Chapter 7 Short Term Financing PDF

Chapter 8: Short Term Financing  Learning Outcomes By the end of this chapter, learners should be able to: – Understand the concept of secured and unsecured financing. – Determine the cost of financing. – Calculate the effective cost of borrowing or short term loans....

Chapter 8: Short Term Financing  Learning Outcomes By the end of this chapter, learners should be able to: – Understand the concept of secured and unsecured financing. – Determine the cost of financing. – Calculate the effective cost of borrowing or short term loans. – Calculate the effective cost of factoring and pledging of receivable.  Chapter Content 1. Types of Short Term Financing a) Secured b) Unsecured 2. Cost of Financing  Introduction Short term financing – a short term obligation that is expected to mature in one year or less. Is usually required to support a large portion of the firm’s current assets. The use is to meet seasonal and temporary fluctuation in the company’s funds.  Pros and Cons of Short Term Debt Flexibility If the needs for funds are seasonal or cyclical, the use of short-term financing is more appropriate as the firm may not want to commit itself to long-term debt. Cost of short Interest will be lower on short-term rates than on long-term term debt is rates. lower Relative riskiness The use of short-term debt tends to be riskier. This is due to: Short term interest rates tend to fluctuate widely while a firm using long-term debt can lock-in a given rate; and If a firm borrows heavily on a short term basis, it may find itself unable to repay or rollover this debt.  Internal or Spontaneous Financing Short-term financing that is internally generated from normal business activities. Can be obtained from: – Accrued wages and taxes – Accounts payable or trade credit  Direct Borrowings from Banks/ Unsecured Financing Consists of short-term financing from external sources. Short Term Bank loans Revolving Commercial Notes Payable Line of Credit Credit Paper  Short Term Bank Loans The banks provide non-spontaneous funds; as the firm’s financing needs increase, it will request its bank to provide the additional funds.  Notes Payable A single payment loan obtained from a commercial bank by a credit-worthy business borrower. This type of loan is made when a borrower needs additional funds for a short period only. The instrument resulting from this type of short term unsecured loan is a note which must be signed by the borrower. The note states the term of the loan, the  Line of Credit It is an agreement between a commercial bank and a business firm that states the amount of unsecured short-term borrowing the bank will make available to the borrower. Typically it is made for a period of one year. It is not a guaranteed loan but it indicates that if the bank has sufficient funds available, it will allow the borrower to owe  Line of Credit The borrower must apply each time he wants to obtain a line of credit and submit documents such as cash budget, proforma income statement and proforma balance sheet.  Revolving Credit Is a guaranteed line of credit. The commercial bank guarantees the borrower that a specified amount of funds will be made available. It could be for one, two or three years depending on the agreement. A commitment fee is charged to the borrower on the unused balance of the credit agreement.  Consumer Revolving Credit Credit card companies, department stores, and banks grant consumers lines of credit up to specified limits. Interest is calculated each month on the outstanding balance and this interest is added to the previous balance. Since interest is compounded monthly, the effective rate will be higher than the stated rate.  Revolving Credit Agreement (RCA) It is a formal arrangement between the borrower and the bank. Involves commitment fee charged on the unused portion of the facility granted. The commitment fee is a penalty for not using the total amount allocated.  Overdraft A short term facility provided by commercial banks to current account holders. Is designed to cover the customer’s short term financial constraint. Interest charged is dependant on the borrower’s financial risk. Interest is calculated on a daily basis and penalty is charged if the borrower does not pay the interest at the end of the  Commercial Paper A form of financing that consists of short- term unsecured promissory notes issued by firms with high credit standing. Generally only large corporations with good reputation are able to issue commercial paper. Maturities range from 3 to 270 days. Generally issued in multiples of RM100,000 or more.  Account Receivable Factoring Involves either pledging of receivables or selling of receivable (known as factoring) to secure a loan.  Pledging Occurs when account receivable is used as collateral for loan. The borrower pledges the account receivables as collateral for a loan and the finance company will assess the creditworthiness of each of the accounts pledged.  