chapter 16 short term financing(1)

7/23/2019 Chapter 16 Short Term Financing(1)

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CASH FLOW TIMELINE &FINANCING

Cash is collected and cash is disbursedIf the ending balance is positive then investmentopportunity arises

If the ending balance is negative then the deficitneed to be financed

Working capital policy of the firm need to bereevaluated

Even the most efficient working capital policy

may have deficit.



FINANCING STRATEGY

Firms always have some or permanent amountof inventory or receivable on book. They do turnover. This minimum level of ongoing inventoryand receivable is referred to as Permanent

Current assets.The temporary component of current assetsrepresents inventory that is accumulated inanticipation of sales and the resulting A/Creceivable generated by increasing sales.



ALTERNATIVE FINANCINGSTRATEGIES

Aggressive Financing Strategy

Conservative Strategy

Moderate strategy



AGGRESSIVE STRATEGY

Aggressive policy is basically a maturitymatching strategy.

Expected life of the assets is matched with theexpected life of the source of funds raised tofinance the assets.

Long term finance will be used to finance fixedassets and permanent current assets and shortterm finance to finance temporary current assets.



FINANCING STRATEGIES: AGGRESSIVE

Fixed AssetsFixed Assets

Permanent Current AssetsPermanent Current Assets

Temporary Current AssetsTemporary Current Assets

TimeTime

$$

Short-Term FinancingShort-Term Financing

Long-TermLong-Term

FinancingFinancing



CONSERVATIVE POLICY

It uses only long term sources for meetingthe financing needs.

As total assets increase as a result of build

up of inventory and receivables, the firmdraw down its excess liquidity stored inshort term investment.

Excess cash is reinvested in short terminvestment.

More expensive strategy.Provide greater solvency position.



FINANCINGSTRATEGIES:CONSERVATIVE




TimeTime

$$

Long-TermLong-Term

FinancingFinancing

Excess LiquidityExcess Liquidity



FINANCING STRATEGIES:MODERATE




TimeTime

$$

Long-TermLong-Term

FinancingFinancing

Short-TermShort-Term

FinancingFinancing

ExcessExcessLiquidityLiquidity



TYPES OF CREDIT

Single payment loan/note

-Granted for specific financial purpose.

-Can be discount or add on note

-Definite beginning and ending time



DISCOUNT NOTE

Interest rate is fixed. Why??

-loan amount = $ 100000

-loan period = 60 days, rate 7 % annually

- Amount received from the Bank = 100000 X [1- .07(60)/360]

= $ 98833.

Amount need to repaid at maturity = $ 100000



ADD ON NOTE

Interest is added to the principal at maturityRate of interest can be fixed/variable over thelife of the loan.

-loan amount = $ 100000-loan period = 60 days, rate 7 % annually(fixed)- Amount received from the Bank = $ 100000

Amount need to be paid= 100000 X [{1+.07(60)/360]

= $ 101167



LINE OF CREDIT

A line of credit is a short term source of fund inthat it represents a fund that a bank standsready to lend a corporate client on demand atanytime during a given period, generally a year.

Clean up feature

Compensating balance – The firm cannot use thefull amount of loan.



PURPOSES

To meet seasonal short term need of theborrower. What is clean up period?

Can be used as a backup to cover the maturingcommercial paper. What is back up line?

To work as liquidity cushion in case ofcontingencies.



UNCOMMITTED CREDIT LINE

Simply a verbal or informally written statementfrom the banker, that with fulfillment of termsand conditions , the bank is prepared to lend thepotential borrower upto the stated amount.

Can be cancelled or terms may be altered butbank rarely do it. Why??

Used to initiate relationship with potentialclients.



COMMITTED CREDIT LINE

Formal legal agreement covering the terms andconditions

Bank requires compensation for commitment

Bank is legally bound to follow the agreement.



COMMITTED VS. UNCOMMITTEDLINE OF CREDIT

Committed – Formal written agreement contractuallybinding the bank to provide the fund when requested

Commitment feeCovenants

Uncommitted Line of credit – Is not binding on theBank, although it is always honored

Attractive to customers-Who rarely use credit line-Who maintain short term financial position-Don’t need to pay for unused balances-Banks like it. It frees the Bank from obligation tohonor commitment to borrowers who creditworthiness has recently been deteriorated.



COMPENSATION FOR CREDIT LINE

Commitment fee-Price for the bank commitment to keep theline available

- Amount may be on total credit line or unusedportion of credit line

-Most widely used for compensation

Compensating balances-Need to keep a certain amount of deposit.-Specified in dollar amount or as a percentageof the lines.



