CHAPTER 8

SHORT TERM FINANCING

Introduction
Def : ST funds that a firm has to repay within a year of obtaining these fund
Sources

NonSpontaneous Financing Secured Short Term Loans Unsecured short-term loan

Spontaneous / Internal Financing Accounts Payable Accrued Taxes and Wages

Spontaneous/Internal Financing
Def : Financing that arise from the normal operation of the firm Sources ; A/C payable and Accrued Taxes and

Wages Account Payable Transaction in which the firm bough goods on credit from its suppliers and no formal is signed
Cost of not utilizing the cash discount (AOC)

= Discount % 360 days___________ (100% - Disc%) X (credit period discount period)

Example
Lawrence Industries operation of a small chain of video stores purchased 1,000 worth of merchandise on Feb 28 from a supplier

extending term of 2/10, net 30.

Non-Spontaneous/External Financing
Secured Short Term Loans
A loan whereby the borrowers need to provide a

security or collateral

Unsecured Short Term Loans

Loans granted by banks without any collateral Sources of unsecured financing are : Notes payable Line of credit Revolving credit Commercial Paper

Cost of Bank Loans

Nominal Interest Rate
Effective Annual I/R Discounted Loan
I/R unadjusted for inflation or term of borrowing The actual cost of borrowings after taking into

considerations of differential in period of compounding and terms associated with borrowings

of the loan period.

Interest on loan is paid in advance or at the beginning

Compensating Balances
Deposit that the firm keeps with the bank in a low-

interest or non-interest bearing to compensate for bank loans or services

Unsecured Short Term Loans

Line of Credit An informal arrangement between a bank and its customer specifying the maximum amount of unsecured credit that the bank will permit the firm to owe at any one time. Interest on loan ; collect basis and discount basis

Cont.
Collect Basis Interest is paid at maturity Formula; EIR = Interest paid X 360 days Principal t Where; t = days loan is outstanding

Cont.
Discount basis Interest is paid in advance / prepaid Formula ; EIR = Interest paid X 360 days Net proceeds t Where ; t = days loan is outstanding Net proceeds = Loan amount interest paid

Example
Mr Lee is going to borrow RM3,000 for one year at 12% interest. What is the effective rate if the loan is :

a) Collect basis b) Discount basis

Answer
a) Collect basis

EIR = Interest paid X 360 days Principal t = 12% (3,000) X 360 days 3,000 360 days = 12%

Cont.
b) Discount basis EIR = Interest paid X 360 days Net proceeds t = 12%(3,000) X 360 days 3,000 360 360 days = 13.64%

Compensating Balance
A required deposit that the firm keeps with the bank

in low interest to compensate for bank loans Calculated as a percentage of the borrower loans outstanding Formula : EIR = Interest paid X 360 days Net proceeds t Where; Net proceed = Loan amount compensating amount

Example
Suppose you borrow RM20,000 at 14% interest rate per annum paid at maturity and the compensating balance requirement is

10%. What will the effective cost of the loan ?

Answer
EIR = Interest paid X 360 days

Net proceeds t = 20,000 (14%) X 360 days 20,000 (10% x 20,000) 360 days = 15.56%

Example
You borrow RM25,000 at 15% interest rate per annum and the compensating requirement is 10%. What is the effective

interest rate of loan if the interest is prepaid ?

Answer
EIR = Interest paid X 360 days

Net proceeds t EIR = 15% X 25,000 X 360 days 25,000 (0.1x25k) (.15 x 25k) 360 days = 20%

Revolving Credit Agreement

A formal and legally binding commitment to give line

of credit to the borrower up to stated amount agreed The borrower pay interest on the used loan and commitment fee on the unused portion of the credit line Formula : EIR = Interest + Commitment fee X 360 days Usable Fund t Where; t = days loan is outstanding Usable funds = amount loan borrowed compensating balance

Example
Binariang Corporation has a revolving agreement with a bank. It can borrow up to RM2,000,000 at 12% interest but is required

to maintain a 10% compensating balance on any funds borrowed under the agreement. In addition, it must pay a 0.5% commitment fee on the unused portion of the formal line. What is the EIR of taking a loan, if the firm utilizes RM800,000 for an entire year.

Answer
EIR = Interest + Commitment fee X 360 days Usable Fund t Interest = 12% x RM800K = RM96,000 Compensating balance = 10% x RM800k = RM80,000 Usable funds = RM800,000 RM80,000 = RM720K Commitment fee = 0.5% X (2mill RM800K) = RM6k
EIR = 96,000 + 6,000 X 360 days 720,000 360 days = 14.16%

Commercial Paper
A short term unsecured promissory note that is generally sold by large corporation on a discount basis to institutional investors and

other corporation It is preferred due to several factors:

Interest rate is lower than bank loans The issuing house does not require any

compensating balance Widely recognized and usually issued by the most creditworthy firm

Cont.
Formula:
EIR = Interest X 360 days Face value interest issuing cost Maturity

Example
On May 2008, Motorola Corporation plan a

commercial paper issue of RM30m. The firm has never used commercial paper before but has decided to go through a dealer to handle the process. The commercial paper will carry 270-day maturity and will require interest based upon a rate of 11% per annum. In addition, the firm will have to pay fees totaling RM200,000 for going through the dealer. What is the effective cost of the commercial paper issue to Motorola Corporation?

Answer
EIR = Interest X 360 days Face value interest issuing cost Maturity Interest = 11% x 30mill = 3.3mill x 270 360 = RM2,475,000 EIR = 2,475,000 X 360 30m 2,475k 200k 270 = 12.07%

Secured Short Term Loans

Short term loan obtained by pledging specific assets as collateral Characteristics;
Lenders require collateral typically current assets Only a certain percentage of book value of acceptable

collateral is advance by the lenders More expensive Increase the administration cost

Collaterals;
Inventory financing Account receivable financing

Account receivable financing

Use accounts receivable as collateral to obtain a loan from other financial institution either through pledging or factoring

receivables

Inventory Financing
Use inventory as short term loan collateral
Characteristic of inventories that can be

evaluated as loan collateral

Marketable
Not perishable Price stability

Cont.
4 ways inventory financing can occur
Floating lien agreement The lenders receive a security interest or general claim on the firms entire inventory that include present and future inventory

Trust receipts The firm holds the inventory for the lender and any proceeds from the inventory must immediately forward to the lenders
Terminal warehouse receipts The inventory forwarded as collateral will be stored in a bonded warehouse operated by a public warehousing company Field warehouse receipts Same procedure as terminal warehouse except the inventory is stored in the firm is own warehouse

Tutorial
April 2008 Q4
Apr 2007 Q5

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