Short-Term Financing
Chapter 7
Firm can use different types of financing to raise capital. But the firms manager need to be concerned with the effective cost and the availability of those types of financing when deciding on these alternatives.
After learning this chapter, you should be able able to:
1.
Understand the concept of secured and unsecured financing
2.
Determine the cost of financing
3.
Calculate the effective cost of borrowing short term loans
4.
Calculate the effective cost of factoring and pledging of receivable.
153 | P a g e
Chapter 7
7.0
Short-Term Financing
INTRODUCTION
Short term financing is a short-term obligation that is expected to mature in one year or less and is required to support a large portion of the firm’s current assets. The use of short-term financing is to meet the seasonal and temporary fluctuation in a company’s funds position as well as to meet permanent needs of the business. For example short-term financing may be used to provide extra net working capital or to finance current assets. Most firms use short-term financing to some extends to support its assets, especially current assets. The use of short-term financing is dynamic due to its short maturity and volatile interest costs. Although short-term debt is generally riskier than using long-term debt, it does have some offsetting advantages. The pros and cons of financing with short-term debt are considered below. 1.
Flexibility. Flexibility. If the needs for funds are seasonal or cyclical, the use of short-term financing is more appropriate as the firm may not want to commit itself to long-term debt. Long-term debt can be repaid early, provided the loan agreement includes a prepayment provision; but, even so, prepayment penalties can be expensive.
2.
If the yield curve is upward sloping, as it often is, Cost of short-term debt is lower. lower. If then interest will be lower on short-term rates than on long-term rates.
3.
Relative riskiness of long-term and short-term Debt. In Debt. In general, the use of shortterm debt by the firm tends to be riskier than using long-term debt. This extra risk is due to: a.
Short-term interest rates tend to fluctuate widely while a firm using long-term debt can "lock-in" a given rate, and
b.
If a firm borrows heavily on a short-term basis, it may find itself unable to repay or rollover this debt.
In the following sections, several sources of short-term financing will be discussed under three categories: 1.
Internal or Spontaneous financing, for example Accruals and Account Payable
2.
Direct Borrowing from banks/Unsecured financing.
For example, Notes Payable,
Line of Credit, Revolving Credit Agreement (RCA), Commercial Paper
154 | P a g e
Short-Term Financing
Chapter 7
3.
Secured financing, for example, Account Receivable Loan, Inventory Loan.
7.1
INTERNAL OR SPONTANEOUS FINANCING
This particular source of short-term financing is internally generated from normal business activities, and may represent a cheap source of funds. However, the company has limited control and its source is not permanent. 7.1.1 7.1.1
Acc rued Wages and Taxes These are the liability for services received for which payment has yet to be paid Firms generally pay employees on a weekly, biweekly, or monthly basis, so the balance sheet will typically show some accrued wages. Similarly, most firms show accrued taxes on their balance sheets. These accruals increase spontaneously as a firm's operations expand, but the firm cannot ordinarily control them. Thus, firms use all the accruals they can, but they have little control over the level of these accounts.
7.1.2 7.1.2
Acc oun ts Payable Payable or Trade Credit This is when trade credit is given to the firm by the supplier. Firms generally make purchases of goods and materials from other firms on credit, recording the debt as an account payable. Accounts payable or trade credit is the largest single category of short-term debt. It represents about 40 percent of the current liabilities of non-financial corporations. Trade credit is a spontaneous source of financing in that it arises from ordinary business transactions. The following examples illustrate how to determine the cost of financing involved. Example 1
Ac co un ts pay able abl e - to calculate cost of foregoing cash discount. If a firm extended credit terms that include a cash discount, it has two options:
a)
Take the cash discount and pay early
b)
Forgo cash discount and pay at the end of the credit period
155 | P a g e
Short-Term Financing
Chapter 7
An exampl exam pl e: Tatoo Company purchased RM 1000 worth of merchandise merchandise on February 27th from a supplier extending terms of 2/10 net 30 caps (end of the month.)
a.
If the firm takes the cash discount, it will have to pay = RM 1000 – 0.02 (RM 1000) = RM980 ON March 10th.
b.
If it foregoes the discount, it will have to pay full amount RM 1000 on March 30th. Therefore, cost of foregoing discount: =
CD X 360 1 – CD N
Where CD
= Cash Discount N = The difference between discount period and credit period. =
0.02 x 1 – 0.02
=
36.73%
360 20
Decision: (i)
The firm must forego the discount if it needs money and has no alternative sources of short-term financing.
