FINANCE MANAGEMENT FIN420 chp 7

Short-Term Financing Chapter 7

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Firm can use different types of financing to raise

capital. But the firms manager need to be concerned

with the effective cost and the availability of those

types of financing when deciding on these alternatives.

Learning objectives

After learning this chapter, you should be able to:

1. Understand the concept of secured and unsecured financing

2. Determine the cost of financing

3. Calculate the effective cost of borrowing short term loans

4. Calculate the effective cost of factoring and pledging of receivable.

Short-Term Financing

GOAL

Chapter 7 Short-Term Financing

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7.0 INTRODUCTION Short term financing is a short-term obligation that is expected to mature in one year or less

and is required to support a large portion of the firm’s current assets.

The use of short-term financing is to meet the seasonal and temporary fluctuation in a

company’s funds position as well as to meet permanent needs of the business. For example

short-term financing may be used to provide extra net working capital or to finance current

assets.

Most firms use short-term financing to some extends to support its assets, especially current

assets. The use of short-term financing is dynamic due to its short maturity and volatile

interest costs. Although short-term debt is generally riskier than using long-term debt, it does

have some offsetting advantages. The pros and cons of financing with short-term debt are

considered below.

1. Flexibility. If the needs for funds are seasonal or cyclical, the use of short-term

financing is more appropriate as the firm may not want to commit itself to long-term

debt. Long-term debt can be repaid early, provided the loan agreement includes a

prepayment provision; but, even so, prepayment penalties can be expensive.

2. Cost of short-term debt is lower. If the yield curve is upward sloping, as it often is,

then interest will be lower on short-term rates than on long-term rates.

3. Relative riskiness of long-term and short-term Debt. In general, the use of short-

term debt by the firm tends to be riskier than using long-term debt. This extra risk is

due to:

a. Short-term interest rates tend to fluctuate widely while a firm using long-term

debt can "lock-in" a given rate, and

b. If a firm borrows heavily on a short-term basis, it may find itself unable to

repay or rollover this debt.

In the following sections, several sources of short-term financing will be discussed under

three categories:

1. Internal or Spontaneous financing, for example Accruals and Account Payable

2. Direct Borrowing from banks/Unsecured financing. For example, Notes Payable,

Line of Credit, Revolving Credit Agreement (RCA), Commercial Paper


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3. Secured financing, for example, Account Receivable Loan, Inventory Loan.

7.1 INTERNAL OR SPONTANEOUS FINANCING This particular source of short-term financing is internally generated from normal business

activities, and may represent a cheap source of funds. However, the company has limited

control and its source is not permanent.

7.1.1 Accrued Wages and Taxes

These are the liability for services received for which payment has yet to be

paid

Firms generally pay employees on a weekly, biweekly, or monthly basis, so

the balance sheet will typically show some accrued wages. Similarly, most

firms show accrued taxes on their balance sheets. These accruals increase

spontaneously as a firm's operations expand, but the firm cannot ordinarily

control them. Thus, firms use all the accruals they can, but they have little

control over the level of these accounts.

7.1.2 Accounts Payable or Trade Credit

This is when trade credit is given to the firm by the supplier. Firms generally make purchases of goods and materials from other firms on

credit, recording the debt as an account payable. Accounts payable or trade

credit is the largest single category of short-term debt. It represents about 40

percent of the current liabilities of non-financial corporations. Trade credit is a

spontaneous source of financing in that it arises from ordinary business

transactions. The following examples illustrate how to determine the cost of

financing involved.

Example 1

Accounts payable - to calculate cost of foregoing cash discount. If a firm

extended credit terms that include a cash discount, it has two options:

a) Take the cash discount and pay early

b) Forgo cash discount and pay at the end of the credit period


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An example: Tatoo Company purchased RM 1000 worth of merchandise on

February 27th from a supplier extending terms of 2/10 net 30 caps (end of the

month.)

a. If the firm takes the cash discount, it will have to pay

= RM 1000 – 0.02 (RM 1000)

= RM980 ON March 10th.

b. If it foregoes the discount, it will have to pay full amount

RM 1000 on March 30th.

Therefore, cost of foregoing discount:

= CD X 360 1 – CD N

Where CD = Cash Discount

N = The difference between discount period and

credit period.

