SHORT – TERM FINANCING

1. Flexibility – if the needs for funds are seasonal or cyclical, the use of short term financing is more appropriate (long term debt commit prepayment penalties that could be so expensive).

2. Lower cost of ST Debt – the interest will be lower on ST rates than on LT rates.

3. Relative riskiness of LT Debt and ST Debt – ST debt more riskier than LT debt due to the ST interest rates tend to fluctuate widely compared to LT.

1. Internal or Spontaneous Financinga. Accrued Wages and Taxes – firms generally pay employees on

a weekly, biweekly, or monthly basis, so the b/sheet will show some accrued wages. These accrual increase spontaneous as a firm’s operations expand, but the firm cannot ordinarily control it.

b. Accounts Payable or Trade Credit – firms generally make purchases of goods and materials from other firms on credit, recording the debt as an account payable. Then, trade credit is a spontaneous source of financing in that it arises from ordinary business transactions. Trade credit can be divided into 2:1. Free Trade Credit

2. Costly Trade Credit

Example:Let assume that Hebat Enterprises purchases materials on terms 3/15, net 30 from one of its supplier. On average, Hebat purchases RM 15 million per year and pay on the 15th day after invoicing and therefore takes advantage of the 3% discount. Find the net purchase per day and average accounts payable.

Net Purchase per day = [RM 15 million x (1 – 0.03)] / 360 = RM 40,417

Avg. Accounts Payable = 15 days x RM 40,417 = RM 606,255

Now suppose that Hebat decided not to take the discount, and instead will pay the full amount of the invoice after 30 days. The cost of this additional credit are:

Avg. Accounts Payable = 30 days x RM 40,417

= RM 1,212,510

Additional Credit = RM 1,212,510 – RM 606,255

= RM 606,255

Cost of Additional Credit = Discount Foregone

Additional Credit

= [(0.03)(RM 15 million)] = 74.22%

RM 606,255

Could also calculate using the following annualized opportunity cost of not taking the discount (AOC):

AOC = [D / (100 – D)] x [360 / (CP – DP)] = [3 / (100 – 3)] x [360 / (30 – 15)] = 74.22%

*CP = Credit Period or days taken to pay

DP = Discount Period

2. External or Spontaneous Financing (Direct Borrowings from Banks)i. ST Bank Loans – appear on balance sheet as notes payable.

Some features of bank loans are:a. Maturity – written as 90-day notes

b. Promissory Note – a legal document signed by both parties which specifies: (1) the amount borrowed, (2) the interest rate, (3) the repayment schedule, (4) collateral for the loan, and (5) any other agreed upon terms and conditions.

c. Compensating Balances – many banks require that customers leave some percentage of borrowings on deposit at the banks= as a compensating balance.

d. Line of Credit – the maximum size loan that the bank will allow the borrower.

e. Revolving Credit Agreement – firm pays commitment fee to obtain the agreement from the bank.

ii. Choosing a bank – there are several differences between various banks and these differences are listed below:a. Different Risk Attitudes – some banks follow conservative lending

while other banks tends to more aggressive in their lending.

b. Counsel Provided – some banks have officials that provide active and ongoing counsel and advice to their loan accounts.

c. Bank Loyalty – banks will differ in the extent to which they will support the activities of the borrower in bad times.

d. Loan Specialization – larger banks have separate documents that specialize in different types of loans. For example, real estate loans (property), hire and purchase (cars) and others.

e. Size of the Bank and the Firm – choose the bank that could provide a better services.

f. Other services – include (1) electronic funds transfers and online banking, (2) foreign exchange operations, (3) pension funds and trust services, and (4) lock-box and collection services.

iii. Cost of Bank Loans – varies for different borrowers at a given time, depending on their credit risks and terms in securing the loans. Rates on bank loans are based on base lending rate (BLR) plus certain percentage point relative to the borrower’s credit risk. a. Nominal Interest Rate – interest rate unadjusted for inflation or terms

of borrowings. It is normally stated at face value of the interest charged on borrowings.

b. Effective Annual Interest Rate – the actual cost of borrowings after taking into considerations of differential in periods of compounding and terms associated with the borrowings.

c. Discounted Loans – interest on loans is paid in advance or at the beginning of the loan period.

d. Compensating balance – deposit that the firm keeps with the bank in a low-interest or non-interest bearing to compensate for bank loans or services.

The Effective Interest Rates (EIR) on loans can be calculated in several different ways depending on the terms of the loan.

Example:Let assume Azert Berhad is planning to borrow RM 10,000 term loan at 12% for (1) one year, and (2) 6 months.

(1) EIR = Interest / Net Proceeds(2) EIR = (Interest / Net Proceeds) x (12 / Maturity in months)

*Interest = (Principal) x (Rate) x (Time of Maturity) Net Proceeds = Principal – Discounted Interest – Compensating Balance

o Regular, Collect, or Simple InterestFor 1 year

Interest = RM 10,000 (0.12) = RM 1,200

Net Proceeds = RM 10,000 – RM 0 – RM 0 = RM 10,000

EIR = RM 1,200 / RM 10,000 = 12%

For 6 months

Interest = RM 10,000 (0.12) (6/12) = RM 600

Net proceeds = RM 10,000 – RM 0 – RM 0 = RM 10,000

EIR = (RM 600 / RM 10,000) (12/6) = 12%

o Discount InterestFor 1 year

Interest = RM 10,000 (0.12) = RM 1,200

Net Proceeds = RM 10,000 – RM 1,200 = RM 8,800

EIR = RM 1200 / RM 8,800 = 13.64%

For 6 monthsInterest = RM 10,000 (0.12) (6/12) = RM 600Net Proceeds = RM 10,000 – RM 600 = RM 9,400

EIR = (RM 600 / RM 9,400) (12/6) = 12.77%

o Compensating Balancing If requirements for compensating balance = 10% of the amount of the loan.

