Working Capital Management

1
Spring 2008

• Chapter 21 - V
• Working Capital Management

2
SHORT-TERM BANK LOANS

• On the balance sheet, short-term bank loans is
  represented by the account notes payable.
• Short-term bank loans are a nonspontaneous source
  of funding.
• They are crucial because they are the prime
  source of funding the cash conversion cycle gap.

3
Advantages of short-term bank loans

• Obtained faster than long-term sources of funding
  (no SEC registration)
• More appropriate for funding seasonal needs.
• short-term loans normally carry a lower i-rate
  than long-term loans.

4
Disadvantages of short-term bank loans

• Short-term i-rates are much more volatile than
  l.t. i-rates
• Short-term debt must be refinanced more
  frequently, and the ability to refinance may be
  in question in a recession.

5
Features of short-term bank laons

• Often written as 90-day notes.
• They are a promissory note specifying amount
  borrowed, interest rate, repayment schedule,
  collateral (if any), and any other agreed-upon
  terms.

6

• May require compensating balances of 10-to-20 of
  the loans face value.
• This raises the effective interest rate on the
  loan, but the practice is less common now than in
  the past.

7
Forms of short-term credit

• A letter of credit is a bank guarantee to make
  funds available if company cannot or will not
  make payment.
• A line of credit allows the company to
  automatically borrow up to a pre-specified limit.
• - line is not guaranteed with a MAC clause
  (material adverse change).
• - typically require 30-60 days of a clean
  balance to ensure line is not being used as
  long-term financing.

8

• A revolving credit agreement is a more formal
  version of a line of credit.
• - bank is committed to provide the line (often a
  for 2-5 year period)
• - restrictive covenants are required
• - commitment fees are charged on unborrowed
  portion of the line
• - more common with larger companies

9

• Example - Assume that Smith Corp has established
  a 50 million revolving credit agreement at an
  i-rate of 6 and with a commitment fee rate of
  1.2. If it uses 40 million of the line for
  eight months (and none of the line for the other
  four months), what are its total fees for the
  year? What is the nominal cost of providing the
  funds used?

10

• The recent trend is for banks to issue credit
  cards that act as a committed line of credit.
• - Wells Fargo offers small businesses a credit
  card of this sort.
• - Groups of banks may participate together in
  issuing credit cards for large companies.

11
BANKERS ACCEPTANCE

• Process
• A US company importing goods (buyer) requests a
  US bank to issue a letter of credit ensuring
  payment.
• The US bank authorizes the foreign exporter
  (seller) to draw a time draft on the letter of
  credit in payment for goods delivered.

12

• The exporter can discount the time draft with its
  foreign bank, receiving payment immediately.
• The foreign bank forwards the time draft to the
  US bank.
• Once accepted by the US bank, the time draft
  becomes a negotiable money market security (a
  bankers acceptance) that trades in the money
  market until maturity.

13
COMMERCIAL PAPER

• Unsecured promissory note (although backed by a
  line of credit or letter of credit)
• Maximum maturity is 270 days (to avoid SEC
  registration), 30 days is most common.
• Most is sold on a discount basis, although some
  are interest-bearing.
• Only very large, financially sound firms can sell
  commercial paper.

14

• Heaviest sellers of commercial paper are consumer
  finance companies.
• Commercial finance and bank holding companies
  sell paper directly to investors, while paper of
  nonfinancial companies is underwritten by
  commercial paper dealers (dealer paper).

15

• Commercial paper yields are only slightly higher
  than T-bill yields.
• This makes commercial paper the lowest-cost
  source of funding available to businesses.
• (Author) April 2005
• iprime5.75 iT-bills 2.82 iCP3.09

16
Commercial paper ratings

• Primary agencies that rate commercial paper are
  Standard Poors, Moodys, Fitch Investor
  Services Corp, and Canadas Dominion Bond Rating
  Service Ltd.
• Ratings range from A to D with refinements like
  A1 to A3, and finally a for the strongest
  firms. So, the highest possible rating is A1.
• Higher ratings mean lower yields.

17
Pros and cons of commercial paper as a source of
funds

• Primary advantage
• Lowest-cost source available
• Primary disadvantages
• very impersonal extensions are not feasible
• commercial paper market disappears in recessions

18
Euro commercial paper

• Many top-rated US corporations now issue
  commercial paper targeted for foreign investors.
• Advantages
• - not subject to SEC requirements
• - not typically rated
• - back-up lines of credit not typically required

19

• Comparison to US market
• - Euro CP maturities are typically longer
  (usually in 60-90 day range)
• - Euro CP issued by US companies face shorter
  effective maximum maturity of 183 days because of
  US withholding tax considerations

20
Securitization of commercial paper

• Some commercial paper is collateralized by a pool
  of financial assets (mortgages, auto loans,
  credit card receivables).
• This type of commercial paper is issued by banks
  and large finance companies to raise funds.

21
USE OF SECURITY IN SHORT-TERM FINANCING

• This topic is deferred to Chapter 22