ShortTerm Financing

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Chapter 17

• Short-Term Financing

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CHAPTER 17Short-Term Financing

• Working capital financing policies
• Accounts payable (trade credit)
• Commercial paper
• Short-term bank loans
• Secured short-term credit

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Working Capital Financing Policies

• Maturity Matching Matches the maturity of the
  assets with the maturity of the financing.
• Aggressive Uses short-term (temporary) capital
  to finance some permanent assets.
• Conservative Uses long-term (permanent) capital
  to finance some temporary assets.

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Maturity Matching Financing Policy

Years
What are permanent assets?
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Aggressive Financing Policy

Years
More aggressive the lower the dashed line.
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Conservative Financing Policy

Years
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• The choice of working capital policy is a classic
  risk/return tradeoff.
• The aggressive policy promises the highest return
  but carries the greatest risk.
• The conservative policy has the least risk but
  also the lowest expected return.
• The moderate (maturity matching) policy falls
  between the two extremes.

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What is short-term credit?What are the major
sources?

• Short-term credit Debt requiring repayment
  within one year.
• Major sources
• Accruals
• Accounts payable (trade credit)
• Commercial paper
• Bank loans

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• Short-term debt is riskier than long-term debt
  for the borrower.
• Short-term rates may rise.
• May have trouble rolling debt over.
• Advantages of short-term debt.
• Typically lower cost.
• Can get funds relatively quickly with low
  transactions costs.
• Can repay without penalty.

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Is there a cost to accruals? Do firms have much
control over amount of accruals?

• Accruals are free in the sense that no explicit
  interest is charged.
• However, firms have little control over accrual
  levels, which are influenced more by industry
  custom, economic factors, and tax laws than by
  managerial actions.

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What is trade credit?

• Trade credit is credit furnished by a firms
  suppliers.
• Trade credit is often the largest source of
  short-term credit for small firms.
• Trade credit is spontaneous and relatively easy
  to get, but the cost can be high.

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JAWS buys 3,030,303 gross, or 3,000,000 net, on
terms of 1/10, net 30. However, the firm pays on
Day 40.How much free and costly trade credit
are they getting?What is the cost of the costly
trade credit?
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Gross/Net Breakdown

• Company buys goods worth 3,000,000. Thats the
  cash price.
• They must pay 30,303 more over the year if they
  forego the discount.
• Think of the extra 30,303 as a financing cost
  similar to the interest on a loan.
• Must compare that cost with the cost of
  alternative credit.

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Net daily purchases
.
Payables level if discount is taken Payables

Payables level if dont take discount
Payables
Credit Breakdown Total trade credit
Free trade credit Costly trade
credit
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Nominal Cost of Costly Trade Credit
Firm loses of discounts to obtain 250,000
in extra trade credit, so
But the 30,303 in lost discounts is paid all
during the year, not just at year-end, so the EAR
is higher.
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Nominal Cost Formula, 1/10, net 40
kNom x x

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Effective Annual Rate, 1/10, net 40
Periodic rate Periods/year EAR
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Commercial Paper (CP)

• CP are short term notes issued by large, strong
  companies. JAWS could not issue CP the company
  is too small.
• CP trades in the market at rates just above the
  T-bill rate.
• CP is bought by banks and other companies, then
  held as marketable securities for liquidity
  purposes.

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A bank is willing to lend JAWS 100,000 for 1
year at an 8 percent nominal rate. What is the
EAR under the following five loans?
1. Simple annual interest, 1 year. 2. Simple
interest, paid monthly. 3. Discount
interest. 4. Discount interest with 10 percent
compensating balance. 5. Installment loan,
add-on, 12 months.
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Why must we use Effective Annual Rates (EARs) to
evaluate the loans?

• In our examples, the nominal (quoted) rate is 8
  in all cases.
• We want to compare loan cost rates and choose the
  alternative with the lowest cost.
• Because the loans have different terms, we must
  make the comparison on the basis of EARs.

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Simple Annual Interest, 1-Year Loan
Simple interest means not a discount or add-on
loan. Interest
k
EAR




Nom
On a simple interest loan of one year, kNom EAR.
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Simple Interest, Paid Monthly
Monthly interest
0
1
12
...
-666.67
100,000
-667.67
-100,000.00
N
I/YR
PV
PMT
FV
(More)
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kNom
æ
ö
EAR


-

1

8.30
è
ø
or NOM, P/YR, EFF
Note If interest were paid quarterly, then
4
æ
ö
EAR


-

1
1
ç

è
ø
Daily, EAR
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8 Discount Interest, 1 Year
Interest deductible
Usable funds

0
1
i ?
-100,000
92,000
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Discount Interest (Continued)
Amount borrowed
Amount needed 1 - Nominal rate
(decimal)

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Need 100,000. Offered loan with terms of 8
discount interest, 10 compensating balance.
Face amount of loan
Amount needed 1 - Nominal rate - CB

(More...)
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Interest 0.08 (121,951) 9,756.
EAR


EAR correct only if amount is borrowed for 1 year.
(More...)
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8 Discount Interest with 10 Compensating
Balance (Continued)
0
1
i ?
N
I/YR
PV
PMT
FV
This procedure can handle variations.
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1-Year Installment Loan, 8 Add-On
Interest Face amount Monthly payment
Approximate cost
Average loan outstanding
(More...)
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Installment Loan
To find the EAR, recognize that the firm has
received 100,000 and must make monthly payments
of 9,000. This constitutes an ordinary annuity
as shown below
Months
0
1
12
2
...
i ?
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kNom APR EAR
NOM enters nominal rate
P/YR enters 12 pmts/yr
EFF
1 P/YR to reset calculator.
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What is a secured loan?

• In a secured loan, the borrower pledges assets as
  collateral for the loan.
• For short-term loans, the most commonly pledged
  assets are receivables and inventories.
• Securities are great collateral, but generally
  firms needing short-term loans generally do not
  have securities.

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Chapter 17 Extension Secured Short-Term Financing

• Accounts receivable financing
• Inventory financing

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Important Legal Forms

• Security Agreement Standard form under the
  Uniform Commercial Code. Specifies when lender
  can claim collateral if default occurs.
• UCC Form-1 Filed with Secretary of State to
  establish collateral claim. Prospective lenders
  will do a claims search, and wont make the loan
  if a prior UCC-1 has been filed.

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What is the difference between pledging and
factoring receivables?

• If receivables are pledged, the lender has
  recourse against both the original buyer of the
  goods and the borrower.
• When receivables are factored, they are generally
  sold, and the buyer (lender) has no recourse to
  the borrower.

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What are three forms of inventory financing?

• Blanket lien.
• Trust receipt.
• Warehouse receipt.
• The form used depends on the type of inventory
  and situation at hand.

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• The End

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