value $1 million quoted at 4% discount rate.

Calculate amount of discount, price and APR (or thecost of Commercial paper ?


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Cost of Commercial Paper QS:A company issued 90 day commercial paper with

face value $1000 at a discount $985. The credit rating

expenses are 0.5%, IPA charges being 0.35% andstamp duty 0.5% of the size of issue. Calculate APRor the cost of Commercial paper ?

SOLUTION:

The discount is Tk 15 and rating and IPA and stampduty amounts to : 1.35% X Tk 1000 = Tk 13.5

Effective rate (APR)/ Cost of CP

15 + 13.5 360= ---------------- X --------

$985 90= 11.6%


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BANKERS ACCEPTANCE

A Bankers Acceptance is an agreement by a bank to

pay a sum of money.These agreements typically arise when a seller sends abill or draft to a customer. The customers bank acceptsthis bill and notes the acceptance on it, which makes itan obligation of the bank.

In this way, a firm that is buying something form asupplier can effectively arrange for the bank to pay the

outstanding bill. The bank charges the client a fee forthis service.


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ACCOUNTS RECEIVABLE AS COLLATERAL

A pledge is a promise that the borrowing firm will

pay the lender (bank or other finance companies)any payments received from the accountsreceivable collateral in the event of default.

Since accounts receivable fluctuate over time, the

lender may require certain safeguards to ensurethat the value of the collateral does not go belowthe balance of the loan.

So, normally a bank/finance companies will onlyloan you 70 -75% of the receivable amount.

Accounts receivable can also be sold outright.This is known as factoring.


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Cost of Borrowing against Receivables Example: Average monthly sales of any firm is

$100,000. Firm offers 60 day terms of credit tocustomers, so average Account Receivable balance offirm is $200,000 (i.e. for 2 months)

Suppose Bank offers loan 70% of Accounts

Receivable which is $140,000 Interest is 3% over prime rate ( 8%),So amount of

interest would be = 11% x $140,000 = $15,400

Suppose Bank charges 1% annual processing fee on

the amount of all receivable balance i.e. = 1% x$12,00,000 = $12,000

APR = $15,400 + $12,000 x 1 year = 19.57%

$140,000


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Cost of Borrowing against Receivables Example: Average monthly sales of any firm is

$200,000. Firm offers 30 day terms of credit tocustomers, so average Account Receivable balance offirm is $200,000. Bank offers loan 75% of AccountsReceivable. Interest charged is 10%. If Bank charges0.05% annual processing fee on the amount of allreceivable balance, Calculate APR?

SOLUTION: Bank offers loan 75% of Accounts Receivablewhich is $150,000.

Amount of interest is = 10% x $150,000 = $15,000

Suppose Bank charges 0.05% processing fee on the amount ofall receivable balance i.e. = 0.05% x $24,00,000 = $12,000

APR = $15,000 + $12,000 x 1 year = 18%

$150,000


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DEBT FACTORING

Debt factoring is a service offered by a financial institutionknown as a factor. Many of the large factors are subsidiaries

of commercial banks. Debt factoring involves the factortaking over the debt collection for a business. In addition tooperating normal credit control procedures, a factor mayoffer to undertake credit investigations and advise on the

creditworthiness of customers. It may also offer protection forapproved credit sales. Two main forms of factoringagreement exist:

Recourse factoring, where the factor assumes noresponsibility for bad debts arising from credit sales.

Non-recourse factoring, where, for an additional fee, thefactor assumes responsibility for bad debts up to an agreed

amount.


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The factor is usually prepared to make an advance tothe business of up to around 80 per cent of approvedtrade debtors (although it can sometimes be as high as

90 per cent). This advance is usually paid immediatelyafter the goods have been supplied to the customer.

The balance of the debt, less any deductions for fees

and interest, will be paid after an agreed period or whenthe debt is collected. The charge made for the factoringservice is based on total turnover and is often around 23 per cent of turnover.

Any advances made to the business by the factor willattract a rate of interest similar to the rate charged onbank overdrafts.


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Debt factoring is, in effect, outsourcing the trade debtors controlto a specialist subcontractor. Many businesses find a factoringarrangement very convenient. It can result in savings in credit

management and can create more certain cash flows.

However, there is a possibility that some will see a factoringarrangement as an indication that the business is experiencingfinancial difficulties. This may have an adverse effect on

confidence in the business.

