Finance 3121

Chapter 18Short- and

Intermediate-Term Funding Alternatives

Finance 3122

Criteria for Choosing Sources of Short-Term Financing

• Cost - Annual Financing Cost– Actual and Opportunity Cost

• Impact on Credit Rating• Reliability• Availability of Credit• Restrictions• Flexibility• Fund Requirements and the Nature of the Firm’s

Operations

Finance 3123

Sources of Short-Term Financing

• Trade credit• Accruals and deferred income

– Legal and practical considerations

• Loans from commercial banks• Commercial paper• Collateral for S-T loans

– A/R– Inventory

Finance 3124

Cost of Short Term Credit

AFC = Interest + Fees

Usable fundsX

365

MaturityDaysSimple interest

APR = [ 1 + Interest + fees

Usable funds ]m

- 1

Compounded interest

Finance 3125

Trade Credit ( T/C )• Extended on open account as A/P

• Spontaneous source of financing

• Cost of T/C is contained in the purchase price• Lost discounts T/C is never “free”

AFC = % discount

100% - % discount

365

Credit period - Discountperiod

x

Finance 3126

Advantages and Disadvantages of Trade Credit

• Advantages– Readily available– Reduces transactions costs – Flexible– Informal - no restrictions– Inspection period– Financial Arbitrage

• Disadvantages– Can affect credit rating– Limited in amount

Finance 3127

Stretching Accounts Payable

• The cost of lost cash discounts can be reduced by payment beyond the due date.

• Tangible costs of late charges or specific interest may offset the savings.

• Intangible costs of lower credit rating and ability to obtain future credit may result.

• Can’t utilize with Electronic Data Interchange

Finance 3128

Accruals and Deferred Income

• Spontaneous Financing

• Accruals of wages, taxes and interest– Determined by legal and practical

considerations

• Deferred Income consists of payments received for goods and services to be delivered at a future date…e.g. magazine subscriptions

Finance 3129

Negotiated Sources of Short-Term Financing

• Commercial Banks

• Credit Corporations such as GE Credit

• Insurance Companies

• Pension Funds

• Money Market

• Securitization– Asset Backed Securities

Finance 31210

Cash-Flow vs. Asset-Based Lenders

• Short term lenders can be classified as either cash-flow or asset-based lenders

• Cash-flow lenders look upon the borrower’s future cash flows as the primary source of repayment

• Asset-based lenders tend to make riskier loans and place greater emphasis on the value of the borrower’s collateral.

Finance 31211

Commercial Bank Loans• Single loans for specific financial needs

• Line of credit– Agreement to borrow a predetermined limit at

any time No guarantee

• Revolving credit– Legally commits the bank– Usually secured– Requires a commitment fee

AFC =

Interestcosts

Usable funds

+Commitment

feex

365

Maturity ( days )

Finance 31212

Commercial Bank Loans - Continued

• Bank loans may be unsecured or secured• Financial institutions are interested in willingness to

repay the loan.• 6 Cs of Credit

– Character– Capacity– Capital– Collateral – Conditions– Country

Finance 31213

Business Loan Proposal• Description of history• Nature of the business• Amount of loan and use of proceeds• Plans for the business - Marketing• Background on key personnel - principals• Audited financial statements• Pro forma financial statements and cash budgets• Repayment of loan• Real estate holdings and “key person” insurance

Finance 31214

Commercial Bank Loans - Single Loans

• Single loans are usually arranged for specific financing need

• Interest is typically tied to LIBOR, Prime or Federal Funds rate

• Regular Interest vs. Discounted Loan

• Fees are now used more than compensating balances.

• Effective annual percentage cost depends on the useable funds and compensating balances requirements.

Finance 31215

Commercial Bank Loans - Line of Credit

• Line of Credit is an agreement which permits the firm to borrow up to a predetermined limit.

• Usually negotiated for a 1-year period with renewal subject to renegotiation

• Interest rate may be tied to LIBOR

• May contain restrictive covenants

• Sometimes requires that the firm have no loans outstanding for a portion of the year

• Does not guarantee that the bank will lend the funds - not legally binding… but...

• May have a fee on the unused balance or require compensating balances

Finance 31216

Commercial Bank Loans - Revolving Credit Agreement

• “Revolver” legally commits the bank to making the loan up to the credit limit

• Frequently extends over several years - e.g. 2 to 5 years

• Usually secured

• Effective annual costs contains both actual interest costs and commitment fees

• Interest rates may be tied to LIBOR

Finance 31217

Commercial Paper• Short Term promissory notes

• Typically issued by large well-known firms (P1)

• Maturities from a few days to 9 months

• Sold at a discount

• Purchasers Corporations Banks Insurance companies Pension funds

Money market funds Other financial institutions

AFC =

Interest costs +

Placement fee

Usable fundsx

365

Maturity ( days )

Finance 31218

Commercial Paper -Continued• Typically unsecured, however, there is asset-based commercial

paper (Securitization).

