short-term financial management chapter 15 – short-term financing

SHORT-TERMFINANCIAL MANAGEMENT

Chapter 15 – Short-Term Financing

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SHORT-TERM FINANCING

Chapter 15 Agenda

Discuss alternative short-term financing strategies, describe the various short-term financing choices, and compute the effective cost of commercial paper.

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Short-Term Financing

Firms finance operations from short and long-term sources.

There is a link between short and long-term financing decisions arising from a firm's cumulative capital requirements.

Ordinarily, financial managers try to match the maturity of capital sources with the life of the assets funded by them.

However, some ‘permanent’ minimum level of working capital is needed and is financed from permanent sources.

Seasonal increase in working capital typically are financed from short-term sources.

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Some of the current assets are supported by spontaneous financing from current liabilities (payables and accruals) and earnings retention.

The balance, if any, must be provided from an external financing source depending on the financial strategy of the firm.

Firms require some level of temporary and permanent current assets.

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Short-Term Financing Strategies

Depending on its risk tolerance, a firm has three basic strategies to finance current assets: Aggressive

Involves financing the new current assets with liabilities having comparable maturities.

Conservative Involves the use of long-term sources of financing to

meet working capital requirements.

Moderate A blend of the two.

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Short-Term Financing Strategies

Depending on its risk tolerance, a firm has three basic strategies to finance current assets:

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Daily ending cash positions can be both positive and negative.

When negative, external sources of short-term financing become an important part of a firm’s liquidity reserve.

Firm’s can borrow:

From the bank

In the money market

In the capital market

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Short-Term Financing – Banks

The most common type of short-term bank credit is a line of credit. It is usually open-ended, revolving, and self-

liquidating. It could be committed or uncommitted.

Other short-term bank options include: Banker’s Acceptance Letter of Credit Repurchase Agreement

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Short-Term Financing – Banks

One option for short-term financing is arranging a credit facility with the bank. Important in the negotiation is:

Amount Term and Structure Stated Rate / Effective Rate

Index (Prime, LIBOR, T-Bill) / Spread Fees (commitment, non-usage, unused portion, etc.) Compensating Balances

Clean-Up Periods Collateral Covenants and Restrictions

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S/T Financing – Example

The equation for calculating the ‘effective rate’ is below:

The numerator includes all interest and fees.

The denominator includes the AVERAGE portion of the funds borrowed available for use by the firm.

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S/T Financing – Example

Based on the terms and structure, the effective rate of various short-term borrowing options can be compared and the most cost-effective option chosen.

Banks can structure loans many ways, and can include a variety of fees…here’s an example:

We’ll start by looking at a traditional bank Line of Credit.

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S/T Financing – Bank Example

A firm has been offered the following credit facility by its bank: $10,000,000 revolving line of credit

Firm expects average annual cash deficit of $4,800,000

One-year commitment

Prime Rate (currently 5%)

1/8% (12.5 bps) up-front fee on commited amount

1/4% (25 bps) back-end fee on unused portion

20% compensating balance on funds drawn These funds would have to be borrowed

Firm expects average annual outstandings of $6,000,000, including borrowing for compensating balances ($4,800,000 / 80%)

30-day required clean-up period

Calculate the effective rate on this deal and compare it to the stated rate (5%).

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While the stated rate is 5%, the effective rate is 6.72%. The effective rate is always greater than or equal to the stated rate. The effective rate can be compared to other borrowing options.

Out-of-Pocket ExpensesUsable Funds

($6,000,000 × 5%) + ($10,000,000 × .12.5%] + [($10,000,000 - $6,000,000) × .25%][$6,000,000 (1 - 20%)]

$322,500$4,800,000

6.72%

Average balance x prime rate

Up-front fee x committed

amount

Back-end fee x unused portion

Funds drawn x (1 - 20% compensating

balance)

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Out-of-Pocket ExpensesUsable Funds

($4,800,000 × 5%) + ($10,000,000 × .12.5%] + [($10,000,000 - $4,800,000) × .25%]$4,800,000

$265,500$4,800,000

5.53%


Now, the effective rate is only 53 bps more than the stated rate, solely due to the fees.

Recalculate the effective rate if the firm is already maintaining the necessary compensating balances in its accounts or if the bank eliminates the compensating balance requirement.

