Essentials of Managerial Finance

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Chapter 15 Managing Short-Term Liabilities
(Financing)
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Short-term financing
Definition

• Any liability originally scheduled for repayment
  within one year

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Sources of short-term financing

• Accruals
• Continually recurring short-term liabilities
• Liabilities, such as wages and taxes, that
  increase spontaneously with operations
• Accounts Payable (Trade Credit)
• Credit created when one firm buys on credit from
  another firm
• Trade credit discounts should be taken when
  offered. Otherwise, the disadvantage is that the
  firms investment in accounts payable rises

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Sources of short-term financing

• Free Trade Credit
• Credit received during the discount period
• Costly Trade Credit
• Credit taken in excess of free trade credit,
  the cost of which is equal to the discount lost
• Short-Term Bank Loans

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Short-term bank loans

• Bank loans appear on a firms balance sheet as
  notes payable and they are second in importance
  to trade credit as a source of short-term
  financing. Bank loans are nonspontaneous funds.
  As a firms financing needs increase, it
  specifically requests additional funds from its
  bank.

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Key features of bank loans

• The bulk of banks commercial lending is on a
  short-term basis. Bank loans to businesses
  frequently are written as 90-day notes.
• When a firm obtains a bank loan, a promissory
  note is executed specifying (1) the amount
  borrowed, (2) the percentage interest rate, (3)
  the repayment schedule, (4) any collateral
  offered as security, and (5) other terms and
  conditions of the loan to which the bank and
  borrower have agreed.
• Banks sometimes require borrowers to maintain a
  compensating balance (CB) equal to 10 to 20
  percent of the face value of the amount
  borrowed. Such required balances generally
  increase the loans effective interest rate.
• A line of credit is an arrangement in which a
  bank agrees to lend up to a specified maximum
  amount of funds during a designated period.

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Key features of bank loans (continued)

• A revolving credit agreement is a formal, or
  guaranteed, line of credit often used by large
  firms.
• Unlike a line of credit, the bank has a legal
  obligation to provide the funds when requested by
  the borrower.
• The borrower will pay the bank a commitment fee
  to compensate the bank for guaranteeing that the
  funds will be available. This fee is paid on the
  unused balance of the commitment in addition to
  the regular interest charge on funds actually
  borrowed.
• Neither the legal obligation nor the fee exists
  under the general line of credit.
• As a general rule, the interest rate on
  revolvers is pegged to the prime rate, so the
  cost of the loan varies over time as interest
  rates change.

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The cost of bank loans

• The costs of bank loans vary for different types
  of borrowers at any given point in time and for
  all borrowers over time. Rates charged will vary
  depending on economic conditions, the risk of
  the borrower, and the size of the loan. Interest
  paid on a bank loan generally is calculated in
  one of three ways (1) simple interest, (2)
  discount interest, and (3) add-on interest.
• The prime rate is a published interest rate
  charged by banks to short-term borrowers (usually
  large, financially secure corporations) with the
  best credit. Rates on short-term loans are
  generally scaled up from the prime rate.

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Computing Cost of Short-Term Credit

• The numerator represents the dollar amount that
  must be paid for using the borrowed funds, which
  includes the interest paid, application fees,
  charges for commitment fees, and so forth.
• The denominator, the amount of usable funds, is
  not necessarily the same as the principal amount,
  or amount borrowed, because discounts or other
  costs might be deducted from the loan proceeds.

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Computing Cost of Short-Term Credit

• The EAR incorporates interest compounding in the
  calculation while the annual percentage rate
  (APR) does not.

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Computing Cost of Short-Term Credit
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The Cost of Trade Credit

• Determining the cost of trade credit is
  accomplished by calculating the periodic cost and
  multiplying it by the number of periods in a
  year.
• The following equation may be used to calculate
  the approximate annual percentage rate of not
  taking cash discounts
• APR Periodic cost ? Periods per year
• APR

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The Cost of Trade Credit - Example

• For example, the approximate cost of not taking
  the cash discount when the credit terms are 2/10,
  net 30, is
• 
  0.0204(18) 0.367 36.7.
• The approximation formula does not consider
  compounding, so the result is the simple annual
  percentage rate, or APR.

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Regular or simple interest rate loans

• With a regular, or simple, interest loan the
  borrower receives the face value of the loan
  (amount borrowed, or principal) and repays both
  the principal and interest at maturity.
• The face value is the amount of the loan, or the
  amount borrowed it is also called the principal
  amount of the loan.
• The only case in which the effective annual rate
  is the same as the simple interest rate is if the
  borrower has use of the entire face value of the
  loan for one full year, and the only cost
  associated with the loan is the interest paid on
  the face value.
• In such cases, interest compounding occurs
  annually

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Discount interest rate loans

• A discount interest loan is one in which the
  interest, which is calculated on the amount
  borrowed, is paid at the beginning of the loan
  period interest is paid in advance so the
  borrower receives less than the face value of the
  loan.
• The effective annual rate for a discounted loan
  is considerably greater than the effective annual
  rate for a simple interest loan with the same
  quoted rate and the same maturity because the
  borrower does not get to use the entire face
  value of the loan.
• If the discount loan is for a period of less than
  one year, interest compounding must be considered
  to determine the effective annual rate.
• Discount interest imposes less of a penalty on
  shorter-term loans than on longer-term loans.

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Installment loans Add-on interest

• Add-on interest is interest that is calculated
  and then added to the amount borrowed to obtain
  the total dollar amount to be paid back in equal
  installments.
• The approximate rate for an add-on loan can be
  determined by dividing the total interest paid by
  one-half of the loans face amount.
• To determine the precise effective annual rate of
  an add-on loan, the techniques of present value
  annuity calculations are used.
• The face value of the loan is the present value
  (PV), the annuity payments (PMT) are the face
  value plus the interest divided by the number of
  periods the loan is outstanding, and N is the
  number of periods the loan is outstanding.
• Once these values are entered in the calculator
  the periodic interest rate can be obtained. Then
  the periodic interest rate is used to determine
  the effective annual rate of the loan.

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Bank loans Computing the annual cost

• Simple interest with compensating balances

• The cost of loan with compensating balance is

APR kPER ?
,
APR
where N is the number of months of the loans
maturity and CB is the compensating balance as a
decimal.
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The effective cost of the loan

• The effective cost of the loan is calculated as
  follows
• (where kper is the percentage cost per period)
• 
  or

• If a firm normally keeps a positive checking
  account balance at the lending bank, then less
  needs to be borrowed to have a specific amount of
  funds available for use and the effective cost of
  the loan will be lower.

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Proposed problem
15-3 cost of bank loans (page 643)