Chapter 19

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 19

Short-Term Financial Planning

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 19-

Chapter Outline

19.1 Forecasting Short-Term Financing Needs19.2 The Matching Principle19.3 Short-Term Financing with Bank Loans19.4 Short-Term Financing with Commercial Paper 19.5 Short-Term Financing with Secured Financing19.6 Putting it All Together: Creating a Short-Term

Financial Plan


Learning Objectives

• Forecast cash flows and short-term financing needs• Understand the principle of matching short-term needs to short-

term funding sources

• Know the types of different bank loans and their tradeoffs• Understand the use of commercial paper as an alternative to

bank financing

• Use financing secured by accounts receivable or inventory• Know how to create a short-term financial plan


19.1 Forecasting Short-Term Financing Needs

• The first step in short-term financing is to forecast the company’s future cash flows to discover:w Surplus or deficit?w Temporary or permanent?



• For example, look at the quarterly cash flows for Springfield Snowboards on the following slide. Is this company considered profitable?


Table 19.1 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Level Sales



• Answer: Springfield is considered a profitable company.

Quarterly net income is almost $500,000.• Based on these current projections, Springfield

will be able to fund projected sales growth from its operating profit and will accumulate excess cash on an on-going basis.



• Three reasons for short-term financingw Seasonalitiesw Negative cash flow shocksw Positive cash flow shocks



Seasonalities• When sales are concentrated during a few

months, sources and uses of cash are also likely to be seasonal.


Table 19.2 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Seasonal Sales



• Negative Cash Flow Shocksw A circumstance in which cash flows are temporarily

negative for an unexpected reason.


Table 19.3 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Level Sales and a Negative Cash Flow Shock



• Positive Cash Flow Shocksw Increased expected sales often require increased

short-term financing for items like marketing and production. Negative cash flow is created before the positive cash flow arrives.


Table 19.4 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Level Sales and a Growth Opportunity


19.2 The Matching Principle

• The matching principle states that short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds.



• Permanent working capital is the amount that a firm must keep invested in its short-term assets to support its continuing operations



• Temporary working capital is the difference between the actual level of investment in short-term assets and the permanent working capital investment.


Table 19.5 Projected Levels of Working Capital for Springfield Snowboards, 2010, Assuming Seasonal Sales



• Financing part or all of the permanent working capital with short-term debt is known as an aggressive financing policy



• Alternatively, a firm could finance its short-term needs with long-term debt, a practice known as a conservative financing policy


19.3 Short-Term Financing with Bank Loans

• Bank loans are typically initiated with a promissory note, which is a written statement that indicates the amount of the loan, the date payment is due, and the interest rate.

• There are three basic types:w Single, End of Periodw Lines of Creditw Bridge Loans



• Single, End of Period Payment Loanw A loan agreement requires that the firm pay interest

on the loan and pay back the principal in one lump sum at the end of the loan



Single, End of Period Payment Loan• Benchmark Interest Rates:

w Prime rate is the rate banks charge their most creditworthy customers.

w LIBOR is the rate of interest at which banks borrow funds from each other in the London interbank market.



Line of Credit• A bank agrees to lend a firm any amount up to a

stated maximum. • This flexible agreement allows the firm to draw

upon the line of credit whenever it chooses.



Line of Credit• Uncommitted: an informal agreement that does

not legally bind the bank to provide the funds• Committed: consists of a written, legally binding

agreement that obligates the bank to provide the funds regardless of the financial condition of the firm



Bridge Loan• A type of short-term bank loan that is often used

to “bridge the gap” until a firm can arrange for long-term financing.



Common Loan Stipulations• Commitment Fees: Various loan fees charged

by banks affect the effective interest rate that the borrower pays

• Loan Origination Fee: a bank charges this to cover credit checks and legal fees.

• Compensating Balance Requirements: reduces the usable loan proceeds

Commitment Fees: Example: $1 million committed line of credit with 10%

EAR and 0.5% EAR commitment fee. Firm borrows $800,000 and repays it at the end of the year.

What is the total cost of this loan?

Interest on borrowed funds = 0.10($800,000) = $80,000

Commitment fee paid on unused portion = 0.005($200,000) = $ 1,000

Total cost $81,000

remember the commitment fee is the fee a firm pays for the unused

portion of the line of credit

Putting these cash flows on a timeline:

interest rate

compounded quarterly

you divide by four because you only

want the interest in the three month

period. (There is 4 quarters in a year (3

months each)actual borrowed

actually owe

Loan Origination Fee• Timmons Towel and Diaper Service is offered a $500,000 loan for three

months at an APR of 12%. • This loan has a loan origination fee of 1%. • The loan origination fee is charged on the principal of the loan. What is

the actual four month interest rate? • The loan origination fee is charged on the principal of the loan so in this

case the fee amounts to 0.01 × $500,000 = $5000, so the actual amount borrowed is $495,000.

• The interest payment for three months is 500,000 (0.12/4) = $15,000

Thus the actual three-month interest rate paid is

Bills has a 3-month $750,000 loan from its bank. The interest payable on the loan is 8% (APR with quarterly compounding) and the bank requires a 10% compensating balance. Assume Bills, Inc.’s bank pays 1% (APR with quarterly compounding) on its compensating balance accounts. What is the EAR of Bills’ $750,000 3-month loan?

• Bill has a 3-month $750,000 loan

• interest on the loan is 8%

• bank requires 10% compensating balance

• bank pays 1% interest (APR with quarterly compounding) on its compensating balance accounts

What we know:

Compensating Balance

What we found out:

• The interest Bills owes on the loan at the end of the 3-month period is $15,000 ($750,000 x (0.08/4)).interest rate

compounded quarterly

• The balance held in the compensating balance account will grow to (75,000)(1 + 0.01/4) = $75,187.50.

interest ratecompounded quarterly

• The final loan payment will be:

750,000 + 15,000 – 75,187.50 = $689,812.50.

