funding the bank 1 10. the relationship between liquidity requirements, cash, and funding sources...

Funding the Bank

1

10

The Relationship Between Liquidity Requirements, Cash, and Funding Sources

The amount of cash that a bank holds is influenced by the bank’s liquidity requirements

The size and volatility of cash requirements affect the liquidity position of the bank Deposits, withdrawals, loan

disbursements, and loan payments affect the bank’s cash balance and liquidity position

2


Recent Trends in Bank Funding Sources Bank customers have become more rate

conscious Many customers have demonstrated a a

strong preference for shorter-term deposits

Core deposits are viewed as increasingly valuable

Bank often issue hybrid CDs to appeal to rate sensitive depositors

4


Recent Trends in Bank Funding Sources Retail Funding

Deposit Accounts Transaction accounts Money market deposit accounts Savings accounts Small time deposits

5


Recent Trends in Bank Funding Sources Borrowed Funding

Federal Funds purchased Repurchase agreements Federal Home Loan Bank borrowings

6


Recent Trends in Bank Funding Sources Wholesale Funding

Includes borrowed funds plus large CDs

Equity Funding Common stock Preferred stock Retained earnings

7


Recent Trends in Bank Funding Sources Volatile (Managed) Liabilities

Funds purchased from rate-sensitive investors

Federal Funds purchased Repurchase agreements Jumbo CDs Eurodollar time deposits Foreign Deposits

Investors will move their funds if other institutions are paying higher rates

8


Recent Trends in Bank Funding Sources Core Deposits

Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise

Includes: Transactions accounts MMDAs Savings accounts Small CDs

9

Characteristics of Retail-Type Deposits Retail Deposits

Small denomination (under $100,000, now $250,000) liabilities

Normally held by individual investors Not actively traded in the secondary

market

13

Characteristics of Retail-Type Deposits Transaction Accounts

Most banks offer three different transaction accounts

Demand Deposits DDAs

Negotiable Order of Withdrawal NOWs

Automatic Transfers from Savings ATS

14


Demand Deposits Checking accounts that do not pay

interest Held by individuals, business, and

governmental units Most are held by businesses since

Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts

15


NOW Accounts Checking accounts that pay interest

ATS Accounts Customer has both a DDA and savings

account The bank transfers enough from savings to

DDA each day to force a zero balance in the DDA account

For-profit corporations are prohibited from owning NOW and ATS accounts

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Although the interest cost of transaction accounts is very low, the non-interest costs can be quite high

Generally, low balance checking accounts are not profitable for banks due to the high cost of processing checks

17

Characteristics of Retail-Type Deposits Nontransactional Accounts

Non-transaction accounts are interest-bearing with limited or no check-writing privileges

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Money Market Deposit Accounts Pay interest but holders are limited to 6

transactions per month, of which only three can be checks

Attractive to banks because they are not required to hold reserves against MMDAs

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Savings Accounts Have no fixed maturity

Small Time Deposits (Retail CDs) Have a specified maturity ranging from

7 days on up Large Time Deposits (Jumbo CDs)

Negotiable CDs of $100,000 or more Typically can be traded in the

secondary market20

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit

Accounts Interest Costs Legal Reserve Requirements Check Processing Costs Account Charges

NSF fees Monthly fees Per check fees

21


Accounts Transaction Account Cost Analysis

Classifies check-processing as: Deposits

Electronic Non-Electronic

Withdrawals Electronic Non-Electronic

22

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis Classifies check-processing as:

Transit Checks Deposited Cashed

Account Opened or Closed On-Us checks cashed General account maintenance

Truncated Non-Truncated

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Accounts Transaction Account Cost Analysis

Electronic Transactions Conducted through automatic deposits,

Internet, and telephone bill payment Non-Electronic Transactions

Conducted in person or by mail Transit Checks

Checks drawn on any bank other than the bank it was deposited into

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Transaction Account Cost Analysis On-Us Checks Cashed

Checks drawn on the bank’s own customer’s accounts

Deposits Checks or currency directly deposited in the

customer's account Account Maintenance

General record maintenance and preparing & mailing a periodic statement

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Transaction Account Cost Analysis Truncated Account

A checking account in which the physical check is ‘truncated’ at the bank and the checks are not returned to the customer

Official Check Issued A check for certified funds.

