978-1259277160 Chapter 8 Lecture Note

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Sources of Short-Term Financing

Author’s Overview

The instructor has the opportunity to cover the various sources of short-term financing with an

eye toward the borrower’s size and the relative cost of doing business. Since banking is such a

rapidly changing area, the instructor may wish to highlight some of the changes that are taking

place. The student should also get some exposure to the various considerations in computing

interest costs. Throughout the chapter, there are ample opportunities to indicate the advantages

and drawbacks of trade credit, bank credit, commercial paper, foreign borrowing and

collateralized borrowing arrangements.

Chapter Concepts

LO1. Trade credit from suppliers is normally the most available form of short-term financing.

LO2. Bank loans are usually short-term in nature and should be paid off from funds from the

normal operations of the firm.

LO3. Commercial paper represents a short-term, unsecured promissory note issued by the

firm.

LO4. By using accounts receivable and inventory as collateral for a loan, the firm may be able

to borrow larger amounts.

LO5. Hedging may be used to offset the risk of interest rates rising.

Annotated Outline and Strategy

I. Trade Credit

A. Usually the largest source of short-term financing

B. A spontaneous source of financing that changes as sales expand or contract

C. Credit period is set by terms of credit but firms may be able to “stretch” the

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payment period.

D. Cash discount policy

1. Suppliers may provide a cash discount for early payment.

2. Foregoing discounts can be very expensive. The cost of failing to take a

discount is computed as follows:

3. Whether a firm should take a discount depends on the relative costs of

alternative sources of financing.

E. Net Credit Position

1. The relationship between a firm’s level of accounts receivable and its

accounts payable determines its net credit position.

2. If the firm’s average receivables exceed average payables, it is a net

provider of credit. If payables exceed receivables, the firm is a net user

of trade credit.

II. Bank Credit

Perspective 8-1: Discuss how financial institutions have changed over time. The

Gramm-Leach-Bliley Act in 1999 allowed banks and investment banks to merge and created a

more competitive market place but also created institutions that were “too big to fail.” The

financial crisis of 2007-2008 that resulted in the Dodd-Frank Act in 2011 impacted the way

banks are regulated and are changing the way banks are managing their risk assets.

A. Banks prefer short-term, self-liquidating loans

B. Bank loan terms and concepts

1. Prime rate: The interest rate charged the most credit-worthy borrowers.

a. The prime rate serves as a base in determining the interest rate for

various risk classes of borrowers.

b. The prime rate of New York banks receives much attention from

government officials in managing the economy.

c. The prime rate has been more volatile in the last couple of

decades than in previous decades.

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Cost of failing Discount % 360

to take discount 100% Discount % Final due date Discount period

– –

PPT Movement of the Prime Rate versus LIBOR (Figure 8-1)

d. The London Interbank Offer Rate (LIBOR) on U.S. dollar

deposits is being used worldwide as a base-lending rate on dollar

loans.

Perspective 8-2: The Finance in Action Box “LIBOR Price Fixing Scandal” is a good lesson

in ethics. Many bank CEOs along with traders lost their jobs and the scandal pointed out the

inadequacy of regulators.

2. Compensating Balances

a. As a loan condition, a borrower may be required to maintain an

average minimum account balance in the bank equal to a

percentage of loans outstanding or a percentage of future

commitments and/or pay a fee for services.

b. Compensating balances raise the cost of a loan and compensate

the bank for its services.

c. If a compensating balance is required, the borrower must borrow

more than the amount needed.

3. Maturity Provisions

a. Most bank loans are short-term and mature within a year.

b. In the last decade more banks have extended intermediate-term

loans (one to seven years) that are paid in installments.

4. Costs of Commercial Bank Financing – The effective interest rate depends

on the loan amount, interest paid, length of the loan, and method of

repayment.

Perspective 8-3: Review Formulas 8-2 through 8-6 including a comparison of the effective

costs of a loan under varying assumptions.

C. Annual Percentage Rate

1. The Truth in Lending Act enacted by Congress in 1968 requires that the

annual percentage rate (APR) be given to the borrower. The thrust of the

legislation was to protect unwary individuals from paying more than the

stated rate without his or her knowledge.

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2. The APR requires the use of the actuarial method of compounded interest

and corresponds to the effective rate used throughout the text.

D. Bank Credit Availability Tends to Cycle

1. Credit crunches seem to appear every 3-5 years.

2. The pattern of the credit crunch has been as follows:

a. The Federal Reserve tightens the money supply to fight inflation.

b. Lendable funds shrink, interest rates rise.

c. Business loan demand increases due to price-inflated inventories

and receivables.

d. Depositors withdraw savings from banks seeking higher return

elsewhere, further reducing bank credit availability.

e. In the early 1990s, the U.S. saw a different kind of credit crunch

from too many bad loans. The supply of funds dwindled and

caused record bankruptcies for bank and savings and loans.

III. Financing through Commercial Paper

A. Short-term unsecured promissory notes issued to the public in minimum units of

$25,000.

B. Issuers

1. Finance companies such as General Motors Acceptance Corporation

(GMAC) that issue paper directly. Such issued are referred to as finance

paper or direct paper.

