Short Term Financing ch'23

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Short Term Financing (ch.23)

• FINC5880 Spring 2008 Shanghai

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Alternative Current Asset Financing

• Self liquidating approach the useful life time
  of the asset is matched with its financing
• Aggressive approach the company finances part of
  its LT assets with short financing (taking the
  risk of changing r )
• Conservative approach the company finances LT
  also ST needs like part of the ST working capital
  requirements (avoiding any risk of changing r
  on short capital)

Making the fit
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Assignment Aggressive or conservative

• Consider your teams company assets LT and current
  over the past 5 years
• Consider the relation between LT assets and LT
  financing and ST assets and ST financing
• Does your teams company follow an aggressive
  approach or conservative
• What is your companies cost of short term
  financing? ( and/or USD)

In between the market and the company
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Short term financing
T Bond rates

• Advantages Fast, flexible, ST debt is cheaper
  then LT
• Disadvantages ST debt is riskier, ST rates vary
  highly

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Sources of ST Financing

• Accruals accrued wages (before salary payments
  are made), accrued taxes (before payment) This is
  interest free capital for the firm.
• Accounts Payables average 40 of current
  liabilities are APs its a trade credit the
  cost depends on discount for earlier
  paymentsthis is substantial

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AP and Financial Statements

• Taking more AP extends this financing source
• Taking more discounts reduces this source but
  increases income
• Whats better is matter of calculation!

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ST Bank Loans

• 66 of bank loans mature within 1 year
• This is the second most important source of ST
  financing
• The agreement is signed by promissory note
  (conditions of the loan)
• Sometimes the firm has to keep a compensating
  balance in account of say 20 of the total loan
  sum
• Informal line of credit firm can draw on good
  for ... account
• Revolving credit often accompanied by a clean up
  close (the balance has to be zero once a year at
  least)
• Bank loan rates move with the prime rate see
  what the prime rate has been over the past years
  to understand the differences in loan rates over
  the years

Where banks invest in.
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Prime rate is base rate for bank loans
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Low growth
High growth
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And now
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Promissory note conditions

• Interest only loan principal will be paid when
  the loan matures the interest rate can be fixed
  or floating
• Collateral generally accounts receivables or/and
  inventory
• Loan guarantees by the owner privately
• Interest is most likely paid monthly
• Maturity for short loans is anywhere in between
  30 days and 1 year
• Sometimes interest will be paid in advance (so
  called discount interest)
• Auto loans have an add-on character the interest
  over the life of the loan is added to the loan
  amount
• Key person (life) insurance guaranteesas
  collateral for the case something happens to key
  persons of the firm

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Banks bank

• Interest paid needs to be paid per month
• Interest on your savings you will get per quarter
  but more likely once per year
• Calculate what amount of interest you pay on a
  10 loan when you pay per month, quarter or per
  year (loan 10,000)
• The monthly rate 10/120.85
• Compounded0.8512 14,2!
• Quarterly 10/42.5
• Compounded 1.0254 10,4

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Discount loans

• Discount the interest up front and deduct it from
  the amount the borrower gets in hand
• Say 1yr loan 10 of 10.000 RMB would give the
  borrower RMB 9000 in hand

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Ready for the calculus?

• 10 per annum is the same as per quarter.
• Is 10 per annum the same if the year is based on
  360 days or 365 days?
• Is paying interest in advance the same as paying
  interest at maturity
• Is paying interest at the beginning of a period
  the same as paying interest at the end of that
  period?

Putting it together
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Your answers

• 1.10 per year is the same as (1.10)0.251.02411
  per quarter or 2,411
• 10 per annum is 10 per annum but the daily
  interest will be different 10/365
  days?10/360days
• Paying interest in advance reduces risk and
  increases liquidity so the interest amount paid
  will be different
• The same is true for paying interest pre/post
  period

Money-wise
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Discounted interest

• The bank deducts the interest on the loan up
  front so the borrower will receive the face value
  of the loan less the total interest to be paid
• The borrower can only default on the pay back of
  the loan
• If a loan of 10,000 has a 10 interest you will
  get 9,000
• The effective rate will be?

Magic Box
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Discounted rates

• Interest 1000
• Money in hands 9000
• Effective rate 1000/9000100 11,11 much
  higher then the nominal rate of 10

Testing your computer
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SOME BANKS ASK FOR COMPENSATING BALANCES

• Say loan is 10,000 and interest is 10 and the
  bank wants a 20 compensating balance
• The bank takes 1000 interest in advance and asks
  for a 2000 balance during the period of the
  loan
• You will get 7000, 2000 stays in the bank and
  8000 needs to be repaid at maturity
• Effective rate?

Experiments
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Your answer

• 1000 interest
• 7000 in hand
• 1000/ 7000100 14,29 much much higher then
  the nominal rate of 10

Money is costly
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Add on interest loans (installment loans like for
cars)

• A 10 loan of 10,000 to be repaid in 1 year in
  monthly installments
• You pay 1000 interest
• But after the first month 11/12 of the loan will
  be outstanding etc.
• On average 5000 will be outstanding during the
  year
• The effective rate is now?

Calculating
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Your staggering answer

• Average outstanding 5000
• Interest paid 1000
• Thus 1000/500010020!
• Twice as high as the nominal rate!
• You pay 11000 in 12 installments being 916,67
  per month
• The IRR of this stream of cash is ?

Got it!
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Your answers

• The IRR of these monthly installments is 1,50
  (rounded ) per month
• The effective annual rate is (11,5)12-1
  19,53
• The annual percentage rate is
• 1,512 17,97 ()

Pealing the Orange
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How to chose a bank

• Willingness to accept risk
• Based on the portfolio (risk spread) of the loans
  of the bank
• Degree of loyalty of the bank some banks rather
  leave their customers in bad times
• Some banks specialize in some sorts of credit
  or/and sectors
• The bank can not give loans higher then 15 of
  its capital to 1 customer (by law)

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Commercial Paper

• Only issued by large and strong firms
• Maturity 1 day-9 months
• Interest rate fluctuates with supply and demand
• Rates vary in between 1,5-3 below the prime rate
  and about 0,125-0,5 above T-bill rate!

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ST securities for financing

• Commercial Paper is never secured
• Loans can be secured
• Collateral can also be given in marketable stocks
  or bonds
• This reduces credit risk and lowers interest on
  the loan

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Many companies have strong seasonal financing
needs.
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Companies like this will negotiate an informal
line of credit with their bank

• Informal agreement between the bank and the
  company
• The bank will assess the companys credit line
  maximum
• The company will draw on this line during the
  year taking down of the line of credit
• The bank does not get a formal fee and the bank
  does not have any legal obligations to extend the
  line of credit in amount or time

Bird flue..egg sales and financing effects
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Revolving credit agreement

• Formal line of credit
• Based on contract and legal obligations
• Bank receives a commitment fee
• Companies pay a fixed fee on the unused part of
  the line of credit
• The rate of the loan is pegged to the T-bill rate
  for revolvers.

Revolvers are popular.
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Working Capital Management?