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Short Term Financing
FINC5880 FALL 2015 Shanghai- session 7 MOOC
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….
Session 7 : Assignment WC and short term Financing
Determine the WC by quarter of your 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? Show the numbers.
Note: Please use the LATEST financial data! This includes FY2015…YTD
Working Capital Management?