For 1 yearInterest = RM 10,000 (0.12) = RM 1,200

Compensating Balance = RM 10,000 (0.10) = RM 1,000Net Proceeds = RM 10,000 – RM 1,000 – 0 = RM 9,000

EIR = RM 1,200 / RM 9,000 = 13.33%

For 6 monthsInterest = RM 10,000 (0.12) (6/12) = RM 600

Compensating Balance = RM 10,000 (0.10) = RM 1,000Net Proceeds = RM 10,000 – RM 1,000 – 0 = RM 9,000

EIR = (RM 600 / RM 9,000) x (12/6) = 13.33%

o Discounted Loans and Compensating BalanceLet the compensating balance of 10% and loan is discounted.

For 1 yearInterest = RM 10,000 (0.12) = RM 1,200

Compensating Balance = RM 10,000 (0.10) = RM 1,000Net Proceeds = RM 10,000 – RM 1,000 – RM 1,200 = RM 7,800

EIR = RM 1,200 / RM 7800 = 15.54%

For 6 monthsInterest = RM 10,000 (0.12) (6/12) = RM 600

Compensating Balance = RM 10,000 (0.10) = RM 1,000Net Proceeds = RM 10,000 – RM 1,000 – RM 600 = RM 8,400

EIR = (RM 600 / RM 8,400) (12/6) = 14.29%

o Installment Loans - known as a flat rate (compounding interest)

Example:

Suppose you plan to purchase a brand new car at RM 40,000 with RM 10,000 down payment. The interest on the loan is 8% and is to be repaid in 6 years of monthly installment. The monthly payments:

Cost of the car RM 40,000

(-) Down payment 10,000

Amount borrowed 30,000

6 years (8%) 14,400 = 30,000 (8%)(6)

Face amount of loan 44,400

Divide by no. of months 72 = 12 months x 6

Monthly payments RM 616.67

So, the approximate effective rate (EIR):

EIR = Average Annual Interest Loan Amount /2

= [(RM 30,000)(0.08)] (RM 30,000/2)

= 0.16@16%

o Revolving Credit Agreement – a formal agreement between the borrower and the bank. It involves commitment fee charged on the unused portion of the facility granted.

Example:

Let assume that a firm has been granted revolving credit amounting RM 100,000 at 14% annual interest and 0.50% of commitment fee. It only uses RM 80,000 and RM 20,000 left unused. The effective cost per year:

Interest = RM 80,000 (0.14) = RM 11,200

Commitment Fee = RM 20,000 (0.005) = RM 100

Compensating balances = None

EIR = (Interest + Commitment Fee) / (Amount Borrowed – Compensating balance)

= (RM 11,200 + 100) / (RM 80,000 – 0) = 0.1413@14.13%

o Commercial Paper – an unsecured promissory note issued by large and financially strong firms. It is sold on discount basis primarily to other business firms, to insurance companies, to pension funds, and to banks.

Example:

Assume that the firm plans to issue RM 100,000 commercial paper that can be sold at 94% of its face value. If maturity is 6 months and the issuing cost is 5%, the effective rate:

Interest = RM 100,000 – RM 100,000 (0.94) = RM 6,000

Cost = RM 100,000 (0.05) = RM 5,000

EIR = [Interest / (Face Value – Interest – Cost)] x (12 / maturity)

= [RM 6,000 / (RM 100,000 – RM 6,000 – RM 5,000)] x (12/6)

= 0.1348 @ 13.48%

3. Accounts Receivable and Inventory Financingi. Accounts Receivable – involves either the pledging of

receivable of the selling of receivable (called factoring) to secure a loan. a. Pledging – the lender is not only claim against the receivables but

also has recourse to the borrower or the seller that is if receivables are uncollectible, the selling firm will bear the loss. Pledging receivables can be on:

Notification basis – notifies the payments on the receivables are to be made directly to the lender

Non-notification basis – not informed of the financial agreements made between the borrower and the lender.

b. Factoring – involves the purchase of account receivable by the lender and normally without recourse to the borrower. The purchaser will provide 3 services: (1) credit checking; (2) lending; and (3) risk bearing.

ii. Inventory Financing – large volume of credit is secured by inventories. Types of inventories that can be used to secure ST loans are not perishable, readily marketable and have price stability. Inventory financing may occur through:a. Floating Lien Arrangement – the lender receives a security interest or

general claim on the firm’s entire inventory that may include present and future inventory.

b. Trust receipts – the firm holds the inventory for the lender. Mostly used for large items with identifiable serial numbers for ease of control.

c. Terminal warehouse receipts – the inventory forwarded as collateral will be stored in a bonded warehouse operated by a public warehousing company.

d. Field warehouse receipts – the same procedure is followed as in terminal warehouse receipt, except the inventory is stored in the firm is own warehouse.