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A firm has been offered the following credit facility by its bank:

$10,000,000 revolving line of credit

90-day commitment

Prime Rate (currently 5%)

1/8% (12.5 bps) up-front fee on commited amount

1/4% (25 bps) back-end fee on unused portion

20% compensating balance on funds drawn

These funds would have to be borrowed

Firm expects average quarterly outstandings of $6,000,000, including borrowing for compensating balances.

Calculate the effective rate on this one-quarter deal.

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If the inputs are modified for a period other than annual, the result must be annualized so that it can be compared to alternatives. The result is the same.

Out-of-Pocket Expenses 365Usable Funds 90

($6,000,000 × 5%/365 x 90) + ($10,000,000 × .12.5%/365 x 90) + [($10,000,000 - $6,000,000) × .25%/365 x 90] 365[$6,000,000 (1 - 20%)] 90

$79,521 365$4,800,000 90

1.66% × 4.0556

6.72%

×

×

×

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S/T Financing – Alternatives

Banker’s Acceptances

BA’s are also commonly used in international transactions.

Here, a time-draft is issued by the importer’s bank drawn on the bank with payment guaranteed by the bank.

The exporter and can discount it through it’s own bank and receive payment prior to the delivery of the goods, freeing up the cash that would have otherwise been tied up during the sales cycle.

The BA can then be traded in the money market.

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Letters of Credit Often a firm will extend credit to an unknown customer.

Doing so involves (1) credit risk and (2) tying up cash as goods are made, shipped, and sold on credit.

In such cases, the selling firm might require a Bank Letter of Credit.

A Letter of Credit is a promise made by the bank to make payment to a third party upon presentation of the required documents (presentment), effectively substituting the credit-worthiness of the firm with that of the bank.

The use of Letters of Credit is most common international trade.

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S/T Financing – Non-Bank Alternatives

Other options for S/T financing include:

Commercial Paper

Asset-Based Loans

Factoring

Inventory Financing

Securitization

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Commercial Paper (CP) Commercial paper is a short-term, promissory note issued

by large, credit-worthy firms in the money markets. For the issuer, rates are less than bank credit (typically

least expensive S/T borrowing source). CP has a fixed maturity (up to 270-days). It issued at a discount at a fixed interest rate. The debt is rated in minimum denominations are

$100,000. It is usually unsecured, but can be supported by a back-

up bank Letter of Credit. For the investor, rates are higher than comparable

treasuries.

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Commercial Paper Example

Commercial Paper Illustrative:

Amount of Issue - $40,000,000 (face value)

Maturity - 60-days

Discount - 2.7%

Dealer Fee – 20 bps (annual)

Back-up LOC Fee – 25 bps (annual)

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Commercial Paper Example (Cont’d)

Annualized Cost of Commercial Paper:Discount + Dealer Fee + Backup Fee 365

Usable Funds Days to Maturity

$180,000 + $13,333 + $16,667 365$39,820,000 60

Discount = Discount Rate x Face Value x Days to Maturity/360= 0.027 x $40,000,000 x 60/360 = $180,000

Usable Funds = Face Value - Discount= $40,000,000 - $180,000 = $39,820,000

Prorated Dealer Fee = Annual Fee x Face Value x Days to Maturity/360= 0.0020 x $40,000,000 x 60/360 = $13,333

Prorated Backup LOC Fee = Annual Fee x Face Value x Days to Maturity/360= 0.0025 x $40,000,000 x 60/365 = $16,667

x

x 3.21%=

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Asset-Based Loans represent a financing source from banks or commercial finance companies, such as CIT Group, Fleet Capital, and GE Capital.

The credit is secured by receivables and/or inventory.

It is a more expensive financing source since the collateral is continuously monitored.

Typical options include: Receivables Financing / Factoring

Inventory Financing

Securitization (Structured Finance)

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Asset-Based Lending - Receivables Financing / Factoring

With A/R Financing (aka ‘Factoring’), the A/R are sold to the lender.

A/R can be sold with or without recourse, and are usually sold at a discount rather than interest being charged.

In effect is a ‘proxy’ for short-term borrowing.

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Asset-Based Lending – Inventory Financing

Banks lend on unsold inventory.

Asset-Based Lending – Securitization

Assets are pooled and sold in the capital market.

Assets can include A/R and credit card receivables.

short-term financial management chapter 15 – short-term financing

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