Short Term Financing

FINC5880 Spring 2014 Shanghai

Alternative Current Asset Financing Self liquidating approach: the

useful life time of the asset is matched with its financing

Aggressive approach: the company finances part of its LT assets with short financing (taking the risk of changing r %)

Conservative approach: the company finances LT also ST needs like part of the ST working capital requirements (avoiding any risk of changing r % on short capital)

Making the fit…

Assignment : Aggressive or conservative

Consider your teams company assets LT and current over the past 5 years

Consider the relation between LT assets and LT financing and ST assets and ST financing

Does your team’s company follow an aggressive approach or conservative

What is your companies’ cost of short term financing? (% and/or USD)

In between the market and the company…

Short term financing Advantages:

Fast, flexible, ST debt is cheaper then LT

Disadvantages: ST debt is riskier, ST rates vary highly…

3 Month 0.82 0.83 0.81 0.79

6 Month 0.93 0.94 0.93 0.94

2 Year 1.73 1.82 1.80 1.79

3 Year 2.15 2.24 2.22 2.27

5 Year 3.07 3.17 3.14 3.20

10 Year 4.07 4.16 4.13 4.24

30 Year 4.91 4.97 4.95 5.07

T Bond rates

Sources of ST Financing

Accruals; accrued wages (before salary payments are made), accrued taxes (before payment) This is interest free capital for the firm.

Accounts Payables: average 40% of current liabilities are AP’s; it’s a trade credit the cost depends on discount for earlier payments…this is substantial

AP and Financial Statements

Taking more AP extends this financing source

Taking more discounts reduces this source but increases income

What’s better is matter of calculation!

ST Bank Loans 66% of bank loans mature within 1

year This is the second most important

source of ST financing The agreement is signed by

promissory note (conditions of the loan)

Sometimes the firm has to keep a compensating balance in account of say 20% of the total loan sum

Informal line of credit; firm can draw on “good for $...” account

Revolving credit; often accompanied by a clean up close (the balance has to be zero once a year at least)

Bank loan rates move with the prime rate; see what the prime rate has been over the past years to understand the differences in loan rates over the years…

Where banks invest in….

Prime rate is base rate for bank loans

4%

10%

High growth

Low growth

And now…

Promissory note conditions Interest only loan; principal will be paid

when the loan matures; the interest rate can be fixed or floating

Collateral: generally accounts receivables or/and inventory

Loan guarantees: by the owner privately Interest is most likely paid monthly Maturity for short loans is anywhere in

between 30 days and 1 year Sometimes interest will be paid in advance

(so called discount interest) Auto loans have an add-on character; the

interest over the life of the loan is added to the loan amount

Key person (life) insurance guarantees…as collateral for the case something happens to key persons of the firm

Banks bank… Interest paid needs to be paid

per month Interest on your savings you

will get per quarter but more likely once per year

Calculate what amount of interest you pay on a 10% loan when you pay per month, quarter or per year (loan $ 10,000)

The monthly rate: 10%/12=0.85%

Compounded:0.85^12= 14,2%!

Quarterly: 10%/4=2.5% Compounded: 1.025^4=

10,4%

Discount loans Discount the interest

up front and deduct it from the amount the borrower gets in hand…

Say 1yr loan 10% of 10.000 RMB would give the borrower RMB 9000 in hand…

Ready for the calculus? 10% per annum is the

same as …% per quarter. Is 10% per annum the

same if the year is based on 360 days or 365 days?

Is paying interest in advance the same as paying interest at maturity

Is paying interest at the beginning of a period the same as paying interest at the end of that period?