Net Indirect Costs Those costs not directly related to the product

such as management salaries or general overhead costs

26

Characteristics of Retail-Type Deposits Calculating the Average Net Cost of

Deposit Accounts Average Historical Cost of Funds

Measure of average unit borrowing costs for existing funds

Average Interest Cost Calculated by dividing total interest

expense by the average dollar amount of liabilities outstanding

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Deposit Accounts

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12ratio)t requiremen Reserve - (1 float ofnet balance Average

incomet Noninteres-expenset Noninteres expenseInterest

sliabilitiebank ofcost net Average


Deposit Accounts Example:

If a demand deposit account does not pay interest, has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float, what is the net cost of the deposit?

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3.29%12.10) - (1 .05) - (1 $5,515

$7.75 - $20.69 $0

Deposit Demand ofCost Net Average

Characteristics of Large Wholesale Deposits Wholesale Liabilities

Customers move these investments on the basis of small rate differentials, so these funds are labeled:

Hot Money Volatile Liabilities Short-Term Non-Core funding

32


Jumbo CDs $100,000 (now $250,000) or more Negotiable

Can be traded on the secondary market Minimum maturity of 7 days Interest rates quoted on a 360-day year basis Insured up to $100,000 (now $250,000) per

investor per institution Issued directly or indirectly through a dealer

or broker (Brokered Deposits)33


Jumbo CDs Fixed-Rate Variable-Rate

Jump Rate (Bump-up) CD Depositor has a one-time option until

maturity to change the rate to the prevailing market rate

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Jumbo CDs Callable Zero Coupon Stock Market Indexed

Rate tied to stock market index performance Rate Boards

Represent venues for selling non-brokered CDs via the Internet to institutional investors

Rate boards help raise funds quickly and represent a virtual branch for a bank

35

Characteristics of Large Wholesale Deposits Individual Retirement Accounts

Each year, a wage earner can make a tax-deferred investment up to $8,000 of earned income

Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty

This makes IRAs an attractive source of long-term funding for banks

36

Characteristics of Large Wholesale Deposits Foreign Office Deposits

Eurocurrency Financial claim denominated in a currency

other than that of the country where the issuing bank is located

Eurodollar Dollar-denominated financial claim at a

bank outside the U.S. Eurodollar deposits

Dollar-denominated deposits in banks outside the U.S.

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Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds

Federal Funds Purchased The term Fed Funds is often used to refer to

excess reserve balances traded between banks This is grossly inaccurate, given reserves averaging

as a method of computing reserves, different non-bank players in the market, and the motivation behind many trades

Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks

Interest rates are negotiated between trading partners and are quoted on a 360-day basis

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Security Repurchase Agreements (RPs or Repos)

Short-term loans secured by government securities that are settled in immediately available funds

Identical to Fed Funds except they are collateralized

Technically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest

40


Security Repurchase Agreements (RPs or Repos)

Most transactions are overnight In most cases, the market value of the

collateral is set above the loan amount when the contract is negotiated.

This difference is labeled the margin The lender’s transaction is referred to as

a Reverse Repo

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Structured Repurchase Agreements Embeds an option (call, put, swap, cap,

floor, etc.) in the instrument to either lower its initial cost to the borrower or better help the borrower match the risk and return profile of an investment

Flipper Repo Carries a floating rate that will convert, or flip,

to a fixed rate after some lock-out period

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Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve

Discount Window Discount Rate

Policy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loans

To borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is granted

Eligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper

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Discount Rate

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Current Interest Rates in effect since 2/19/2010

Primary Credit 0.75%

Secondary Credit 1.25%

Seasonal Credit 0.20%

Fed Funds Target 0 - 0.25%


Primary Credit Available to sound depository

institutions on a short-term basis to meet short-term funding needs

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Secondary Credit Available to depository institutions that

are not eligible for primary credit Available to meet backup liquidity

needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution

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Seasonal Credit Designed to assist small depository

institutions in managing significant seasonal swings in their loans and deposits

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Emergency Credit May be authorized in unusual and

exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions

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Characteristics of Large Wholesale Deposits Other Borrowing from the Federal