• Dealer-placed vs. Direct Placement

• Advantages:

– Cheaper than prime

– Huge available market

• Disadvantages:

– Impersonal market

– Can’t pay off prior to maturity

– Unused line of credit needed

– $10 million or more outstanding paper needed

Finance 31219

A/R as Collateral• Fairly liquid

• Easy to handle

• Subject to fraud

• High administrative costs

• Two common forms– Pledging– Factoring

• Securitization

Finance 31220

Pledging Accounts Receivable• Firm retains title

• A/R remains on the balance sheet

• Continuous arrangement

• Lender has recourse

• Non-notification basis

• 50 to 80 % of the face value of the A/R

• Annual percentage cost includes – Interest cost on the loan– Service fees charged for processing the receivables.. e.g. 1 % of

pledged A/R

Finance 31221

Factoring Accounts Receivable

• Sale of Accounts Receivable (typically)

• Non-recourse basis

– Factor assumes risk of default

• Notification to customer

• Maturity Factoring

– The firm receives the payment from the factor at the normal collection or due date

• Advance Factoring

– Firm receives a loan (advance) against future collections

• Credit Cards

Finance 31222

Factoring Accounts Receivable -Continued

• Functions of a Factor– Credit checking and collections– Absorbs Bad Debt Expenses– Extend advances to borrower– At times, the Factor will borrow from the firm when

the firm has excess cash

• Costs of Factoring– Fees and charges for services– Interest on loan

Finance 31223

Factoring Accounts Receivable - Used in Plays by Shakespeare

• Merchant of Venice

• The Comedy of Errors

• Othello

• Henry IV– “percy is but my factor, good my lord”

• Richard III– “ to or lowly factor for another’s gain”

Finance 31224

Financing From Foreign A/R

• Insured by the Export-Import Bank• Forfait Company finances contracts

guaranteed by – Foreign bank– Government

• Trading companies– Takes tittle to goods– Arranges shipments

Finance 31225

Inventory as Collateral• Stability• Characteristics

– Perishability– Identifiability– Marketability– Price stability

• Possession of the collateral– Floating lien– Trust receipt– Terminal warehouse– Field warehouse

Finance 31226

Floating Lien• A floating lien or blanket lien is a general claim

on all the firm’s inventory

• Loan amount as a percentage of inventory value is usually smaller

• Used for large-volume, small-value, high-turnover inventories

Finance 31227

Trust Receipt

• Requires specifically identifiable units of inventory

• Borrower holds collateral

• As inventory is sold, proceeds are forwarded to lender

• Common for automobiles and appliances

Finance 31228

Terminal Warehouse

• Inventory is held in bonded warehouse operated by a public warehouse company

• Warehouse issues a receipt for the merchandise which then becomes collateral for the lender

• As the loan is paid off, the lender authorizes the warehouse to release the inventory

• Costs:– Interest on loan

– Fees for storage

Finance 31229

Field Warehouse

• Goods are kept in a segregated portion under control of the warehouse company

• Notification of Field Warehouse

• Costs:– Interest on loan– Warehouse fees

• Used with canned goods

Finance 31230

Term Loans• Maturity

– 1 to 10 years

• Less expensive in smaller amounts than issuing bonds or stock

• Financing Working Capital needs• Interest costs

– Credit risk of borrower– Size of loan– Maturity– General level of interest rates

Finance 31231

Term Loans - Continued• Amortization

– Mortgage -type loan– Equal reductions of principal– Partial amortization and “balloon” payment– Bullet Loan

• Loan agreements seldom call for compensating balances

• Warrants and equity kickers

Finance 31232

Term Loans - Continued

• Covenants– Affirmative (Thou Shall)– Negative (Thou Shall Not)– Restrictive

• Default provisions– Can insist on immediate repayment

Finance 31233

Sources of Term Loans• Banks

• Insurance companies

• Pension funds

• Government agencies SBA - SBIC’s - IDA’s - Municipal bonds

• Equipment suppliers– Conditional sales contracts– Chattel mortgages

• Property other than real estate

Finance 31234

Security Provisions• Dependent on the borrowers credit standing

• Provisions– Assignment of payments due

• from a particular contract

– Assignment or pledging of inventories, A/R or securities– Floating lien– Mortgage– Life insurance– Pledge of marketable securities

Finance 31235

Equipment Financing Loans

• Equipment is usually readily marketable…such as truck

• Security Instruments used:– Conditional Sales Contract

• Seller retains title until the buyer has made all the payments required by the financing contract

– Chattel Mortgage• Lien on property other than real estate

Finance 31236

Short and Intermediate Term Debt - Conclusion

• Criteria for choosing• Sources

– Trade credit– Bank loans– Commercial Paper– Collateralized Loans

• Pledging A/R• Factoring A/R• Inventory

• Term Loans