= 0.02 x 360 1 – 0.02 20

= 36.73%

Decision:

(i) The firm must forego the discount if it needs money

and has no alternative sources of short-term financing.

(ii) The firm must take the discount if it already has

sufficient short-term financing.

Example 2

A trade credit of 3/15, net 30 means that a 3 percent discount is given if

payment is made within 15 days of the invoice date; otherwise full payment is

due and payable within 30 days. Suppose your firm makes average daily

purchases of RM2,000, and decided to pay in 30 days, you will enjoy a

RM60,000 (=2,000 x 30) credit facilities (accounts payable) from your


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suppliers. If your sales, and consequently purchases were to double, then its

accounts payable would increase to RM120,000. You will generate an

additional RM60,000 of financing.

For a given credit term, it involves two components of trade credit:

(i) Free Trade Credit. It involves credit received during the discount

period for 10 days. To enjoy this privilege, the firm must pay within

10 days at 2 percent discount allowed.

(ii) Costly Trade Credit. It involves credit more than the free credit or

beyond the discount period. This credit has an implicit cost equal to

the foregone discounts.

We could use the following the annualized opportunity cost of not taking the discount (AOC) formula to calculate the approximate annual percentage

cost of not taking discounts for the above example.

Let D : Discount rate percentage

CP : Credit period or days taken to pay

DP : Discount period

AOC = [D / (100 – D)] x [360 / (CP – DP)

= [3 / (100 – 15] x [360 / (30 – 15)

= %

From the formula, paying late can reduce the cost. For example if Heat could

get away with paying in 90 days rather than 30 days, the cost would be:

AOC = [D / (100 – D)] x [360 / (CP – DP)

= [3 / (100 – 3)] x [360 / (90 – 15)

= 14.83%

There are, however, problems associated with this practice. The first problem

is that Heat may not be able to get away with practice for very long; and

secondly, their credit reputation may be affected, thus impairing their ability to

obtain credit from other sources.


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7.2 DIRECT BORROWINGS FROM BANKS/UNSECURED FINANCING

Another form of short-term financing is from external sources. In this case, the firm is

requires to request, negotiate for the funds, or issue financial securities for funds. It may

represent a higher cost of funds and is required to go through certain procedures and

involves costs before it can be obtained. On the other hand, the source of funds is relatively

stable and the firm can exercise certain level of control. Funds raised by the firm without

pledging an asset as collateral.

7.2.1 Short-Term Bank Loans

Short-term loans from banks appear on firm's balance sheets as notes

payable, are second in importance to trade credit as a source of short-term

financing. The banks' influence is actually greater than it appears from the

Ringgit amounts they lend. This is because banks provide non-spontaneous

funds; that is, as a firm's financing needs increase, it will request its bank to

provide the additional funds. If the request is denied, then the firm may be

forced to reduce its rate of growth. However, that often firms have pre-

arranged credit line agreements with their bank and short-term loans may be

practically spontaneous. Several sources of unsecured financing are:

a) Notes payable - it is a single payment loan obtained from a

commercial bank by credit-worthy business

borrower. This type of loan is made when a

borrower needs additional funds for a short

period only.

The instrument resulting from this type of short

term unsecured loan is a note which must be

signed by the borrower. The note states the

term of the loan, the maturity date and the

interest charged.

b) Line of Credit - It is an agreement between a commercial bank

and a business firm that states the amount of

unsecured short-term borrowing the bank

will make available to the borrower. Typically it

is made for a period of one year.


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It is not a guaranteed loan but it indicates that if

the bank has sufficient funds available, it will

allow borrower to owe it up to a certain amount

of money.

It eliminates the need to examine the credit

worthiness of a customer each time it borrows

money.

The borrower must apply each time he wants to

obtain a line of credit and submit documents

such as cash budget, proforma income

statement and proforma balance sheet. The

interest rate is normally stated as the prime interest rate plus a certain percentage (as a

risk of credit worthy).

c. Revolving credit - It is a guaranteed line of credit. The

agreement (RCA) commercial bank making the

agreement guarantees the borrower that a

specified amount of funds will be made

available regardless of the tightness of money.

The RCA could be for one, two or three years

depending on the agreement.