Putting it together

Your answers… 1.10 per year is the same as

(1.10)^0.25=1.02411 per quarter or 2,411%

10% per annum is 10% per annum but the daily interest will be different; 10%/365 days≠10%/360days

Paying interest in advance reduces risk and increases liquidity so the interest amount paid will be different

The same is true for paying interest pre/post period…

Money-wise

Discounted interest The bank deducts the interest

on the loan up front so the borrower will receive the face value of the loan less the total interest to be paid

The borrower can only default on the pay back of the loan…

If a loan of $ 10,000 has a 10% interest you will get $ 9,000

The effective rate will be?Magic Box

Discounted rates

Interest $ 1000 Money in hands: $ 9000 Effective rate:

$1000/$9000*100%= 11,11% much higher then the nominal rate of 10%

Testing your computer…

SOME BANKS ASK FOR COMPENSATING BALANCES

Say loan is $ 10,000 and interest is 10% and the bank wants a 20% compensating balance

The bank takes $1000 interest in advance and asks for a $ 2000 balance during the period of the loan

You will get $ 7000, $ 2000 stays in the bank and $ 8000 needs to be repaid at maturity

Effective rate?

Experiments…

Your answer

$ 1000 interest $ 7000 in hand $ 1000/$ 7000*100%= 14,29% much

much higher then the nominal rate of 10%

Money is costly…

Add on interest loans (installment loans like for cars)

A 10% loan of $ 10,000 to be repaid in 1 year in monthly installments

You pay $ 1000 interest But after the first month 11/12 of

the loan will be outstanding etc. On average $ 5000 will be

outstanding during the year The effective rate is now?

Calculating…

Your staggering answer Average outstanding $ 5000 Interest paid $ 1000 Thus

$1000/$5000*100%=20%! Twice as high as the

nominal rate! You pay $ 11000 in 12

installments being $ 916,67 per month

The IRR% of this stream of cash is ?

Got it!

Your answers… The IRR% of these monthly

installments is 1,50% (rounded *) per month

The effective annual rate is: (1+1,5%)^12-1= 19,53%

The annual percentage rate is:

1,5%*12= 17,97% (*)Pealing the Orange

How to chose a bank Willingness to accept risk Based on the portfolio (risk

spread) of the loans of the bank…

Degree of loyalty of the bank; some bank’s rather leave their customers in bad times

Some banks specialize in some sorts of credit or/and sectors

The bank can not give loans higher then 15% of its capital to 1 customer (by law)

Commercial Paper Only issued by large

and strong firms Maturity 1 day-9

months Interest rate fluctuates

with supply and demand

Rates vary in between 1,5-3% below the prime rate and about 0,125-0,5% above T-bill rate!

ST securities for financing Commercial Paper is

never secured Loans can be secured Collateral can also be

given in marketable stocks or bonds…

This reduces credit risk and lowers interest on the loan…

Many companies have strong seasonal

financing needs….

Quarterly Sales Wal Mart

0

10000

20000

30000

40000

50000

60000

70000

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37

Quarterly Sales Wal Mart

Qtr 1 Qtr 2 Qtr 3 Qtr 4

13920 16237 16827 20361

17690 19942 20418 24448

20440 22723 22913 27550

22772 25587 25644 30856

25409 28366 28777 35386

29819 33521 33509 40785

34717 38170 40432 51394

42985 46112 45676 56556

48565 53269 51754 64211

Companies like this will negotiate an informal line of credit with their bank

Informal agreement between the bank and the company

The bank will assess the company’s credit line maximum

The company will draw on this line during the year “taking down” of the line of credit

The bank does not get a formal fee and the bank does not have any legal obligations to extend the line of credit in amount or time… Bird flue..egg sales and

financing effects…

Revolving credit agreement Formal line of credit Based on contract and

legal obligations Bank receives a

commitment fee Companies pay a fixed

% fee on the unused part of the line of credit…

The rate of the loan is pegged to the T-bill rate for revolvers….

Revolvers are popular….

Assignment: WC and short term Financing Determine the WC by quarter of your team’s

company Is there a seasonal effect ? How does your company normally Finance the

seasonal effect? (look at the current liabilities during the season)

Would you say your company is aggressively, conservatively or at liquidity financed during the season?

Working Capital Management?