PROBLEM: COMPENSATING BALANCE VS.LINE OF CREDIT

Line of credit $ 2000000-Existing average cash balance=$200000-Opportunity cost = 8% annually-Option A Cash fee 3/8% of the line so, 20000000 X 3/8% = $ 75000-Option B

-Compensating balance 5 % of the amount of the line so 20000000 X 5% = $ 1000000Increased amount of compensating balance= 1000000- 200000 = 800000

800000 X 0.08 = $ 64000, so the option is Choice B



COMMITMENT FEE FOR UNUSEDLINE OF CREDIT

Credit line $5000000Commitment fee ¼% of the unused portion ofthe loan

- For 1st six months it borrowed $3000000-For 2nd six months it borrowed $1000000

Fee 1st half= .0025/2 (5000000 – 3000000)

=$2500Fee 2nd half= .0025/2 (5000000 – 1000000)=$5000



LETTER OF CREDIT

A Letter of Credit is a promise , generally by aBank to make commitment to make payment to aparty on presentation of draft provided that theparty complies with certain documents

requirement as stated in the Letter of Creditagreement.



BANKERS ACCEPTANCE

A banker’s acceptance is a time draft drawnagainst a deposit in a commercial Bank but withpayment at maturity guaranteed by the Bank.



COMMERCIAL PAPER

Unsecured promissory notes of anorganization issued for specific amount and afixed maturity.

Issued to the provider of fund.It does not need to be registered with SEC ifits maturity is less than 270 days and itfulfills one of the three conditions mentionedbelow:

-Proceeds are used to finance currenttransactions

-Notes are guaranteed by an bank-Not offered to public



MATURITY: COMMERCIALPAPER & DENOMINATION

Most of the commercial papers have amaturity of 30 days or less, so they must berolled over. Why?

Unlike a commercial bank, the replacement

commercial paper is sold to differentpurchasersCommercial paper can be issued in anydenomination. Majority of the issues havevalue of $100000 or more but it can also be

issued as little as $ 25000Commercial paper is generally discount notebut it can be interest bearing. Howeverinterest rate and fees are same for both loans.



UNSECURED BORROWING

Made on the basis of financial strength of theborrower

Also referred to as Financial statement lending

In case of default the Bank becomes generalcreditor

Usually granted to firms having long stablehistory of strong financial performance



SECURED BORROWING

Gives the lender to right to claim a specific assetin case of default by the borrower

It can be a collateralized loan or an asset basedloan.



COLLATERALIZED LOAN

Collateral must be adequate to cover the loanbut the Bank does not view it as a means ofrepaying the loan

A/C receivable may loose value when the bank

wants to collect it laterInventory may fail to obtain its full value whenit is soldRaw materials – Commodity valueWIP – Very little value

Finished goods – may have reasonable valueDifficulty in generating cash flows arisesbecause sales are below projections – Obtainingfull value for inventory is rare occurrence.



FACTORING

Sale of A/C receivable without recourse toanother party (factor)

Once the account has been purchased it is

the property and responsibility of thefactor.Three major types of factoringarrangement

-Maturity factoring-Conventional factoring-Maturity factoring with an assignment ofequity



INVENTORY FINANCING

Floating Lien- Borrower pledges its inventorieswithout particular specification. Relatively smallfraction of total value of inventory is pledged

Trust Receipt- Lender has a direct lien on aspecific inventory item. Suitable for relativelyexpensive and low turnover item



Warehouse receipts- Field Warehousing asegregated area of the borrower’s facility housingthe facility. A third party is responsible forissuing the receipts, which ensures that pledged

items are physically located on the premisesTerminal warehouse receipts



PROBLEM: INVENTORY VALUATION

Suppose a company has $ 1,000,000 ininventory pledged as collateral. The breakup of the inventory is as follows:Finished goods - $ 500000

WIP - $ 400000Raw materials - $ 100000If the Bank applied 50% factor to Finishedgoods, 40% to raw materials and 0% toWIP

then maximum amount of loan the Bankwill get= .5X 500000 + 0 X 100000 + .4 X 400000 = $ 410,000



PROBLEM: A/C RECEIVABLE VALUATION

A/C receivable also face problem in obtaining full value. Qualified receivable = total receivable- 3 months olderreceivable – receivable from companies facingbankruptcy

Bank then determines the loan amount by multiplying

QR by factor. If total receivable = $ 5,000,000 $ 500000 older than 90 days $ 100000 from firms facing Bankruptcy If factor = 70% then

maximum loan =0.7(5,000,000-500000-100000) = 30,8000What is psychological value of collateral?