The requirement for the agreement is the same

as line of credit but a commitment fee is

charged to the borrower on the unused balance of the credit agreement.

d. Commercial paper - It is a form of financing that consists of short-

term, unsecured promissory notes issued by

firms with a high credit standing. Generally,

only large corporations with good reputation are

able to issue commercial paper, (e.g. Telekom,

Renong etc.)


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Most commercial papers have maturities

ranging from 3 to 270 days. It is generally

issued in multiples of RM100,000 or more.

The sales of it can be done by placing directly

with the investors or through a commercial

paper dealers where a dealer’s for is charged.

7.2.2 Cost of Bank Loans The cost of bank loans varies for different borrowers at a given time,

depending on their credit risks and terms in securing the loans. In general,

interest rates are higher for riskier borrower and for smaller loans. If a firm

can qualify as a "prime risk" because of its size and financial strength, it can

borrow at the prime rate; that is the lowest rate that banks charge. Rates on

bank loans are based on base lending rate (BLR) plus certain percentage

point relative to the borrower's credit risk. Key terms to understand in

determining the cost of bank loans are:

a) Nominal Interest Rate

Interest rates unadjusted for inflation or terms of borrowings. It is

normally stated at face value of the interest charged on borrowings.

b) Effective Annual Interest Rate

The interest rates as if it is were compounded once per time period

rather than several times per period. It is the actual cost of borrowings

after taking into considerations of differential in periods of

compounding and terms associated with the borrowings.

c) Discounted Loans

Interest on loans is paid in advance or at the beginning of the loan

period. Therefore, it reduces the loan proceeds or the actual amount

of RM that can be used by the borrower.


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d) Compensating Balances

Deposit that the firm keeps with the bank in a low-interest or non-

interest bearing to compensate for bank loans or services. These

requirements will also reduces the loan proceeds.

The effective interest rates (EIR) on loans can be calculated in several

different ways depending on the terms of the loan. To illustrate, let assume

Alert Berhad is planning to borrow RM10,000 term loan at 12 percent for: (1)

one year; and (2) 6 months. The basic cost equation equals interest divided

by net proceeds; that is amount borrowed minus costs:

EIR = Interest / Net proceeds Where…

Interest = (Principal)(Rate) (Time or maturity)

Net proceeds = Principal – Discounted interest – Compensating Balance

The above equation is applicable only if the maturity is for one year. Different

maturity periods require some adjustment as follows:

EIR = (Interest / Net proceeds) (12 / maturity in months)

The following example will illustrates the calculation of EIR using Alert Berhad loans

requirement of RM10,000 at 10% with various terms and maturity.

1. Regular, collect, or Simple Interest. This is the typical loan, whereby the

borrower receives RM10,000 now and repays RM11,200 at the end of the

year, or RM10,600 after 6 months.

For 1 year

• Interest = RM10,000(0.12) = RM1,200

• Net proceeds = RM10,000 – RM0 = RM10,000

Effective Interest Rate = RM1,200 / RM10,000 = 12%

For 6 months

• Interest = RM10,000 (0.12)(6 / 12) = RM600

• Net proceeds = RM10,000 – RM0 = RM10,000


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Effective Interest Rate = (RM600 / RM10,000)(12 / 6) = 12%

2. Discounted Interest. If the bank deducts the interest in advance; that is

discounts the loan, the effective rate of interest is increased. On the one year,

RM10,000 loan for 12 percent, the discount is RM1,200, and the borrower

obtains the use of only RM8,800. The effective rate of interest is 13.64

percent versus 12 percent on a simple interest loan.

For 1 year

• Interest = RM10,000(0.12) = RM1,200

• Net proceeds = RM10,000 – RM1,200 = RM8,800

Effective Interest Rate = RM1,200 / RM8,800 = 13.64% For 6 months

• Interest = = RM600

• Net proceeds = = RM9,400

Effective Interest Rate = = 12.77%

3. Compensating Balancing. With the present of compensating balances on

loans, the effective interest rates on loans increased. For example, if

requirements for compensating balance equal to 10 percent of the amount of

the loan. The effective rate:

For 1 year

• Interest = RM10,000(0.12) = RM1,200

• Compensating balance = RM10,000(0.10) = RM1,000

• Net proceeds = RM10,000 – RM1,000 = RM9,000

Effective Interest Rate = RM1,200 / RM9,000 = 13.33%

For 6 months


• Compensating balance = = RM1,000




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In the event that the firms on the average maintain the amount required in its

account, the funds for compensating balance is not required. For example, if

the firm maintains on average RM1,500 in current account with the bank, the

RM1,000 for compensating balance can be ignored as the current balance is

enough to meet the CB requirements. Therefore, net proceeds will remains at

RM10,000.