Not all businesses will find factoring arrangements the answer totheir financing problems. Factoring agreements may not bepossible to arrange for very small businesses.

In addition, businesses engaged in certain sectors such asretailers or building contractors, where trade disputes are part ofthe business culture, may find that factoring arrangements are

simply not available.


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INVOICE DISCOUNTINGInvoice discounting involves a business approaching afactor or other financial institution for a loan based on a

proportion of the face value of credit sales outstanding. Ifthe institution agrees, the amount advanced is usually7580 per cent of the value ofthe approved sales invoices outstanding.

The business must agree to repay the advance within arelatively short period perhaps 60 or 90 days. Theresponsibility for collecting the trade debts outstanding

remains with the business and repayment of theadvance is not dependent on the trade debts beingcollected.


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Invoice discounting will not result in such a closerelationship developing between the business and thefinancial institution as occurs with factoring. It may be a

one-off arrangement whereas debt factoring usuallyinvolves a longer-term arrangement between the clientand the financial institution.Nowadays, invoice discounting is a much more

important source of funds to businesses than factoring.

There are three main reasons for this:i) It is a confidential form of financing which the businesss

customers will know nothing about.

ii) The service charge for invoice discounting is only about0.20.3 per cent of turnover compared to 2.03.0 per cent of

turnover for factoring.


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iii) Many businesses are unwilling to relinquish control oftheir customers records. Customers are an importantresource of the business and many businesses wish to

retain control over all aspects of their relationship withtheir customers.

Factoring and invoice discountingare forms ofasset-

based finance as the assets of debtors are, in effect,used as security for the cash advances received by the

business.


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INVENTORY AS COLLATERAL A major problem with inventory financing is

valuing the inventory. For this reason, lenders will generally make a

loan in the amount of only a fraction of the

value of the inventory. The fraction will differdepending on the type of inventory.

If inventory is long lived, they (lender or acustomer) may loan you up to 75% of the resalevalue.

If inventory is perishable, you wont get much


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SOURCES OF MEDIUM TERM FINANCE

LEASING

Leasing enables a business to acquire the use ofassets such as plant and machinery without having topay large sums of money forownership of theequipment, initially. Instead a business simply leases

the equipment from a leasing company who retainownership.There are two main forms of lease:Operating lease

Finance lease


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Operating Lease - in which the company pays for useof the equipment for a set period of time after which it isreturned to the leasing company.

Finance Lease - where at the end of the lease periodthere is the option to purchase the equipment outright for

a further nominal amount.

Whilst leasing does not inject money directly into the

business, and in the long term usually costs more than

buying the equipment outright, in cash flowterms its aneffective method of a business getting the equipment it

needs when its cash flow is tight.


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Hire PurchaseA hire purchase agreement enables a business topurchase ownership of plant and machinery from a supplier,

by paying by installments to a third party i.e. a financehouse.The buyer will normally place a down payment with thesupplier who will then deliver the equipment, the finance

house then pays the supplier the remaining amount owed forequipment. Finance Co. collects installments from the buyerover a set period of time for this amount plus interest.

Hire purchase agreements are interesting, in that ownershipof the equipment first passes to the finance house, and willnot pass to the buyer until the last installment is paid. If thebusiness fails to pay installments the equipment will berepossessed by the finance house.


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Advantages Short-term Financing

A short-term credit can be obtained much faster than thelong-term credit, while long term credit requires thoroughexamination of the financial condition of the firm.

Firms in need of seasonal or cyclical fund, may look to

short-term markets (money market). Because floatation costare higher for long term debt; long term debt can be prepaidearly but prepayment penalties are expensive and long termdebt have covenants or provision which constraints the firms

future actions.

Since yield curve are normally upward slopping indicatingthat interest rates are generally lower on short term than long

term debt.


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Disadvantages of Short-term Financing

Short-term debt is often less expensive than long-term

debt, but shot term credit subjects the firm to more risks.This occurs for two reasons:

i) If a firms borrows on a long-term basis, its interestcosts will be relatively stable over time. But if it uses

short-term credit, its interest expense will fluctuatewidely with market interest rate, at times going quitehigh.

ii) If a firm borrows heavily on short-term basis, it mayfind itself unable to repay this debt and it may be in sucha weak financial position that the lender will not extendthe loan, this too could force the firm into bankruptcy.

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Copy of Short-term Fiannce