Reserve Term Auction Facility

Allows banks to bid for an advance that will generally have a 28-day maturity

Banks must post collateral against the borrowings and cannot prepay the loan

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Characteristics of Large Wholesale Deposits Other Borrowing from the Federal

Reserve Term Securities Lending Facility

A facility in which the Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers

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Characteristics of Large Wholesale Deposits Federal Home Loan Bank Advances

The FHLB system is a government-sponsored enterprise created to assist in home buying

The FHLB system is one of the largest U.S. financial institutions, rated AAA because of the government sponsorship

Any bank can become a member of the FHLB system by buying FHLB stock

If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB

FHLB advances have maturities from 1 day to as long as 20 years

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Electronic Money

Intelligent Card Contains a microchip with the ability to

store and secure information Memory Card

Simply store information

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Electronic Money

Debit Card Online

PIN based Transaction goes through the ATM

system Offline

Signature based transactions Transaction goes through the credit

card system

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Electronic Money

Electronic Funds Transfer (EFT) An electronic movement of financial data,

designed to eliminate the paper instruments normally associated with such funds movement

Types of EFT ACH: Automated Clearing House POS: Point of Sale ATM Direct Deposit Telephone Bill Paying Automated Merchant Authorization Systems Preauthorized Payments

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Check 21

Check Clearing for the 21st Century Act Facilitates check truncation by reducing

some of the legal impediments Foster innovation in the payments and

check collection system without mandating receipt of check in electronic form

Improve the overall efficiency of the nation’s payment system

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Check 21

Check Truncation Conversion of a paper check into an

electronic debit or image of the check by a third party in the payment system other than the paying bank

Facilitates check truncation by creating a new negotiable instrument called a substitute check

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Check 21

Substitute Check The legal equivalent of the original check

and includes all the information contained on the original

Check 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checks It does allow banks to handle checks

electronically instead of physically moving paper checks

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Check 21

Check Clearing Process Banks typically place a hold on a check

until it verifies that the check is “good” Expedited Funds Availability Act

Under Reg CC, it states that: Local check must clear in no more than two

business days Non-local checks must clear in no more than

five business days Government, certified, and cashiers checks

must be available by 9 a.m. the next business day

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Measuring the Cost of Funds

Average Historical Cost of Funds Many banks incorrectly use the

average historical costs in their pricing decisions

The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall.

Pricing decisions should be based on marginal costs compared with marginal revenues

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The Marginal Cost of Funds Marginal Cost of Debt

Measure of the borrowing cost paid to acquire one additional unit of investable funds

Marginal Cost of Equity Measure of the minimum acceptable

rate of return required by shareholders Marginal Cost of Funds

The marginal costs of debt and equity64


The Marginal Cost of Funds Costs of Independent Sources of

Funds It is difficult to measure marginal costs

precisely Management must include both the

interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets

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Funds Marginal costs may be defined as :

66

jLiability of Balance InvestableNet

Insurance Costs Acquistion Costs Servicing RateInterest

jLiability ofCost Marginal


The Marginal Cost of Funds Costs of Independent Sources of Funds

Example: Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of

balances Net investable balance is 85% of the balance

(10% required reserves and 5% float)

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Funds Example:

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9.24% 0.09240.85

0.00250.010.0410.025Cost Marginal



Funds Cost of Debt

Equals the effective cost of borrowing from each source, including interest expense and transactions costs

This cost is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue

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Cost of Debt Example:

Assume the bank will issue: $10 million in par value subordinated

notes paying $700,000 in annual interest and a 7-year maturity

It must pay $100,000 in flotation costs to an underwriter

The effective cost of borrowing (kd) is 7.19%

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Funds Cost of Debt

Example:

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7.19% k Thus

)k(1

0$10,000,00

)k(1

$700,000$9,900,000

d

7d

7

1tt

d



Funds Cost of Equity

The marginal cost of equity equals the required return to shareholders

It is not directly measurable because dividend payments are not mandatory

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Funds Cost of Equity

Several methods are commonly used to approximate this required return:

Dividend Valuation Model Capital Asset Pricing Model (CAPM) Targeted Return on Equity Model

Cost of Debt + Risk Premium

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Cost of Preferred Stock Preferred stock acts as a hybrid of debt and common

equity Claims are superior to those of common

stockholders but subordinated to those of debt holders

Preferred stock pays dividends that may be deferred when management determines that earnings are too low.