4. Discounted loans and compensating balance. From above, let the

compensating balance of 10 percent and the loan is discounted.

For 1 year

• Interest = RM10,000(0.12) = RM1,200

• Compensating balance = RM10,000(0.10) = RM1,000

• Net proceeds = RM10,000 – RM1,000 – RM1,200

= RM7,800

Effective Interest Rate = RM1,200 / RM7,800 = 15.54% For 6 months


• Compensating balance = = RM1,000



The present of discounted interest and compensating balance will actually

increase the amount borrowed. This is particularly true in event if the firm really

needs RM10,000 and no less for the above illustration. For example in the case of

compensating balance of 8% and discounted interest of 10%:

Amount of Loan = (Funds Needed) / (1 – CB% - Interest rate)

= (RM10,000)/(1 – 0.08 – 0.10)

= RM12,195.12

The firm must pay is RM1,219.51 (=RM12,195.12 x 10%) in interest for one year and

maintain RM975.61 (=RM12195.12 x 8%) in compensating balance. Therefore, the

firm will only get use of RM10,000 (=12,195.12 – 1,219.51 – 975.61) , with the rest


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going to meet the discounted interest and the compensating balance requirements of

the bank. The effective rate of interest can be calculated as follows:

EIR = (Interest Paid)/(Funds Actually Used)

= RM1,219.51 / RM10,000

= 12.20%

Let’s Try The Following Exercise

Charles Corporation borrows RM 70,000 at 19%annual interest. Principal and

interest is due in one year. What is the effective interest rate?

i) Effective interest rate is calculated based on simple interest rate. Therefore:

a) Amount of Interest = Principal x rate x time

= 70,000 x 19% x 360 360 = 13,300

b) The proceeds = Total loan

= RM 70,000

c) Time period = 1/Time

= 1/360/360

= 1/1

EIR = Amount of Interest x 1/Time Proceeds

= 13,300 x 1/1 70,000

= 19%

ii) If the interest is deducted in advance (discounted), what is the new EIR?

EIR = 70,000 X 19% X 1 X 1/1 70,000 – (70,000 X 19%) = 13,300 X 1 X 1/1 56,700

= 23.5%

The interest rate is higher because we have to pay the interest in advance.

Therefore the amount of proceeds becomes less.


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iii) In order to ensure that the borrower will be a good customer, most short-term

unsecured bank loans require the borrower to maintain a compensating

balance in a checking account balance equal to a certain percentage of the

amount borrowed (normally between 10% - 20%)

Let’s say from the above example now we assume the bank requires a 20%

compensating balance. So the new EIR will be:

EIR = 70,000 x 19% x 1 70,000 – (20% X 70,000) = 13,300 x 1/1 56,000 = 23.75%

If the firm normally maintains a balance of RM 14,000 (i.e. 20%) or more in

the checking accounts, then the effective interest rate is more than the stated

interest rate i.e. 19%, so the borrower is at a disadvantage. The best option

is where EIR = stated interest rate.

7.2.3 Consumer Revolving Credit

Credit card companies, department stores, and banks grant consumers lines

of credit up to specified limits. Interest is calculated each month on the

outstanding balance, and this interest is added to the previous balance. Since

the interest on this type of credit is normally compounded monthly, the

effective rate on the credit will be higher than the stated rate that is in annual

terms.

7.2.4 Revolving Credit Agreement (RCA)

As previously mentioned, it is a formal arrangement between the borrower

and the bank. It involves commitment fee charged on the unused portion of

the facility granted. The commitment fee is a penalty for not using the total

amount allocated, and it is normally 0.25 percent to 0.50 percent on the

unused portion.