ASSET BASED LOAN

Difference between collateralized loan and assetbased loan

-Primary repayment source of collateralized loan-Cash flow generating potential

-Primary repayment source of asset based loan- Asset value that represents loan Probability of failure to repay is high Asset value will be stable during the time of the

loan



COMPARING THE EFFECTIVE COSTOF FUNDS

Single Payment Loan

Interest at maturity

Total payment to be made at maturity,

MP = Principal + Interest + loan fees at maturity

Net proceeds of the loan,

PR = net proceeds of the loan

t = # of days the loan is outstanding

Effective rate, I = (MP-PR)/MP X 365/t



COMPARING THE EFFECTIVE COSTOF FUNDS: SINGLE PAYMENT LOAN

(EXAMPLE)Interest at maturity

60 day single payment loan,

loan amount = $ 500000, interest rate 12%

Loan originating fee = $ 500 paid in advance

The amount paid at maturity

= 500000 [1+.12(60/365)] = 509863

I = (509863-499500)/509863 X 365/60

= 12.36%



COMPARING THE EFFECTIVECOST OF FUNDS:

SINGLE PAYMENT LOAN(EXAMPLE)Discount loan

60 day discount loan of $600000

interest rate 12%

The proceeds of the loan are,PR = 600000[1-.12(60/365)] = 588164

I = (600000 - 588164)/588164 X 365/60

= 12.24%



COMPARING THE EFFECTIVECOST OF FUNDS:

LINE OF CREDITWhy it is difficult to calculate effective interestrate for line of credit?

Credit line obtained may include a buffer

Borrowing varies with cash flow needs

Commitment fee or compensating balances maybe based on total amount of the line or unusedportion of the line



COMPARING THE EFFECTIVE COST OFFUNDS:LINE OF CREDIT (PROBLEM - WHEN

COMMITMENT FEE IS BASED ONCOMPENSATING BALANCE



COMPARING THE EFFECTIVE COST OFFUNDS:LINE OF CREDIT (PROBLEM - WHEN

COMMITMENT FEE IS BASED ON UNUSEDLINE OF CREDIT



CHAPTER 16 PROBLEM 4

Ralph, treasurer for M and M productsrecently updated his firm’s short term cashforecast only to discover that the firm willsuffer a cash shortage of $ 12 million for aperiod of 30 days. One option is to liquidate aportion of his marketable securities portfolio,but with interest rate up this is not a goodalternative. Ralph just learned from one of

his commercial paper dealers that paper inthe 30 days range is in demand and thatasked discount rate are comparably good atabout 9 percent.




The dealer’s annual fee is 20 basis point andthe annual commitment fee on a back up lineof credit is 50 basis point.

a. Estimate the effective cost of the commercial

paper assuming that this is the onlycommercial paper issue planned for the year.

b. Estimate the effective cost of the commercialpaper assuming that there will be recurringissues of commercial paper all year long.




M&M Products, Inc. - estimating the cost ofcommercial paper.

ASSUMPTIONS:

Face amount = $12,000,000 Discount rate = 9.00% Maturity (days) = 30 Dealer annual fee=0.20%

Commitment fee =0.50%




a.) Assume this is the only commercial paperissue planned for the year.

Issue price = Face - (Discount rate *

(Days/360) * Face Amount) Issue Price =$11,910,000 Interest paid = Face - Issue price

Interest paid = $90,000




Commitment fee = Face * (Commitmentfee * (360/360))

Commitment fee = $60,000(Assuming only CP issue this year.)

Dealer fee = Face * rate * (30/360) Dealer fee = $2,000 Out of pocket cost = Interest + Dealerfee + Commitment fee




Out of pocket cost = $152,000

Usable Funds = Issue price - Interest

Usable funds = $11,910,000

Effective rate = (Out of pocket cost /Usable funds) * (365/Days)

Effective rate = 15.53%



b.)Assume there will be recurring issues ofcommercial paper all year long.

Assuming the issue of CP is recurring throughoutthe year adjusts commitment fee to just 30 days

of usage allocated to this CP issue.

Commitment fee =Face * (Commitment fee* (30/360))

Commitment fee =$5,000

chapter 16 short term financing(1)

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