The marginal cost of preferred stock can be approximated in the same manner as the Dividend Valuation Model however, dividend growth is zero

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Funds Trust Preferred Stock

Trust preferred stock is attractive because it effectively pays dividends that are tax deductible

This loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock

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Weighted Marginal Cost of Total Funds This is the best cost measure for asset-

pricing purposes It recognizes both explicit and implicit

costs associated with any single source of funds

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Weighted Marginal Cost of Total Funds It assumes that all assets are financed

from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds

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m

1j

WMC jjkw

Funding Sources and Banking Risks Banks face two fundamental problems

in managing liabilities. Uncertainty over: What rates they must pay to retain and

attract funds The likelihood that customers will

withdraw their money regardless of rates

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Funding Sources and Banking Risks Funding Sources: Liquidity Risk

The liquidity risk associated with a bank’s deposit base is a function of:

The competitive environment Number of depositors Average size of accounts Location of the depositor Specific maturity and rate

characteristics of each account

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Funding Sources and Banking Risks Funding Sources: Liquidity Risk

Interest Elasticity How much can market interest rates change

before the bank experiences deposit outflows?

If a bank raises its rates, how many new funds will it attract?

Depositors often compare rates and move their funds between investment vehicles to earn the highest yields

It is important to note the liquidity advantage that stable core deposits provide a bank

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Funding Sources and Banking Risks Funding Sources: Interest Rate Risk

Many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change

Banks must offer a substantial premium to induce depositors to lengthen maturities

Those banks that choose not to pay this premium will typically have a negative one-year GAP

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Funding Sources and Banking Risks Funding Sources: Interest Rate Risk

One strategy is to aggressively compete for retail core deposits

Individual are not as rate sensitive as corporate depositors and will often maintain their balances through rate cycles as long as the bank provides good service

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Funding Sources and Banking Risks Funding Sources: Credit and Capital Risk

Changes in the composition and cost of bank funds can indirectly affect a bank’s credit risk by forcing it to reduce asset quality

For example, banks that substitute purchased funds for lost demand deposits will often see their cost of funds rise

Rather than let their interest margins deteriorate, many banks make riskier loans at higher promised yields

While they might maintain their margins in the near-term, later loan losses typically rise with the decline in asset quality

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Overview of Credit Policy and Loan Characteristics

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Recent Trends in Loan Growth and Quality Larger banks have, on average, recently

reduced their dependence on loans relative to smaller banks.

Real estate loans represent the largest single loan category for banks.

Residential 1-4 family homes contribute the largest amount of real estate loans for banks. Commercial real estate is highest for banks

with $100 million to $1 billion in assets

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Recent Trends in Loan Growth and Quality Commercial and industrial loans

represent the second highest concentration of loans at banks

Loans to individuals are greatest for banks with more than $1 billion in assets

Farmland and farm loans make up a significant portion of the smallest banks’ loans

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Recent Trends in Loan Growth and Quality Wholesale Bank

Emphasizes lending to businesses Retail Bank

Emphasizes lending to individuals Primary funding is from core deposits

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Recent Trends in Loan Growth and Quality FDIC Bank Categories

Credit Card Banks International Banks Agricultural Banks Commercial Lenders

Vast majority of FDIC-insured institutions fall in this category

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Recent Trends in Loan Growth and Quality FDIC Bank Categories

Mortgage Lenders Consumer Lenders Other Specialized Banks (less than $1

billion) All Other Banks (less than $1 billion) All Other Banks (more than $1 billion)

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Recent Trends in Loan Growth and Quality Noncurrent Loans

Loans and leases past due 90 days or more and still accruing interest plus all loans and leases in a nonaccrual status

Nonaccrual loans and leases are those: that are maintained on a cash basis because of

deterioration in the financial position of the borrower

where full payment of interest and principal is not expected

where principal or interest has been in default for a period of 90 days or more, unless the obligation is both well secured and in the process of collection

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Recent Trends in Loan Growth and Quality Net Losses (Net Charge-offs)

The dollar amount of loans that are formally charged off as uncollectible minus the dollar value of recoveries on loans previously charged off