To illustrate, let assume that a firm has been granted a revolving credit

amounting RM100,000 at 14 percent annual interest and 0.50% of


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commitment fee. It only uses RM80,000 and RM20,000 left unused.

Therefore, to calculate the effective cost it will include a commitment fee.

For example:-

1) A commitment fee is charged to the borrower on the unused balance of the credit agreement. So the formula of calculating the EIR would

fbe adjusted as shown here:

EIR = Amount of interest + Commitment Fees x 1/Time The Proceeds

Interest = RM80,000 (0.14) = RM11,200

Commitment fee = RM20,000 (0.005) = RM100

Compensating balances = None = RM0

EIR = (Interest + Commitment Fee) (Amount Borrowed – Compensating Balances)

= (RM11,200 + 100) (RM80,000 – 0) = 14.13%

2) John Smith Company has RM 2 million RCA with its bank. Its average

borrowing under the agreement for the past year was RM 1.5 million,

at 10% stated interest rate.

• The bank charges a commitment fee of ½% of unused portion of the

commitment funds. Therefore:

EIR = (1,500 x 0.1) + (0.005 x 500,000) x 1/1

1,500

= 152,500 x 1/1

1,500,000

= 10.16%


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7.2.5 Overdraft

This is a short-term facility provided by commercial banks to current account

holders. It is designed to assists firms or individuals to cover their short-term

financial constraint. Before the facility is granted, certain requirements must

be meet by the customers. It allows the customer to withdraw more than the

current account's balance.

The interest charged is dependent upon the borrower's financial risk above

certain point of the bank's base lending rate. The interest is calculated on

daily basis and charges a penalty if the borrower does not pay the interest at

the end of the month.

7.2.6 Commercial Paper

Commercial paper is an unsecured promissory note issued by large and

financially strong firms. It is sold on discount basis primarily to other business

firms, to insurance companies, to pension funds and to banks. Although the

amounts of commercial paper outstanding are much smaller than bank loan

outstanding, this form of financing has grown rapidly in recent years.

This form of financing has a very short maturity, usually only one to six

months. The cost of commercial paper is usually about 0.5% (50 points) to

1.5% (150 points) below the prime rate and there are no compensating

balances required. In practice, the use of commercial credit is limited to a

comparatively small number of firms that are exceptionally good credit risks.

The ultimate suppliers of capital in the market are firms with temporary cash

surpluses. A firm can borrow in the commercial paper market one-month, and

supply funds to it the next month.

To illustrate the cost of commercial paper, assume that the firm plans to issue

RM100,000 commercial paper that can be sold at 94% of its face value. If

maturity is 6 months and the issuing cost is 5%, the effective rate:


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Interest = RM100,000 – RM100,000 (0.94) = RM6,000

Cost = RM100,000 (0.05) = RM5,000

EIR = [Interest / (Face value – Interest – Cost)](12 / maturity)

= [RM6,000 / (RM100,000 – RM6,000 – RM5,000)](12 / 6)

= 13.48%

Another example, if Renong Corporation, has just issued RM 1 million worth

of commercial paper that has a 90-day maturity and sells for RM980,000. At

the end of 90 days, the purchaser of this paper will receive RM 1 million for its

RM980,000 investment. Calculate the effective interest rate on the paper, if

interest is 2%

EIR = Amount of interest x 1/Time

Proceeds = 20,000 x1/90/360 980,000 = 20 x 1/Time 980 = 8.16%

Given a choice, it is ordinarily better to borrow on an unsecured basis, as the

bookkeeping costs of secured loans are often high. However, weak firms may

find that they can borrow only if they put up some kind security to protect the

lender, or that by using some security they can borrow at a lower rate. For a

firm, the types of assets used most often for securing loans is accounts

receivable and inventory.

7.2.7 Accounts Receivable Financing

Accounts receivable financing involves either the pledging of receivable or the

selling of receivable (called factoring) to secure a loan. The lender (finance

company) will evaluate the quality of the receivables to be pledged and the

average size of the account pledged. Accounts receivable pledging and

factoring services are convenient and advantageous, but they can be costly.