EAR = (1.0219)4 – 1 = 9.05%

• Since Bills only has the use of $675,000 ($750,000 - $75,000)

• the actual 3 month Rate paid is

(689,812.50 / 675,000) – 1 = 2.19%.

EAR = (1 + .0219)4 – 1 = 9.05%

EAR = 9.05%

original loan amount 10% compensating

balance

final loan payment

actual loan in use

actual loan in use

this is 4 because we want to get annual rate (3 months x 4 = 1 year)

The interest earned on the compensating

balance reduced the overall interest cost for

the loan


19.4 Short-Term Financing with Commercial Paper

• Commercial paper is short-term, unsecured debt used by large corporations that is usually a cheaper source of funds than a short-term bank loan. w The minimum face value is $25,000, and most

commercial paper has a face value of at least $100,000.

w The interest on commercial paper is typically paid by selling it at an initial discount.


Figure 19.2 The Commercial Paper Advantage


19.4 Short-Term Financing with Commercial Paper

• With direct paper, the firm sells the security directly to investors. With dealer paper, dealers sell the commercial paper to investors in exchange for a spread (or fee) for their services. The spread decreases the proceeds that the issuing firm receives, thereby increasing the effective cost of the paper.

A firm issues three-month commercial paper with a $100,000 face value and receives $98,000. What effective annual rate is the firm paying for its funds?

Commercial Paper

• The three-month rate can be computed by comparing the present value ($98,000) with the future value ($100,000).

• From there, we can convert it into an EAR using Eq 5.1: EAR= (1 + r)n − 1, where n is the number of 3-month periods in a year.

EAR= (1 + r)n − 1EAR= (1 + 0.0204)n − 1EAR= (1 .0204)4 − 1EAR= 1.084 − 1

EAR= 0.084

EAR= 8.4%

• The three-month rate can be computed by comparing the present value ($98,000) with the future value ($100,000).

• We need to subtract the one in order to get the percent difference

• Then take the EAR formula

• Substitute for the variables

• Then Solve

The financial manager needs to know the EAR of all of the firm’s funding sources to be able to make comparisons across them and choose the least-costly way to finance the firm’s short-term needs.

Bills, Inc’s bank issues a three-month commercial paper with a 100,000 face value and receives 97,000. What EAR is the firm paying for the funds?

Commercial Paper

EAR= (1 + r)n − 1

EAR= (1.03093)4 − 1

EAR= 0.1294

EAR= 12%


19.5 Short-Term Financing with Secured Financing

• Businesses can also obtain short-term financing by using secured loans, which are loans collateralized with short-term assets—most typically the firm’s accounts receivables or inventory.

• Commercial banks, finance companies, and factors, which are firms that purchase the receivables of other companies, are the most common sources for secured short-term loans.



Accounts Receivable as Collateral• In pledging of accounts receivable agreement,

the lender reviews the invoices that represent the credit sales of the borrowing firm and decides which credit accounts it will accept as collateral for the loan, based on its own credit standards.



Accounts Receivable as Collateral• In factoring of accounts receivable

arrangement, the firm sells receivables to the lender (i.e., the factor), and the lender agrees to pay the firm the amount due from its customers at the end of the firm’s payment period.



Inventory as Collateral• In a floating lien, general lien, or blanket lien

arrangement, all of the inventory is used to secure the loan.



Inventory as Collateral• With a trust receipts loan or floor planning,

distinguishable inventory items are held in a trust as security for the loan.

The Row Cannery wants to borrow $2 million for one month. Using its inventory as collateral, it can obtain a 12% (APR with monthly compounding) loan. The lender requires that a warehouse arrangement be used. The warehouse fee is $10,000, payable at the end of the month. Calculate the effective annual rate of this loan for Row Cannery.

Calculating the Effective Annual Cost of Warehouse Financing

What we know:

• Row Cannery is borrowing $2,000,000 at 12% interest (APR with monthly compounding)

• The warehouse fee is $10,000, payable at the end of the month.

Calculating the Effective Annual Cost of Warehouse Financing

What we know:

• Row Cannery is borrowing $2,000,000 at 12% interest (APR with monthly compounding)

• The warehouse fee is $10,000, payable at the end of the month.

What we can figure out:

• The monthly interest rate is 12% / 12 = 1%

• At the end of the month, Row will owe $2,000,000 × 1.01 = $2,020,000

• plus the warehouse fee of $10,000

number of months in a year

• so in total, Row Cannery owes $2,030,000

• the actual one month interest payment is

Expressing this as an EAR gives:

EAR= (1 + r)n − 1

EAR= (1.015)12 − 1

EAR= 0.196

EAR= 19.6%

The warehouse arrangement is quite costly: the EAR on the loan itself is (1.01)12-1=.1268, or 12.68%, but the warehouse arrangement raises it to 19.6%!


Chapter Summary

• Managing cash flows determines how efficiently the company will operate. Understanding short-term financial investments aids in this task.w The Matching Principlew Bank Loansw Commercial Paperw Secured Financing


Chapter Quiz

1. What are seasonalities and what role do they play in short-term financial planning?

2. What is the difference between permanent working capital and temporary working capital?

3. Why is it important to distinguish between permanent and temporary shortfalls?

4. Describe the different approaches a firm could take preparing for cash flow shortfalls.

5. Why is it important to distinguish between permanent and temporary shortfalls?

Chapter 19

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