11 9 th CHAPTER NINT H EDITIO N

11 9 th CHAPTER NINT H EDITIO N Foundations of Financial Management ELEVEN Sources of Short‑Term Financing Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management T 6 -1 NINT H th EDITIO N There are various sources of short-term funds available to a firm: – Trade Credit from Suppliers – Bank Loans – Corporate Promissory Notes – Foreign Borrowing – Loans Against Receivables and Inventory Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -2 NINT H N I. Trade Credit The largest provider of short‑term credit is in the form of account payable. Payment period Trade credit is usually extended for 30 to 60 days. Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -3 NINT H N I. Trade Credit Cash discount policy A cash discount allows a reduction in price if payment is made within a specified time period. Cost of failing Discount % 360 = ------------ x --------------------to take discount 100%‑Discount % Final due date ‑Discount period Ex: A 2 / 10, net 90 days Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -4 NINT H N I. Trade Credit Net Credit Position - A firm’s Accounts Receivable (A/R) minus its Accounts Payable (A/P) - If A/R is greater than A/P, it is a net provider of trade credit (positive number) Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -5 NINT H N I. Trade Credit - If A/P is greater than A/R, it is a net user of trade credit (negative number) - Larger firms tend to be net providers of trade credit, while smaller firms are net users Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -6 NINT H N I. Trade Credit If a firm has average daily sales of $5, 000 and collects in 30 days, the accounts receivable balance will be $150, 000. If this is associated with average purchases of $4, 000 and a 25 days average payment period, the average accounts payable balance is $100, 000. Indicating $50, 000 more in credit is extended than receivable. Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -7 NINT H N II. Bank Credit Prime Rate - The interest rate charged to a bank’s best customers - Acts as a benchmark for calculating other interest rates The London Interbank Offer Rate (LIBOR) U. S. dollar deposits is being used worldwide as a base lending rate on dollar loans. Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -9 NINT H N II. Bank Credit Compensating Balance - When a bank requires a minimum average account balance in order to qualify for a loan - Can be thought of as a form of collateral Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -10 NINT H N II. Bank Credit Ex: If you need $100, 000 in funds, you must borrow $125, 000. Amount to be borrowed = Amount needed / ( 1 - C ) Block Hirt Irwin/Mc. Graw-Hill = 100, 000 / ( 1 - 0. 2 ) = $125, 000 ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -11 NINT H N II. Bank Credit Effective Interest Rate - The actual interest rate or “true” cost of a loan - Also known as the annual percentage rate (APR) Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -12 NINT H N II. Bank Credit Ex: $60 interest on $1, 000 loan for one year would carry a 6 percent interest rate. What is effective rate per year ? ER = ( I / P ) x ( 360 / Days loan ) = ( 60 / 1, 000 ) x ( 360 / 360 ) =6% Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -13 NINT H N II. Bank Credit Interest cost with discounted loan - When a bank deducts the interest on the loan in advance and lends the balance. Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -14 NINT H N II. Bank Credit Ex: a $1, 000 one year loan with $60 of interest deducted in advance. ER = ( I / ( P – I )) x ( 360 / Days loan ) = (60 / ( 1, 000 – 60 ) ) x ( 360 / 360 ) = 6. 38% Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -15 NINT H N II. Bank Credit Interest costs with compensating balance When a compensating balance is required as part of the loan Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -16 NINT H N II. Bank Credit Ex: 6 percent is the state annual rate and 20 percent compensating balance is required. ER = I -------1 - C = 6 % / ( 1 – 20% ) = 7. 5% Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -17 NINT H N II. Bank Credit Ex: We are paying $60 interest on a $1, 000 loan, but are able to use only $800 of the funds. The loan is for a year. ER = I ------P-C x 360 -------Days loan = ( 60 / ( 1, 000 – 200 )) x ( 360 / 360 ) = 7. 5 % Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -18 NINT H N II. Bank Credit Interest cost on installment loan - Calls for a series of equal payments over the life of the loan - ex. , most car loans and home mortgages Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 Foundations of Financial Management th EDITIO T 6 -19 NINT H N II. Bank Credit Ex: you borrow $1, 000 on a 12 -month installment basis and the interest requirement is $60. 2 x No of Payment x I ER = ------------------( No of Payment + 1 ) x P = ( 2 x 12 x 60 ) / (( 12 + 1 ) x 1, 000 ) = 11. 08 % Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -20 NINT H N II. Bank Credit Commercial Paper: - A short-term unsecured promissory note issued to the public in minimum units of $25, 000 - Total amount of commercial paper outstanding has increased greatly in recent years Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -21 NINT H N II. Bank Credit Eurodollar - A U. S. dollar held or deposited in a foreign bank - Loans from foreign banks denominated in American dollars are called Eurodollar loans Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000

9 th EDITIO Foundations of Financial Management T 6 -22 NINT H N II. Bank Credit A/R financing includes 2 choices - Pledging accounts receivable as collateral for a loan - An outright sale (factoring) of receivables to a bank or finance company Block Hirt Irwin/Mc. Graw-Hill ©The Mc. Graw-Hill Companies, Inc. 2000