The credit-checking commission is 1% to 3% of the amount of invoices

accepted by the factor. The cost of money is reflected in the interest rate

(usually 2% to 3% over prime) charged on the unpaid balance of funds


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advanced by the factor. When the risk to the factoring firm is excessive, it

purchases the invoices at discount from the face value.

• Factoring.

Factoring involves the purchase of account receivable by the lender or

the factor and normally without recourse to the borrower or the seller.

The factor or the purchaser generally provides at least two of the

following services: (1) financing; (2) maintaining the accounts; (3)

collections, and (4) risk bearing. The seller can select various

combinations of these functions by changing provisions in the

factoring agreement. Several types of factoring are:

1. Confidential factoring or inter-credit factoring. The factor

enters into a factoring arrangement with the seller with a

recourse or non-recourse without the knowledge of the

customers. The supplier continues to collect payments from

the customers and forward the money to the factor. The factor

will act as a financier and advance immediate payment upon

completion of the formal documentation. In addition, the factor

will also maintain the ledgers.

2. Disclosed factoring. Or old-line factoring. The arrangement is

similar to the confidential factoring, but customers are notified

of the factoring arrangement. Therefore, the customers are

required to forward the monthly payments directly to the factor.

The factor will act as the financier and the administrator of the

debt.

3. Maturity factoring. The facility is similar to the disclosed

financing except there is no immediate cash advance is given

to the seller upon completion of the documentation. Payments

are made after collection or at an agreed maturity date,

whichever is earlier. This type of factoring is useful for

companies with no need for immediate cash, but cannot afford

customers delaying the settlement of debts beyond the agreed

credit period.


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• Costs of Factoring Factoring costs mainly consists of service charge and interest charge.

1. Service charge or administrative charge relates to the

administering of sales ledger, credit management and

collection services. The charges range form 0.75% to 2.5% of

the gross invoice value depending on the factor’s workload and

the receivables turnover.

2. Interest charge or discounted charge is the fixed interest

charged on the amount to be received by the firm. The rate

may range from 2% to 3.5% above the base-lending rate of the

factor.

To illustrate, assume that Silvering Company with an average monthly

sales of RM50,000 receivables is trying to obtain factoring financing

from a finance company. The receivables carries a 60-day credit

terms and the factor required a 2% factor’s fee, 6% reserve and 12%

interest per annum on advances. From the information given, the

commission, discount charges, maximum advance and the annual

percentage rate (APR) can be determined as follows:

Let C : Monthly commission rate

IV : Invoice value

r : Interest rate

n : Number of months

RE : Reserve

1. Face or invoice value = Monthly sales x Credit periods in

months

= 50,000 x 2

= 100,000

2. Monthly Commission = C x IV

= 0.01 x 100,000

= 1,000


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3. Monthly discount charges = IV – [IV x (1 + r/12) – n] = 200,000 – [200,000 x (1 + 12%/12– 1]

= 100,000 – 99,010

= 990

Therefore, total monthly charges = 1,000 + 990

= RM1,990.00

4. Reserve = RE x IV

= 6% x 100,000

= 6,000

5. Amount received = IV – Fees – Reserve

= 100,000 – 1,000(2) – 6,000

= 92,000

6. Interest = Amount receive x Monthly Interest x

Maturity in months

= 92,000(12%/12)2

= 1,840

7. Maximum advance = Amount receive – Interest

= 92,000 – 1,840

= 90,160

8. Total charges = Fees + Interest

= 1,000(2) + 1,840

= 3,840

9. APR = (Total charges / Maximum

advance) (12 / Maturity in months)

= (3,840 / 90,160)(12 / 2)

= 25.55%

Reserve does not represent a cost of factoring, and therefore the

factor will return the reserve to the borrower if the factor has collected

all the debts from the customers, less interest and fees. Beside the

higher costs of factoring, the company can reduce the overhead costs,


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improves cash flows, reduce bad debts and increase return on capital

by utilizing the factoring facilities.

Another example, if S.A. Berhad, a producer of children’s rainwear,

has recently factored a number of accounts. The factor holds an 8

percent reserve, charges on and deducts from the book value of

actored accounts a 2 percent factoring commission, and charges I 1

percent month interest (12 percent per year) on advances. The

company wishes to obtain an advanced on a factored account having

a book value of RM1,000 due in 30 days. Calculate the cost of

factoring these accounts.