(ii)
The firm must take the discount if it already has sufficient short-term financing.
Example 2
A trade credit of 3/15, net 30 means that a 3 percent discount is given if payment is made within 15 days of the invoice date; otherwise full payment is due and payable within 30 days. Suppose your firm makes average daily purchases of RM2,000, and decided to pay in 30 days, you will enjoy a RM60,000 (=2,000 x 30) credit facilities (accounts payable) from your
156 | P a g e
Short-Term Financing
Chapter 7
suppliers. If your sales, and consequently purchases were to double, then its accounts payable would increase to RM120,000. You will generate an additional RM60,000 of financing.
For a given credit term, it involves two components of trade credit:
(i)
Free Trade Credit. Credit . It involves credit received during the discount period for 10 days. To enjoy this privilege, the firm must pay within 10 days at 2 percent discount allowed.
(ii)
Costly Trade Credit. Credit . It involves credit more than the free credit or beyond the discount discount period. This credit has an implicit implicit cost equal to
the foregone discounts. We could use the following the annualize annualized d opportunit y cost of not taking the discount (AOC) formula (AOC) formula to calculate the approximate annual percentage cost of not taking discounts for the above example. Let
D
: Discount rate percentage
CP
: Credit period or days taken to pay
DP
: Discount period
AOC
= [D / (100 – D)] x [360 / (CP – DP) = [3 / (100 – 15] x [360 / (30 – 15) =
%
From the formula, paying late can reduce the cost. For example if Heat could get away with paying in 90 days rather than 30 days, the cost would be:
AOC
= [D / (100 – D)] x [360 / (CP – DP) = [3 / (100 – 3)] x [360 / (90 – 15) = 14.83%
There are, however, problems associated with this practice. The first problem is that Heat may not be able to get away with practice for very long; and secondly, their credit reputation may be affected, thus impairing their ability to obtain credit from other sources.
157 | P a g e
Chapter 7
7.2
Short-Term Financing
DIRECT BORROWINGS FROM BA NKS/UNSECURED FINANCING
Another form of short-term financing is from external sources. In this case, the firm is requires to request, negotiate for the funds, or issue financial securities for funds. It may represent a higher cost of funds and is required to go through certain procedures and involves costs before it can be obtained. On the other hand, the source of funds is relatively stable and the firm can exercise certain level of control. Funds raised by the firm without pledging an asset as collateral.
7.2.1 7.2.1
Short -Term -Term Bank Loans Short-term loans from banks appear on firm's balance sheets as notes payable, are second in importance to trade credit as a source of short-term financing. The banks' influence is actually greater than it appears from the Ringgit amounts they lend. This is because banks provide non-spontaneous funds; that is, as a firm's financing needs increase, it will request its bank to provide the additional funds. If the request is denied, then the firm may be forced to reduce its rate of growth. However, that often firms have prearranged credit line agreements with their bank and short-term loans may be practically spontaneous. Several sources of unsecured financing are: a)
Notes payable
- i t is a single payment loan obtained from a commercial bank by credit-worthy business borrower.
This type type of loan is made when a
borrower needs additional funds for a short period only. The instrument resulting from this type of short term unsecured loan is a note which must be signed by the borrower.
The note states states the
term of the loan, the maturity date and the interest charged. b)
Line of Credit
- It is an agreement between a commercial bank and a business firm that states the amount of unsecured short-term borrowing
the
bank
will make available to the borrower. Typically it is made for a period of one year.
158 | P a g e
Short-Term Financing
Chapter 7
It is not a guaranteed loan but it indicates that if the bank has sufficient funds available, it will allow borrower to owe it up to a certain amount of money. It eliminates the need to examine the credit worthiness of a customer each time it borrows money. The borrower must apply each time he wants to obtain a line of credit and submit documents such
as
cash
budget,
proforma
income
statement and proforma balance sheet.
The
interest rate is normally stated as the prime interest rate plus a certain percentage (as a risk of credit worthy). c.
Revolving credit
- It is a guaranteed
line of credit. The
agreement (RCA) commercial bank making the agreement guarantees the borrower that a specified
amount
of
funds
will
be
made
available regardless of the tightness of money. The RCA could be for one, two or three years depending on the agreement. The requirement for the agreement is the same as line of credit but a commitment fee is charged to the borrower on the unused balance of the credit agreement. d.