Inventory Financing Terminal Field Floating Lien Trust Receipts Warehouse Warehouse Agreement Receipts Receipts The firm The firm holds The inventory is Similar to receives the inventory for forwarded as terminal security interest the lender and collateral that warehouse on the firm’s any proceeds will be stored in receipt, but the entire inventory from the a bonded inventory is that may include inventory must warehouse. The stored in the present and be forwarded to warehouse will firm’s own future inventory. the lender. only release the warehouse. The inventory when inventory is authorized by separated from the lender as the firm’s other the borrower inventories. Only repays its loan. the lender has the authority to release the  Cost of Loan Effective Nominal Discounted Compensating Annual Interest Interest Rate Loan Balance Rate Interest rate The actual cost Interest on Deposit that unadjusted for of borrowing loans is paid in the firm keeps inflation or after taking into advanced. with the bank to terms of consideration Reduces loan compensate for borrowing. the differential proceeds that bank loans or Is normally in periods of can be used by services. stated at face compounding the borrower. Will also value of the and terms reduce interest associated with proceeds. charged on the borrowings. borrowings.  Effective Interest Rate EIR = Interest x 12 Net Proceeds Maturity in months Example: If the borrower receives RM10,000 now at 12% interest for a one year period, what is the EIR?  Effective Interest Rate Interest = RM10,000 x 12% = RM1,200 EIR = RM1,200 x 12 RM10,000 12 = 12% Example: If the borrower receives RM10,000 now at 12% interest for a period of 6 months, what is the EIR?  Effective Interest Rate Interest = RM10,000 x (0.12/ 2) = RM600 EIR = RM600 x 12 RM10,000 6 = 12%  Discounted Interest Rate Occurs when the bank deducts the interest in advance. Example: If the borrower borrows RM10,000 at 12% interest for a one year period at discounted interest, what is the EIR?  Discounted Interest Rate Interest = RM10,000 (0.12) = RM1,200 Net = RM10,000 – RM1,200 = RM8,800 Proceeds EIR = RM 1,200 x 12 Example: RM8,800 12 = If the borrower 13.64% borrows RM10,000 at 12% interest at discounted basis for a six months period, what is the EIR?  Discounted Interest Rate Interest EIR == RM RM10,000 10,000 (0.12/2) (0.12/2) x = RM600 12 Net = RM10,000 RM9,400 – RM600 = RM9,400 6 Proceeds = 12.77% EIR = RM 600 x 12 RM9,400 6 = 12.77%  Compensating Balance Compensating balance will increase the effective interest rate. Example: If the borrower borrows RM10,000 at 12% interest for a one year period and is required to have a compensating balance of 10%, what is the EIR?  Compensating Balance Interest = RM10,000 (0.12) = RM1,200 Compensating = RM10,000 (0.10) = RM1,000 Balance Net Proceeds = RM10,000 – = RM9,000 RM1,000 EIR = RM 1,200 x 12 Example: If the borrower borrows RM10,000 at 12% RM9,000 12 interest at discounted = basis for a six months period and 13.33% is required to have a compensating balance of 10%, what is the EIR?  Compensating Balance Interest = RM10,000 (0.12/2) = RM600 Compensating = RM10,000 (0.10) = RM1,000 Balance Net Proceeds = RM10,000 – = RM9,000 RM1,000 EIR = RM 600 x 12 RM9,000 6 = 13.33%  Discounted Interest and Compensating Balance Example: If a firm borrows RM10,000 for a one year period and is charged a compensating balance of 8% and discounted interest of 10%. What is the firm’s effective interest rate?  Discounted Interest and Compensating Balance Interest = RM10,000 (0.10) = RM1,000 Compensating = RM10,000 (0.08) = RM800 Balance Net Proceeds = RM10,000 – = RM8,200 RM1,000 – RM800 EIR = RM 1,000 x 12 RM8,200 12 = 12.20%  Illustration 1 Assume that a firm has been granted a revolving credit amounting RM100,000 at 14% annual interest and 0.50% of commitment fee. It only uses RM80,000 and RM20,000 left unused. What is the EIR of the firm?  Solution Interest = RM80,000 (0.14) = RM11,200 Commitment = RM20,000(0.005) = RM100 Fee Compensating = None Balance EIR = Interest + Commitment Fee x 12 Amount Borrowed – Time Compensating Balance = RM11,200 + RM100 X 12  Illustration 2 Assume that a firm plans to issue RM100,000 commercial paper that is sold at 94% of its face value. If the maturity is 6 months and the issuing cost is 5%, calculate the EIR.  Solution Interest = RM100,000 – RM100,000 (0.94) = RM6,000 Cost = RM100,000 (0.05) = RM5,000 EIR = Interest x 12 (Face Value – Interest – Cost) Time = RM6,000 X 12 RM100,000 – RM6,000 – 6 RM5,000 = 13.48%  Illustration 3 Renong Corporation has just issued RM1 million worth of commercial paper that has a 90-day maturity and sells for RM980,000. At the end of 90 days, the purchaser of this paper will receive RM 1 million for their investment. Calculate the effective rate of interest if the interest charged is 2%.  Solution Interest = RM1 million (0.02) = RM20,000 Proceeds = RM980,000 EIR = Interest x 12 Proceeds Time = RM20,000 X 360 RM980,000 90 = 8.16%  Exercise 1 Mustika Bhd has a revolving credit agreement with AGS Bank under which it can borrow up to RM15 million. The company must maintain a 10% compensating balance on outstanding loans. Interest on the borrowed funds is 15% and the commitment fee is 1.5% on the unused portion of the credit line. Find the effective interest rate for Mustika Bhd if the amount borrowed is: – RM3 million – RM15 million  Exercise 2 Ratu Bhd determined that it needs an additional capital of RM100 million. The financial manager of the company has decided to issue a commercial paper to fund the capital. The interest rate is 9.5% and the placement fee is RM150,000. The commercial paper has a 270-day maturity. Calculate the effective rate for this paper.  References 1. Financial Management by Rohani A. Ghani and Mohd Sabri Hj Mohd Amin, InED, UiTM Shah Alam. End of Chapter 8 ANY QUESTION End of Chapter 8 ANY QUESTION