1st: Calculate the proceeds to the company. RM Book value of account 1,000

Less: Reserve (8% x 1,000) 80

Less: Factoring commission (2% x 1000) 20

Funds available for advance 900

Less: Interest on advance (1% x 900) 9

Proceeds from advance 891 2nd: Calculate the effective annual cost of factoring E/R = Amount of Interest + Commission x 1/Time Proceeds = RM9 + RM20 x 1/30/360 = 29 x 12 891 = 39%

Even though the cost of factoring looks high, it provides some

advantages to the firms. First, it gives the firm the ability to turn

accounts receivable immediately into cash. Secondly, it ensures a

known pattern of cash flows. In addition, if factoring is undertaken on


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a continuous basis, the firm can eliminate its credit and collection

departments.

7.2.8 Pledging

When account receivables are used as collateral for loan, it is called Pledging

of receivables.

The pledging of account receivable is characterized by the fact that the lender

is not only has a claim against the receivables but also has recourse to the

borrower or the seller. If the receivables are uncollectible, the selling firm will

bear the loss. The borrower only pledges the account receivable as collateral

for a loan obtained from finance companies, and consequently the finance

company has the right to assess the creditworthiness of each of the accounts

pledged. Pledging receivables can be on:

a. Notification basis. The borrower notifies its accounts that payments on

the receivables are to be made directly to the lender or factor.

b. Non-notification basis. The accounts are not informed of the financial

agreements made between the borrower and the lender.

7.2.9 Costs of pledging

The costs of Pledging include interest levied on advances and processing

fees or services charges to cover the administrative costs.

The lender normally advance up to 75% of the face value of the receivables

pledge and charge certain percentage for processing fess and interest on the

advanced. To illustrate, let assume Andalusia Berhad pledges all its

receivable amounting to RM500,000 with a 60-day credit terms. The finance

company charges 1% processing fees every month, 10% interest per annum

and is willing to advance 70% of the face value of the receivables pledged.

From the information given, the maximum advance and the annual

percentage rate (APR) can be determined as follows:


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The face value RM500,000 Maximum advance = Face value x Rate of advance

= 500,000(0.70)

= 350,000

Interest = (Monthly rate)(maturity in months)(Advance)

= (0.10/12)(2)350,000

= 5,833.33 For 2 months

Processing fees = (Monthly fees)(Maturity in months)(Face value)

= (0.01)(2)500,000

= 10,000.00 For 2 months APR = [(Interest + Processing fees) / Advance] (12 / Maturity on months)

= [(5,833.33 + 10,000.00) / 350,000] (12 / 2)

= 27.14%

As shown in the above example, the cost of pledging 27.14% is relatively high

but it provides several advantages. Pledging is flexible and provides

continuous source of financing as long as new account receivables are

created. In addition, it will reduces the firm’s overhead dealing with the

receivables given that the lender provides billing and collection services.

Let’s look at another example: Bobby needs RM5 million for the two month period. The company has made

an arrangement with WIRA Bank for RM5 million loan secured by account

receivable. Bank has agreed to advanced 80% of the pledged receivable

(Book Value) at a rate of 12% per annum and 1% processing fees on all

receivables pledged.

1st You have to determine the Book Value, where:

Amount of loan = 80% x Book Value

RM5 mil = 80% x X

X = RM 5 mil 0.8

= RM6,250,000 (Book Value)


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2nd Therefore Processing fee can be calculated, that is Fees = 1% x Book Value

= 1% x 6,250,000

= RM62,500

3rd Determine the interest, where:

Interest = 12% x RM5 mil x 2/12

= RM100,000

To calculate the effective cost of pledging: ER = Interest + Processing fees x 1/Time Proceeds ER = RM100,000 + RM62500 x 1/60/360 RM5 million = 0.0325 x 6 = 19.5%

7.2.10 Inventory Financing

A rather large volume of credit is secured by inventories. If a firm is a

relatively good credit risk, the mere existence of the inventory may be a

sufficient basis for receiving an unsecured loan. Types of inventories that can

be used to secure short-term loans are not perishable, readily marketable and

have price stability. Inventory financing may occur through:

7.2.11 Floating Lien Arrangement

The lender receives a security interest or general claim on the firm’s entire

inventory that may include present and future inventory. Frequently used for

inventories with low average value and or with high turnover.