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Measuring Aggregate Asset Quality It is extremely difficult to assess individual

asset quality using aggregate quality data Different types of assets and off-balance

sheet activities have different default probabilities Loans typically exhibit the greatest credit

risk Historical charge-offs and past-due loans

might understate (or overstate) future losses depending on the future economic and operational conditions of the borrower

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Measuring Aggregate Asset Quality Concentration Risk

Exists when banks lend in a narrow geographic area or concentrate their loans in a certain industry

Country Risk Refers to the potential loss of interest

and principal on international loans due to borrowers in a country refusing to make timely payments

102

Trends in Competition for Loan Business In 1984, there were nearly 14,500 banks

in the U.S. This fell to fewer than 7,300 at the

beginning of 2007 Recently, the Treasury’s efforts to provide

capital to banks via TARP further differentiated between strong and weaker banks, as those in the worst condition did not qualify for the capital and ultimately either failed or were forced to sell

This has forced consolidation

103

Trends in Competition for Loan Business Banks still have the required expertise

and experience to make them the preferred lender for many types of loans

Technology advances have meant that more loans are becoming “standardized,” making it easier for market participants to offer loans in direct competition to banks

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Trends in Competition for Loan Business Structured Note

Loan that is specifically designed to meet the needs of one or a few companies but has been packaged for resale

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The Credit Process

Loan Policy Formalizes lending guidelines that

employees follow to conduct bank business Credit Philosophy

Management’s philosophy that determines how much risk the bank will take and in what form

Credit Culture The fundamental principles that drive

lending activity and how management analyzes risk

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The Credit Process

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The Credit Process

Credit Culture The fundamental principles that drive

lending activity and how management analyzes risk

Values Driven Focus is on credit quality

Current-Profit Driven Focus is on short-term earnings

Market-Share Driven Focus is on having the highest market share

109

The Credit Process

Business Development and Credit Analysis Business Development Market research Train employees:

What products are available What products customers are likely to need How they should communicate with

customers about those needs Advertising and Public Relations Officer Call Programs

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The Credit Process

Business Development and Credit Analysis Credit Analysis

Evaluate a borrower’s ability and willingness to repay

Questions to address What risks are inherent in the operations of the

business? What have managers done or failed to do in

mitigating those risks? How can a lender structure and control its own

risks in supplying funds?

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The Credit Process


Five C’s of Good Credit Character Capital Capacity Conditions Collateral

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The Credit Process


Five C’s of Bad Credit Complacency Carelessness Communication Contingencies Competition

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The Credit Process


Procedure1. Collect information for the credit file

2. Evaluate management, the company, and the industry in which it operates

3. Conduct a financial statement analysis

4. Project the borrower’s cash flow and its ability to service the debt

5. Evaluate collateral or the secondary source of repayment

6. Write a summary analysis and making a recommendation

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The Credit Process

Credit Execution and Administration Loan Decision

Individual officer decision Committee Centralized underwriting

115

The Credit Process

Credit Execution and Administration Loan Agreement

Formalizes the purpose of the loan Terms of the loan Repayment schedule Collateral required Any loan covenants States what conditions bring about a

default

116

The Credit Process

Credit Execution and Administration Documentation: Perfecting the

Security Interest Perfected

When the bank's claim is superior to that of other creditors and the borrower

Require the borrower to sign a security agreement that assigns the qualifying collateral to the bank

Bank obtains title to equipment or vehicles

117

The Credit Process

Credit Execution and Administration Position Limits

Maximum allowable credit exposures to any single borrower, industry, or geographic local

Risk Rating Loans Evaluating characteristics of the

borrower and loan to assess the likelihood of default and the amount of loss in the event of default

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The Credit Process

Credit Execution and Administration Loan Covenants

Positive (Affirmative) Indicate specific provisions to which the

borrower must adhere Negative

Indicate financial limitations and prohibited events

120

The Credit Process

Credit Execution and Administration Loan Review

Monitoring the performance of existing loans

Handling problem loans Loan review should be kept separate from

credit analysis, execution, and administration

The loan review committee should act independent of loan officers and report directly to the CEO of the bank

121

The Credit Process

Credit Execution and Administration Problem Loans

Often require special treatment Modify terms of the loan agreement to

increases the probability of full repayment Modifications might include:

