Chapter 15 Managing Short Term Liabilities Financing Essentials

Chapter 15 Managing Short Term Liabilities (Financing) Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 19

Short term financing Definition • Any liability originally scheduled for repayment within one year Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 19

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 firm’s investment in accounts payable rises Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 19

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 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 19

Short term bank loans • Bank loans appear on a firm’s 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 firm’s financing needs increase, it specifically requests additional funds from its bank. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 19

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 main tain a compensating balance (CB) equal to 10 to 20 per cent of the face value of the amount borrowed. Such required balances generally increase the loan’s 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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 19

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 bor rowed. – 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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 19

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 con ditions, 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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 19

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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 19

Computing Cost of Short Term Credit • The EAR incorporates interest compounding in the calculation while the annual percentage rate (APR) does not. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 19

Computing Cost of Short Term Credit Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 19

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 = Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 19

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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 19

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 Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 19

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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 19

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 loan’s 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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 19

Bank loans: Computing the annual cost • Simple interest with compensating balances Compensating balance requirement = CB = Required loan (principal) amount ( Principal amount ) ( X Compensating balance stated as a decimal ) (Amount of usable funds needed) 1 - (CB as a decimal) = • The cost of loan with compensating balance is APR = k. PER , APR = where N is the number of months of the loan’s maturity and CB is the compensating balance as a decimal. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 19

The effective cost of the loan • The effective cost of the loan is calculated as follows: (where kper is the percentage cost 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. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 19

Proposed problem 15 3 cost of bank loans (page 643) Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 19