7.2.12 Trust Receipts

Under this agreement, the firm holds the inventory for the lender. Any

proceeds from the inventory must immediately forward to the lender. Mostly

used for large items with identifiable serial numbers for ease of control.


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7.2.13 Terminal Warehouse Receipts

Under a terminal warehouse arrangement, the inventory forwarded as

collateral will be stored in a bonded warehouse operated by a public

warehousing company. The Warehouse Company will issue a warehouse

receipt listing the specific items received, and will only release the inventory in

progress when authorized by the lender as the borrower repays the loan.

7.2.14 Field Warehouse Receipts

The same procedure is followed as in terminal warehouse receipt, except the

inventory is stored in the firm is own warehouse. However, the inventory

involved will be separated from the firm's other inventories under the control

of a field warehouse company. Only the lender has the authority to release

the goods.

7.2.15 Costs of secured loan Example 1

Let assume that Feres Industry Berhad is in need of 60-day loan RM200,000.

One of its bankers is willing to offer a secured loan under a floating inventory

lien with an interest of 14% per annum. The bank is willing to advance up to

40% of the average book value of the secured inventory. The effective

interest rate (EIR) for the loans:

Book value of the inventory = Amount needed / Percentage of advance

= 200,000 / 0.4

= 500,000

Interest costs = Principal x Rate x Time

= 200,000(0.14)(2 /12)

= 4,666.66

Effective interest rate = (Interest / net proceeds)(1 / time)

= 4,667.66 / 200,000)(12 / 2)

= 14.00%


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The effective cost of interest is similar to the stated rate as there is no

discounted interest, compensating balance and other costs involve.

Example 2 Milda Toy Company, a manufacturer of children’s plastic toys, needs a loan of

RM125,000 for 60 days. The company’s primary bank has told management

that a loan secured under a floating inventory lies is possible.

The annual interest rate would be about 14 percent. Funds would be

advanced up to 40 percent of the average book value of the secured

inventory. Calculate the cost of financing the inventory.

Book value of inventory as collateral = RM125,000 0.4 = RM312,500 The cost = 0.14 x 125,000 x 2/12 (the amount of interest) = RM2917 EIR = RM2917 x 2/12 125,000 = 14%


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QUESTION 1

a) Mustika Bhd. has a revolving credit agreement with AGS Bank under which it

can borrow up to RM15 million. The company must maintain a 10%

compensating balance on outstanding loans. Interest on the borrowed fund is

15% and the commitment fee is 1.5% on the unused portion of the credit line.

Find the effective interest rate for Mustika Bhd. if the amount borrowed is :

i) RM3 million (4 marks) ii) RM15 million (4 marks)

b) Ratu Bhd. has determined that it needs an additional capital of RM100 million.

The Financial Manager of the company has decided to issue a commercial

paper to fund the capital. The interest rate is 9.5% and the replacement fee is

RM150,000. The commercial paper has 270-day maturity. Calculate the

effective rate for this paper.

(4 marks) QUESTION 2 Define the following terms using examples:

i) Permanent asset investment.

ii) Temporary asset investment.

iii) Permanent sources of financing.

iv) Temporary sources of financing.

(10 marks)

QUESTION 3

a) Asahari Industries has a line of credit at Bank Sepuluh which requires it to

pay 11 percent interest on its borrowing and maintain a compensating

balance equal to 15 percent of the amount borrowed. The firm has borrowed


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RM800,000 during the year under the agreement. Calculate the effective

annual interest rate of the firm’s borrowing in each of the following

circumstances :

i) The firm normally maintains no deposit balances at Bank Sepuluh.

ii) The firm normally maintains RM70,000 in deposit balances at Bank

Sepuluh.

iii) The firm normally maintains RM150,000 in deposit balances at Bank Sepuluh.

iv) Compare, contrast and discuss your findings in (i), (ii) and (iii).

(15 marks) b) Do both trade credit and accruals represent a spontaneous source of capital

for financing growth? Explain.

(5 marks)


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Documents

FINANCE MANAGEMENT FIN420 chp 7