Chapter 20: Short Term Financing

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Chapter 20
May 11, 2009
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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 and inventory as
  collateral for short-term loans.

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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 their
  inventory or other short term asset needs rather
  than wait until they have saved enough.
• Firms prefer short-term financing instead of
  long-term sources of financing due to
• easier availability
• usually has lower cost (remember yield curve)
• matches need for short term assets, like inventory

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Sources of Short-term Financing

• Short-term loans.
• borrowing from banks and other financial
  institutions for one year or less.
• Trade credit.
• borrowing from suppliers
• Commercial paper.
• only available to large credit- worthy businesses.

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Types of short-term loans

• Promissory note
• A legal IOU that spells out the terms of the loan
  agreement, usually the loan amount, 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 Financial Institution
  occasionally with suppliers or equipment
  manufacturers

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Types of short-term loans

• Line of Credit
• The borrowing limit that a bank sets for a firm
  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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Trade Credit

• Trade credit is the act of obtaining funds by
  delaying payment to suppliers, who typically
  grant 30 days to pay.
• The cost of trade credit may be some interest
  charge that the supplier charges on the unpaid
  balance.
• More often, it is in the form of a lost discount
  that would be given to firms who pay earlier.
• Credit has a cost. That cost may be passed along
  to the customer as higher prices, (furniture
  sales, Office Max), or borne by the seller as
  lower profits, or some of both.

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Estimation of Cost of Short-Term Credit

• Calculation is easiest if the loan is for a one
  year period
• Effective Interest Rate is used to determine the
  cost of the credit to be able to compare
  differing terms.

Example You borrow 10,000 from a bank, at a
stated rate of 10, and must pay 1,000 interest
at the end of the year. Your effective rate is
the same as the stated rate 1,000/10,000
.10 10
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Variations in Loan Terms

• A discount loan requires that interest be paid up
  front when the loan is given.
• This changes the effective cost in the previous
  example since you only get to use
• (10,000 - 1,000) 9,000.
• Effective 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 kept in your
  bank account. It is taken from the amount you
  want to borrow.
• If your compensating balance requirement is 500,
  then the amount you can use is reduced by that
  amount.
• Effective Rate (APR) for a 10,000 simple
  interest 10 loan with a 500 compensating
  balance 1,000/(10,000-500) .1053 10.53.

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Both Discount Interest and Compensating Balance

• Sometimes, lenders will require both discount
  interest (paid in advance) and a compensating
  balance.
• If the interest is 1,000 and the compensating
  balance is 500, then the effective rate (APR)
  becomes
• 1,000 / 10,000 - 1,000 - 500
• 1,000 / 8,500 11.76

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Cost of Short Term Credit

• Cost of Trade Credit
• Typically receive a discount if you pay early.
• Stated as 2/10, net 60
• Purchaser receives a 2 discount if payment is
  made within 10 days of the invoice date,
  otherwise payment is due within 60 days of the
  invoice date.
• The cost is in the form of the lost discount if
  you dont take it.

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Calculating APR (same as EIR)

• Interest Rate x Principle x Time
• i.e. Int 6 x 1,000 x 90/360 15
• APR Interest (cost) x 1
• Net Borrowed Time
• APR 15 x 1 / 90 1.5 x 4
  6.0
• 1,000 360
• Say you have a loan fee of 5.00, then
• APR 15 5 x 1/90 2.0 x 4 8.0
• 1,000 360

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Cost of Trade Credit 2/10 net 60

• Assume your purchase is 100 list price.
• If you take the discount, you pay only 98. If
  you dont take the discount, you pay 100.
• Therefore, you (buyer) are paying 2 for the
  privilege of borrowing 98 for the additional 50
  days. (Note the first 10 days are free in this
  example).
• APR 2/98 x 365/50 14.9 (If you pay in 60
  days)
• What if 2/10, net 30
• APR 2/98 x 365/20 37.25! (If you pay in
  30 days)

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Commercial Paper

• Commercial paper is quoted on a discount basis,
  meaning that the interest is subtracted from the
  face value to arrive at the price. See 3 steps
  below for calculation
• Step 1 Compute the discount (D) from face value
  of the commercial paper
• Discount (D) (Discount rate x par x DTG)/365
• DTG days to go (to maturity)
• Step 2 Compute the price Face value -
  Discount
• Step 3 Compute Effective Annual Rate (APR)
• interest you pay/ you get to use

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Cost of Commercial Paper Example

• 1 million issue of 90 day commercial paper
  quoted at 4 discount rate. Step 1 Calculate D
  .04 x 1 mill. x 90 10,000
  360
• Step 2 Calculate price (amount you get)
  1,000,000 - 10,000
  990,000
• Step 3 Calculate effective rate (APR)
  10,000 / 990,000 1.010 x 4 4.04

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Accounts Receivable as Collateral

• A pledge is a promise that the borrowing firm
  will pay the lender any payments received from
  the accounts receivable collateral in the event
  of default.
• Since accounts receivable fluctuate over time,
  the lender may require certain safeguards to
  ensure that the value of the collateral does not
  go below the balance of the loan.
• So, normally a bank will only loan 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

• Average monthly sales 100,000
• 60 day terms, so average Acct Rec balance
  200,000
• Bank loans 70 of Accts Rec 140,000
• Interest is 3 over prime (say 8) 11 x
  140,000 15,400
• 1 fee on all receivables 1 x 100,000 x 12
  12,000
• APR 15,400 12,000 x 1/1 19.57!
• 140,000

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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 differ
  depending on the type of inventory.
• If inventory is long lived, i.e. lumber, they
  (lender or a customer) may loan you up to 75 of
  the resale value.
• If inventory is perishable, i.e., lettuce, you
  wont get much ?

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The End

• The End!

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Prof D
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Students