2. Industrial or utility firms that issue paper indirectly through dealer. This

type of issue is called dealer paper.

3. Asset backed commercial paper was primarily bundled mortgage-backed

securities that increased in popularity until the banking crises in 2007.

C. There has been very rapid growth in the commercial paper market in the last few

decades. Using Figure 8-2, emphasize how the commercial paper market

collapsed in 2007 and continued on a downhill slide. Only non-financial paper

began to recover in early 2010 and by 2015 had almost reached its previous peak

set in 2001.

PPT Total Commercial Paper Outstanding (Figure 8-2)

D. Traditionally, commercial paper has been a paper certificate issued to the lender

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to signify the lender’s claim to be repaid. There is a growing trend among

companies that sell and buy commercial paper to handle the transaction

electronically. Actual paper certificates are not created. Documentation of the

transactions is provided by computerized book-entry transactions and transfers

of money are accomplished by wiring cash between lenders and commercial

paper issuers.

E. Advantages

1. Commercial paper may be issued at below the prime rate at commercial

banks.

2. No compensating balances are required, though lines of credit are

necessary.

3. Prestige.

F. Limitations

1. The primary limitation is the possibility that the commercial paper

market might “dry up” unexpectedly as it does whenever an investment

grade company has its credit rating lowered by Standard & Poor’s,

Moody’s or Fitch.

2. A credit crisis like the one of 2007-2009 might cause the market to stop

functioning for a period of time.

PPT Comparison of Commercial Paper Rate to Bank Prime Rate

(Table 8-1)

IV. Foreign Borrowing

A. Loans from foreign banks are an increasing source of funds for U.S. firms.

B. Foreign loans denominated in U.S. dollars are called Euro-dollar loans. These

loans are usually short to intermediate term in maturity.

C. A possibly cheaper alternative to borrowing Euro-dollars is the borrowing of

foreign currencies that are converted to dollars and forwarded to the U.S. parent

company.

V. Use of Collateral in Short-Term Financing

A. The lending institution may require collateral to be pledged when granting a

loan.

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B. Lenders lend on the basis of the cash-flow capacity of the borrower. Collateral

is an additional but secondary consideration.

VI. Accounts Receivable Financing

1. Pledging accounts receivable as collateral

a. Convenient means of financing. Receivables levels are rising as

the need for financing is increasing.

b. May be relatively expensive and preclude use of alternative

financing sources.

c. Lender screens accounts and loans a percentage (60% – 80%) of

the acceptable amount.

d. Lender has full recourse against borrower.

e. The interest rate, which is usually well in excess of the prime rate,

is based on the frequently changing loan balance outstanding.

2. Factoring Receivables

a. Receivables are sold, usually without recourse, to a factoring

firm.

b. A factor provides a credit-screening function by accepting or

rejecting accounts.

c. Factoring costs.

1) Commission of 1% – 3% of factored invoices

2) Interest on advances

3. Asset-backed public offerings

a. Public offerings of securities backed by receivables as collateral

are a means of short-term financing.

b. Several problems exist:

1) Historically firms that sold receivables were considered to

be in financial trouble.

2) The receivables might not be paid in the case of a

recession or credit crisis.

VII. Inventory Financing

A. The collateral value of inventory is based on several factors.

1. Marketability

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a. Raw materials and finished goods are more marketable than

goods-in-process inventories.

b. Standardized products or widely traded commodities qualify for

higher percentage loans.

2. Price Stability

3. Perishability

4. Physical Control

a. Blanket inventory liens: Lender has general claim against

inventory of borrower. No physical control.

b. Trust receipts: Also known as floor planning; the borrower holds

specifically identified inventory and proceeds from sale in trust

for the lender.

c. Warehousing: Goods are physically identified, segregated, and

stored under the director of an independent warehousing company.

Inventory is released from warehouse openly upon presentation of

warehouse receipt controlled by the lender.

1) Public warehouse — facility on the premises of the

warehousing firm.

2) Field warehouse — independently controlled facility on the

premises of borrower.

B. Inventory financing and the associated control methods are standard procedures

in many industries.

Finance in Action: How About Going to the Internet to Borrow Money?

This article discusses a form of Internet social lending that shows promise as a source of

financing. To avoid high interest rates from traditional lenders, borrowers are finding lower

rate loans on the Internet through loan brokerage sites such as Prosper.com. Like e-bay or other

auction sites, borrowers register their loan needs including the amount needed, the length of

time the funds will be needed, and the interest rate they are willing to pay. Lenders register the

amount they have to loan starting with as little as $50 and the rate they want to receive. Loans

can then be consolidated from several small lenders so the risk to any one lender is minimized.

VIII. Hedging to Reduce Borrowing Risk

A. Firms that continually borrow to finance operations are exposed to the risk of

interest rate changes.

B. Hedging activities in the financial futures market reduces the risk of interest rate

changes.

C. Hedging involves entering into a contract to buy or sell treasury bonds in the

future, at a price negotiated in the present. Changes in the interest rate will drive

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changes in the future purchase price of the investment and result in a profit or

loss.

Perspective 8-4: Hedging and the use of derivative products is one of the hottest topics in

finance. This example helps explain the general concept of hedging.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 9, Pierce Control System (bank financing)

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