Deferring interest and principal payments

Lengthening maturities Liquidating unnecessary assets

122

Characteristics of Different Types of Loans UBPR Classifications

Real Estate Loans Commercial Loans Individual Loans Agricultural Loans Other Loans and Leases in Domestic

Offices Loans and Leases in Foreign Offices

123

Characteristics of Different Types of Loans Real Estate Loans

Construction and Development Loans Commercial Real Estate Multi-Family Residential Real Estate 1-4 Family Residential Home Equity Farmland Other Real Estate Loans

124


Commercial Real Estate Loans Typically short-term loans consisting

of: Construction and Real Estate Development

Loans Land Development Loans Commercial Building Construction and

Land Development Loans

125


Commercial Real Estate Loans Construction Loans

Interim financing on commercial, industrial, and multi-family residential property

Interim Loans Provide financing for a limited time until permanent

financing is arranged Land Development Loans

Finance the construction of road and public utilities in areas where developers plan to build houses

Developers typically repay loans as lots or homes are sold

126


Commercial Real Estate Loans Takeout Commitment

An agreement whereby a different lender agrees to provide long-term financing after construction is finished

127


Residential Mortgage Loans Mortgage

Legal document through which a borrower gives a lender a lien on real property as collateral against a debt

Most are amortized with monthly payments, including principal and interest

128


Residential Mortgage Loans 1-4 Family Residential Mortgage Loans

Holding long-term fixed-rate mortgages can create interest rate risk for banks with loss potential if rates increase

To avoid this, many mortgages now provide for: Periodic adjustments in the interest rate Adjustments in periodic principal payments The lender sharing in any price appreciation of

the underlying asset at sale All of these can increase cash flows to the lender

when interest rates rise

129


The Secondary Mortgage Market Involves the trading of previously

originated residential mortgages Can be sold directly to investors or

packaged into mortgage pools

130


Home Equity Loans Second Mortgage Loans

Typically shorter term than first mortgages Subordinated to first mortgage

Home Equity Lines of Credit (HELOC)

131


Equity Investments in Real Estate Historically, commercial banks have been

prevented from owning real estate except for their corporate offices or property involved in foreclosure

Regulators want banks to engage in speculative real estate activities only through separate subsidiaries

The Gramm-Leach-Bliley Act of 1999 allowed for commercial banks and savings institutions to enter into the merchant banking business

132

Characteristics of Different Types of Loans Commercial Loans

Loan Commitment/Line of Credit Formal agreement between a bank and

borrower to provide a fixed amount of credit for a specified period

The customer determines the timing of actual borrowing

133


Working Capital Requirements Net Working Capital

Current assets – Current liabilities For most firms, net working capital is

positive, indicating that some current assets are not financed with current liabilities

134


Working Capital Requirements Days Cash

Cash/(Sales/365) Days Receivables

AR/(Sales/365) Days Inventory

Inventory/(COGS/365)

135


Working Capital Requirements Days Payable

AP/(Purchases/365) Days Accruals

Accruals/(Operating Expenses/365)

136


Working Capital Requirements Cash-to-Cash Asset Cycle

How long the firm must finance operating cash, inventory and accounts receivables from the day of first sale

Cash-to-Cash Liability Cycle How long a firm obtains interest-free

financing from suppliers in the form of accounts payable and accrued expenses to help finance the asset cycle

138


Working Capital Requirements

139


Seasonal versus Permanent Working Capital Needs

All firms need some minimum level of current assets and current liabilities

The amount of current assets and current liabilities will vary with seasonal patterns

140



Permanent Working Capital The minimum level of current assets minus

the minimum level of adjusted current liabilities

Adjusted Current Liabilities Current liabilities net of short-term

bank credit and current maturities of long-term debt

141



Seasonal Working Capital Difference in total current assets and

adjusted current liabilities

142


Seasonal Working Capital Loans Finance a temporary increase in net

current assets above the permanent requirement

Loan is seasonal if the need arises on a regular basis and if the cycle completes itself within one year

Loan is self-liquidating if repayment derives from sales of the finished goods that are financed

144


Short-Term Commercial Loans Short-term funding needs are financed

by short-term loans, while long-term needs are financed by term loans with longer maturities

