04/18/23 Working Capital: Short Term Liabilities 1

Working Capital: Short-Term Liabilities

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Sources of Short Term Funds

1. Trade Credit

2. Bank Borrowing (Prime Rate)

3. Commercial Paper (Direct or Dealer Placed)

4. Accounts Receivable Financing (Factoring)

5. Inventory Financing

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Bank Credit Terminology

Prime Rate:– the interest rate charged to a bank’s better customers (large strong companies don’t

borrow from a bank)– acts as a benchmark for calculating other interest rates–note that the prime rate is related to but not the same as the fed funds rate,

EURIBOR, or LIBOR.Compensating Balance:

– when a bank requires a minimum average account balance for business customers in order to qualify for a loan

– can be thought of as a form of collateralEffective Interest Rate:

– the actual interest rate or “true” cost of a loan– adjusts the APR for compounding

LIBOR (London Interbank Offered Rate):– rate that most international banks charge one another for dollar-denominated loans

in the London market. Euro bond market is unregulated.

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Example Rates

Money Rates as of

April 23, 2008

Indicator Value

Prime Rate 5.25

30 Year T-Bond 4.56

10 Year T-Note 3.67

91 Day T-Bill 1.32

Fed Funds 2.25

LIBOR 3 Month 2.92

30 Year Mortgage 5.82

Some sites for rate information:

•http://www.forecasts.org/interest-rate/fed-funds-interest-rate.htm

•http://www.bankrate.com/brm/ratehm.asp

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Turning Short-Term Interest Rates Into Annual RatesEffective Annual Rate =

Short-Term Rate X Days in the year

Days loan is outstanding

Example: Borrow $10,000

Interest $800

Period 150 days

Effective

Annual = $800 X 360 = 19.2%

Rate $10,000 150

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Cost of Trade Credit

Implicit cost of trade credit =

Discount % X 360

100% - Discount % Final Due Date - Discount Period

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Cost of Trade Credit ExampleTerms: 2/10 net 30Actual: pay in 45 days

For every $100 of payment: 2 = 2.04% 98

Pay in 30 days 2 X 360 = 36.73% 98 20

Pay in 45 days 2 X 360 = 20.99% 98 35

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Cost of Installment LoanEffective rate

on installment = 2 X Annual no. of payments X Interest

loan (Total no. of payments + 1) X Principal

Grant’s

Approximate = Interest

rate Average Amount of Loan

Salesmen’s = Interest

stated rate Amount of Loan

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Cost of Installment Loan ExampleBorrow $10,000Interest $1,000Payments 12 payments of $916.67

Salesmen’s 1,000 = 10% stated rate 10,000 Grant’sApproximate 1,000 = 20% rate 5,000

Effective 2 X 12 X $1,000 = 18.5% rate 13 X $10,000

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Cost of a Discount LoanEffective = Interest

rate Principal - Interest

Example

Borrow $10,000

Interest 10%

Effective rate = 1,000 = 11.11%

10,000 - 1,000

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Cost of Loan with Compensating Balance

Effective = Interest rate rate (1- c)

where c = compensating balance expressed as a decimal

Example:Borrow $10,000Interest 10%Compensating balance 20%

Effective = 10% = 12.5% rate 1 - .2

Effective = $1,000 = 12.5% rate $10,000 - $2,000

or

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Movement of Prime Rate and the London Interbank Offer Rate on U.S. Dollar Deposits

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Commercial Paper Characteristics Short-term (3 months is common) Unsecured IOU from large prestigious firms $25,000 minimum Finance paper or direct paper (i.e.,GMAC) Dealer paper (Industrial Companies) Interest is below prime Low default risk Good marketability

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Comparison of Commercial Paper Rate to Prime Rate*

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Total Commercial Paper Outstanding

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Accounts Receivable Financing Pledging Accounts Receivable Factoring Receivables Asset-Backed Public Offerings

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Inventory Financing Stages of Production

Raw Materials Work-In-Process Finished Goods

Nature of Lender Control Blanket Liens Trust Receipts Warehousing (Bonding)