CH 23 Show

23 - 1
CHAPTER 23
Short-Term Financing
 Working capital financing policies

 Accounts payable (trade credit)
 Commercial paper
 Short-term bank loans
 Secured short-term credit
Copyright © 2002 Harcourt, Inc. All rights reserved.
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Working Capital Financing Policies
 Maturity Matching: Matches the

maturity of the assets with the
maturity of the financing.
 Aggressive: Uses short-term
(temporary) capital to finance some
permanent assets.
 Conservative: Uses long-term
(permanent) capital to finance some
temporary assets.
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Maturity Matching Financing Policy

$ Temp. C.A.
S-T
Loans
Perm C.A. L-T Fin:

Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
What are “permanent” assets?
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Aggressive Financing Policy

$ Temp. C.A.
S-T
Loans
L-T Fin:
Perm C.A.
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
More aggressive the lower the dashed line.
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Conservative Financing Policy

$ Marketable Securities
Zero S-T
debt
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
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 The choice of working capital policy is

a classic risk/return tradeoff.
 The aggressive policy promises the
highest return but carries the greatest
risk.
 The conservative policy has the least
risk but also the lowest expected
return.
 The moderate (maturity matching)
policy falls between the two extremes.
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What is short-term credit?

What are the major sources?
 Short-term credit: Debt requiring

repayment within one year.
 Major sources:
Accruals
Accounts payable (trade credit)
Commercial paper
Bank loans
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 Short-term debt is riskier than

long-term debt for the borrower.
Short-term rates may rise.
May have trouble rolling debt over.
 Advantages of short-term debt.
Typically lower cost.
Can get funds relatively quickly with
low transactions costs.
Can repay without penalty.
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Is there a cost to accruals?

Do firms have much control over
amount of accruals?
 Accruals are free in the sense that

no explicit interest is charged.
 However, firms have little control
over accrual levels, which are
influenced more by industry
custom, economic factors, and tax
laws than by managerial actions.
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What is trade credit?
 Trade credit is credit furnished by a

firm’s suppliers.
 Trade credit is often the largest
source of short-term credit for small
firms.
 Trade credit is spontaneous and
relatively easy to get, but the cost
can be high.
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B&B buys $3,030,303 gross, or

$3,000,000 net, on terms of 1/10, net
30. However, the firm pays on Day 40.
How much free and costly trade credit

are they getting?
What is the cost of the costly trade

credit?

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Gross/Net Breakdown
 Company buys goods worth

$3,000,000. That’s the cash price.
 They must pay $30,303 more over
the year if they forego the discount.
 Think of the extra $30,303 as a
financing cost similar to the interest
on a loan.
 Must compare that cost with the
cost of alternative credit.
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Net daily purchases = $3,000,000/360
= $8,333.
Payables level if discount is taken:
Payables = $8,333 (10) = $83,333.
Payables level if don’t take discount:
Payables = $8,333 (40) = $333,333.
Credit Breakdown:
Total trade credit = $333,333
Free trade credit = 83,333
Costly trade credit = $250,000
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Nominal Cost of Costly Trade Credit
Firm loses 0.01($3,030,303) = $30,303

of discounts to obtain $250,000 in
extra trade credit, so
$30,303
k Nom = = 0.1212 = 12.12%.
$250,000
But the $30,303 in lost discounts is

paid all during the year, not just at
year-end, so the EAR is higher.
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Nominal Cost Formula, 1/10, net 40
Discount % 360
kNom = 1 - Discount % x Days taken - Discount period
1 360
= 99 x 30 = 0.0101 x 12
= 0.1212 = 12.12%.
Pays 1.01% 12 times per year.

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Effective Annual Rate, 1/10, net 40
Periodic rate = 0.01/0.99 = 1.01%.
Periods/year = 360/(40 - 10) = 12.
EAR = (1 + Periodic rate)n - 1.0

= (1.0101)12 - 1.0 = 12.82%.

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Commercial Paper (CP)
 CP are short term notes issued by

large, strong companies. B&B could
not issue CP; the company is too
small.
 CP trades in the market at rates just
above the T-bill rate.
 CP is bought by banks and other
companies, then held as marketable
securities for liquidity purposes.
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A bank is willing to lend B&B $100,000

for 1 year at an 8 percent nominal rate.
What is the EAR under the following
five loans?
1. Simple annual interest, 1 year.

2. Simple interest, paid monthly.
3. Discount interest.
4. Discount interest with 10 percent
compensating balance.
5. Installment loan, add-on, 12 months.
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Why must we use Effective Annual

Rates (EARs) to evaluate the loans?
 In our examples, the nominal

(quoted) rate is 8% in all cases.
 We want to compare loan cost rates
and choose the alternative with the
lowest cost.
 Because the loans have different
terms, we must make the
comparison on the basis of EARs.
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Simple Annual Interest, 1-Year Loan
“Simple interest” means not discount

or add-on.
Interest = 0.08($100,000) = $8,000.
$8,000
k Nom = EAR = = 0.08 = 8.0%.
$100,000
On a simple interest loan of one year,

kNom = EAR.
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Simple Interest, Paid Monthly
Monthly interest = (0.08/12)($100,000)

= $666.67.
0 1 12
...
100,000 -666.67 -667.67
-100,000.00
12 100000 -666.67 -100000
N I/YR PV PMT FV
0.66667
(More…)
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kNom = (Monthly rate)(12)
= 0.66667%(12) = 8.00%.
12
 0.08
EAR =  1 +  − 1 = 8.30%.
 12 
or: 8 NOM%, 12 P/YR, EFF% = 8.30%.