145


Open Credit Lines Used to meet many types of temporary needs

in addition to seasonal needs Informal Credit Line

Not legally binding but represent a promise that the lender will advance credit

Formal Credit Line Legally binding even though no written

agreement is signed A commitment fee is charged for making credit

available, regardless of whether the customer actually uses the line

146


Asset-Based Loans Loans Secured by Accounts Receivable

The security consists of paper assets that presumably represent sales

The quality of the collateral depends on the borrower’s integrity in reporting actual sales and the credibility of billings

147


Asset-Based Loans Loans Secured by Accounts Receivable

Accounts Receivable Aging Schedule List of A/Rs grouped according to the

month in which the invoice is dated Lockbox

Customer’s mail payments go directly to a P.O. Box controlled by the bank

The bank processes the payments and reduces the borrower’s balance but charges the borrower for handling the items

148


Highly Levered Transactions Leveraged Buyout (LBO)

Involves a group of investors, often part of the management team, buying a target company and taking it private with a minimum amount of equity and a large amount of debt

Target companies are generally those with undervalued hard assets

149


Highly Levered Transactions Leveraged Buyout (LBO)

The investors often sell specific assets or subsidiaries to pay down much of the debt quickly

If key assets have been undervalued, the investors may own a downsized company whose earnings prospects have improved and whose stock has increased in value

The investors sell the company or take it public once the market perceives its greater value

150


Highly Levered Transactions Arise from three types of transactions

LBOs in which debt is substituted for privately held equity

Leveraged recapitalizations in which borrowers use loan proceeds to pay large dividends to shareholders

Leveraged acquisitions in which a cash purchase of another related company produces an increase in the buyer’s debt structure

151


Highly Levered Transactions An HLT must involve the buyout,

recapitalization, or acquisition of a firm in which either:

1. The firm’s subsequent leverage ratio exceeds 75 percent

2. The transaction more than doubles the borrower’s liabilities and produces a leverage ratio over 50 percent

3. The regulators or firm that syndicates the loans declares the transaction an HLT

152


Term Commercial Loans Original maturity greater than 1 year

Typically finance: Depreciable assets Start-up costs for a new venture Permanent increase in the level of

working capital

153


Term Commercial Loans Lenders focus more on the borrower’s

periodic income and cash flow rather than the balance sheet

Term loans often require collateral, but this represents a secondary source of repayment in case the borrower defaults

154


Term Commercial Loans Balloon Payments

Most of the principal is due at maturity Bullet Payments

All of the principal is due at maturity

155


Revolving Credits A hybrid of short-term working capital loans

and term loans Typically involves the commitment of funds for

1 – 5 years At the end of some interim period, the

outstanding principal converts to a term loan During the interim period, the borrower

determines how much credit to use Mandatory principal payments begin once the

revolver is converted to a term loan

156

Characteristics of Different Types of Loans Agricultural Loans

Proceeds are used to purchase seed, fertilizer and pesticides and to pay other production costs

Farmers expect to repay the debt with the crops are harvested and sold

Long-term loans finance livestock, equipment, and land purchases

The primary source of repayment is cash flow from the sale of livestock and harvested crops in excess of operating expenses

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Characteristics of Different Types of Loans Consumer Loans

Installment Require periodic payments of principal

and interest Credit Card Non-Installment

For special purposes Example: Bridge loan for the down

payment on a house that is repaid from the sale of the previous house

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Characteristics of Different Types of Loans Venture Capital

A broad term use to describe funding acquired in the earlier stages of a firm’s economic life

Due to the high leverage and risk involved banks generally do not participate directly in venture capital deals

Some banks have subsidiaries that finance certain types of equity participations and venture capital deals, but their participation is limited

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Venture capital firms attempt to add value to the firm without taking majority control

Often, venture capital firms not only provide financing but experience, expertise, contacts, and advice when required

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Types of Venture Financing Seed or Start-up Capital

Early stages of financing Highly levered transactions in which the

venture capital firm will lend money for a percentage stake in the firm

Rarely, if ever, do banks participate at this stage

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Types of Venture Financing Later-Stage Development Financing:

Expansion and replacement financing Recapitalization or turnaround financing Buy-out or buy-in financing Mezzanine financing

Banks do participate in these rounds of financing, but if the company is overleveraged at the onset, the banks will be effectively excluded from these later rounds of financing

funding the bank 1 10. the relationship between liquidity requirements, cash, and funding sources...

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