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Chapter 8

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Chapter 8

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  1. Chapter 8 Sources of Short-TermFinancing

  2. Chapter 8 - Outline • Sources of Short-Term Financing • Trade Credit • Net Credit Position • Bank Credit Terminology • Types of Bank Loans • Corporate and Foreign Borrowing Terminology • Accounts Receivable Financing

  3. Sources of Short-Term Financing There are various sources of short-term funds available to a firm: – Trade Credit from Suppliers – Bank Loans – Corporate Promissory Notes – Foreign Borrowing – Loans Against Receivables and Inventory

  4. Trade Credit • The largest source of short-term financing for a firm. Approximately 40 percent of short-term financing is in the form of accounts payable or trade credit • Accounts payable • Is a Spontaneous source of funds • Grows as the business expands • Contracts when business declines • Extending the payment period to an unacceptable period results in: • Alienate suppliers • Diminished ratings with credit bureaus • It is usually a 30-60 day grace period before a bill is due • A cash discount is often given if payment is made within a specified time – Ex., 2/10 net 30 means a 2% discount is given if paid in 10 days; if not, the full amount is due in 30 days

  5. Net-Credit Position • Determined by examining the difference between accounts receivable and accounts payable • Positive if accounts receivable is greater than accounts payable and vice versa • Larger firms tend to be net providers of trade credit (relatively high receivables) • Smaller firms in the relatively user position (relatively high payables)

  6. Cash Discount Policy • Allows reduction in price if payment is made within a specified time period • Example: A 2/10, net 30 cash discount means: • Reduction of 2% if funds are remitted 10 days after billing • Failure to do so means full payment of amount by the 30th day • Cost of NOT taking a discount:

  7. Bank Credit Terminology Prime Rate: – the interest rate charged to a bank’s best customers – acts as a benchmark for calculating other interest rates Compensating Balance: – when a bank requires a minimum average account balance for business customers in order to qualify for a loan – can be thought of as a form of collateral Effective Interest Rate: – the actual interest rate or “true” cost of a loan – also known as the annual percentage rate (APR)

  8. Types of Bank Loans Discounted Loan: – when a bank deducts the interest on the loan in advance and lends the balance Installment Loan: – calls for a series of equal payments over the life of the loan – ex., most car loans and home mortgages Compensating Balance Loan: – when a compensating balance is required as part of the loan

  9. Effective Rates for Different Types of Bank Loans Effective Rate = Interest / $ Received x 360 / Days loan is outstanding Or % / 1 x 360 / Days loan is outstanding For Discounted Loan subtract Interest from Principal (or int. % from 1) when computing denominator. For Compensating Balance Loan: Subtract Compensating Balance from Principal (or % CB from 1) when computing denominator. • If discounted loan with compensating balance, then subtract interest plus compensating balance (or % and CB%). For Installment Loan, the approximation for annualizing is: 2 x Annual # of payments / Total number of payments + 1 (instead of x 360 / days loan is outstanding – note that all annualizing shown ignores compounding of interest)

  10. Corporate and Foreign Borrowing Terminology Commercial Paper: – a short-term unsecured promissory note issued to the public in minimum units of $25,000 – total amount of commercial paper outstanding has increased greatly in recent years Eurodollar: – a U.S. dollar held or deposited in a foreign bank – loans from foreign banks denominated in American dollars are called Eurodollar loans

  11. Advantages of Commercial Paper • May be issued at below the prime interest rate • No associated compensating balance requirements • Associated prestige for the firm to float their paper in an elite market

  12. Disadvantages of Commercial Paper • Many lenders have become risk-averse post a multitude of bankruptcies • Firms with downgraded credit rating do not have access to this market • The funds generation associated with this is less predictable • Lacks the degree of commitment and loyalty associated with bank loans

  13. Accounts Receivable Financing • A/R financing includes 2 choices: – pledging accounts receivable as collateral for a loan OR – an outright sale (also called factoring) of receivables to a bank or finance company • Tends to be a relatively expensive source of financing

  14. The Credit Crunch Phenomenon • The Federal Reserve tightens the growth in the money supply to combat inflation – the affect: • Decrease in funds to be lent and an increase in interest rates • Increase in demand for funds to carry inflation-laden inventory and receivables • Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns • Credit conditions can change dramatically and suddenly due to: • Unexpected defaults • Economic recessions • Changes in monetary policy • Other economic setbacks