Note: If interest were paid quarterly, then:
4
 0.08
EAR =  1 +  − 1 = 8.24%.
 4 
Daily, EAR = 8.33%.

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8% Discount Interest, 1 Year
Interest deductible = 0.08($100,000)

= $8,000.
Usable funds = $100,000 - $8,000
0 = $92,000. 1
i=?
92,000 -100,000
1 92 0 -100
N I/YR PV PMT FV
8.6957% = EAR
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Discount Interest (Continued)
Amount needed
Amt. borrowed = 1 - Nominal rate (decimal)
$100,000
= 0.92 = $108,696.

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Need $100,000. Offered loan with

terms of 8% discount interest, 10%
compensating balance.
Amount needed
Face amount of loan =
1 - Nominal rate - CB
$100,000
= = $121,951.
1 - 0.08 - 0.1
(More...)
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Interest = 0.08 ($121,951) = $9,756.

Interest paid
Cost = .
Amount received
$9,756
EAR = = 9.756%.
$100,000
EAR correct only if amount is borrowed

for 1 year.
(More...)
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8% Discount Interest with 10%

Compensating Balance (Continued)
0 1
i=?
121,951 Loan -121,951

-9,756 Prepaid interest + 12,195
-12,195 CB -109,756
100,000 Usable funds
1 100000 0 -109756
N I/YR PV PMT FV
9.756% = EAR
This procedure can handle variations.
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1-Year Installment Loan, 8% “Add-On”
Interest = 0.08($100,000) = $8,000.

Face amount = $100,000 + $8,000 = $108,000.
Monthly payment = $108,000/12 = $9,000.
Average loan
outstanding = $100,000/2 = $50,000.
Approximate cost = $8,000/$50,000 = 16.0%.

(More...)
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Installment Loan
To find the EAR, recognize that the firm

has received $100,000 and must make
monthly payments of $9,000. This
constitutes an ordinary annuity as
shown below:
Months
0 1 2 12
i=? ...
100,000 -9,000 -9,000 -9,000
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12 100000 -9000 0
N I/YR PV PMT FV
1.2043% = rate per month
kNom = APR = (1.2043%)(12) = 14.45%.

EAR = (1.012043)12 - 1 = 15.45%.
14.45 NOM enters nominal rate
12 P/YR enters 12 pmts/yr
EFF% = 15.4489 = 15.45%.
1 P/YR to reset calculator.

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What is a secured loan?

 In a secured loan, the borrower
pledges assets as collateral for the
loan.
 For short-term loans, the most
commonly pledged assets are
receivables and inventories.
 Securities are great collateral, but
generally firms needing short-term
loans generally do not have securities.
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What are the differences between

pledging and factoring receivables?
 If receivables are pledged, the lender

has recourse against both the
original buyer of the goods and the
borrower.
 When receivables are factored, they
are generally sold, and the buyer
(lender) has no recourse to the
borrower.
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What are three forms of inventory

financing?
 Blanket lien.
 Trust receipt.
 Warehouse receipt.
 The form used depends on the
type of inventory and situation at
hand.
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Legal stuff is vital.
 Security agreement: Standard form

under Uniform Commercial Code.
Describes when lender can claim
collateral.
 UCC Form-1: Filed with Secretary of
State to establish claim. Future
lenders do search, won’t lend if prior
UCC-1 is on file.

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23 - 1

 Working capital financing policies

Working Capital Financing Policies

 Maturity Matching: Matches the

Maturity Matching Financing Policy

Perm C.A. L-T Fin:

Aggressive Financing Policy

Conservative Financing Policy

 The choice of working capital policy is

What is short-term credit?

 Short-term credit: Debt requiring

 Short-term debt is riskier than

Is there a cost to accruals?

 Accruals are free in the sense that

What is trade credit?

 Trade credit is credit furnished by a

B&B buys $3,030,303 gross, or

How much free and costly trade credit

What is the cost of the costly trade

Copyright © 2002 Harcourt, Inc. All rights reserved.

 Company buys goods worth

Nominal Cost of Costly Trade Credit

Firm loses 0.01($3,030,303) = $30,303

But the $30,303 in lost discounts is

Nominal Cost Formula, 1/10, net 40

Pays 1.01% 12 times per year.

Copyright © 2002 Harcourt, Inc. All rights reserved.

Effective Annual Rate, 1/10, net 40

Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 360/(40 - 10) = 12.

EAR = (1 + Periodic rate)n - 1.0

Copyright © 2002 Harcourt, Inc. All rights reserved.

Commercial Paper (CP)

 CP are short term notes issued by

A bank is willing to lend B&B $100,000

1. Simple annual interest, 1 year.

Why must we use Effective Annual

 In our examples, the nominal

Simple Annual Interest, 1-Year Loan

“Simple interest” means not discount

On a simple interest loan of one year,

Simple Interest, Paid Monthly

Monthly interest = (0.08/12)($100,000)

or: 8 NOM%, 12 P/YR, EFF% = 8.30%.

Daily, EAR = 8.33%.

8% Discount Interest, 1 Year

Interest deductible = 0.08($100,000)

Discount Interest (Continued)

Copyright © 2002 Harcourt, Inc. All rights reserved.

Need $100,000. Offered loan with

Interest = 0.08 ($121,951) = $9,756.

EAR correct only if amount is borrowed

8% Discount Interest with 10%

121,951 Loan -121,951

1-Year Installment Loan, 8% “Add-On”

Interest = 0.08($100,000) = $8,000.

Approximate cost = $8,000/$50,000 = 16.0%.

To find the EAR, recognize that the firm

kNom = APR = (1.2043%)(12) = 14.45%.

1 P/YR to reset calculator.

What is a secured loan?

What are the differences between