Commercial paper - It is a form of financing that consists of shortterm, unsecured promissory notes issued by firms with a high credit standing.
Generally,
only large corporations with good reputation are able to issue commercial paper, (e.g. Telekom, Renong etc.)
159 | P a g e
Short-Term Financing
Chapter 7
Most
commercial
papers
have
ranging from 3 to 270 days.
maturities
It is generally
issued in multiples of RM100,000 or more.
The sales of it can be done by placing directly with the investors or through a commercial paper dealers where a dealer’s for is charged.
7.2.2 7.2.2
Cost of Bank Loans The cost of bank loans varies for different borrowers at a given time, depending on their credit risks and terms in securing the loans. In general, interest rates are higher for riskier borrower and for smaller loans. If a firm can qualify as a "prime risk" because of its size and financial strength, it can borrow at the prime rate; that is the lowest rate that banks charge. Rates on bank loans are based on base lending rate (BLR) plus certain percentage point relative to the borrower's credit risk. Key terms to understand in determining the cost of bank loans are: a)
Nominal Interest Rate Interest rates unadjusted for inflation or terms of borrowings. It is normally stated at face value of the interest charged on borrowings.
b)
Effective Ann ual Interest Rate The interest rates as if it is were compounded once per time period rather than several times per period. It is the actual cost of borrowings after
taking
into
considerations
of
differential
in
periods
of
compounding and terms associated with the borrowings. c)
Discounted Loans Interest on loans is paid in advance or at the beginning of the loan period. Therefore, it reduces the loan proceeds or the actual amount of RM that can be used by the borrower.
160 | P a g e
Short-Term Financing
Chapter 7
Compensating Compensating Balances Balances
d)
Deposit that the firm keeps with the bank in a low-interest or noninterest bearing to compensate for bank loans or services. These requirements will also reduces the loan proceeds. The effective interest rates (EIR) (EIR) on loans can be calculated in several different ways depending on the terms of the loan. To illustrate, let assume Alert Berhad is planning to borrow b orrow RM10,000 RM10,0 00 term loan at 12 percent for: (1) (1 ) one year; and (2) 6 months. The basic cost equation equals interest divided by net proceeds; that is amount borrowed minus costs: EIR
= Interest / Net proceeds
Where… Interest
= (Principal)(Rate) (Time or maturity)
Net proceeds = Principal – Discounted interest – Compensating Balance The above equation is applicable only if the maturity is for one year. Different maturity periods require some adjustment as follows:
EIR
= (Interest / Net proceeds) (12 / maturity in months)
The following example will illustrates the calculation of EIR using Alert Berhad loans requirement of RM10,000 at 10% with various terms and maturity.
1.
Regular, collect, or Simple Interest. Interest. This is the typical loan, whereby the borrower receives RM10,000 now and repays RM11,200 at the end of the year, or RM10,600 after 6 months. For 1 year •
Interest
= RM10,000(0.12)
= RM1,200
•
Net proceeds
= RM10,000 – RM0
= RM10,000
= RM1,200 / RM10,000
= 12%
Effective Interest Rate For 6 months •
Interest
= RM10,000 (0.12)(6 / 12)
= RM600
•
Net proceeds
= RM10,000 – RM0
= RM10,000
161 | P a g e
Short-Term Financing
Chapter 7
Effective Interest Rate 2.
= (RM600 / RM10,000)(12 / 6)
= 12%
Discounted Interest. Interest. If the bank deducts the interest in advance; that is discounts the loan, the effective rate of interest is increased. On the one year, RM10,000 loan for 12 percent, the discount is RM1,200, and the borrower obtains the use of only RM8,800. The effective rate of interest is 13.64 percent versus 12 percent on a simple interest loan. For 1 year •
Interest
= RM10,000(0.12)
= RM1,200
•
Net proceeds
= RM10,000 – RM1,200
= RM8,800
= RM1,200 / RM8,800
= 13.64%
Effective Interest Rate For 6 months •
Interest
=
= RM600
•
Net proceeds
=
= RM9,400
=
= 12.77%
Effective Interest Rate 3.
Compensating Balancing. Balancing. With the present of compensating balances on loans, the effective interest rates on loans increased. For example, if requirements for compensating balance equal to 10 percent of the amount of the loan. The effective rate: For 1 year •
Interest
= RM10,000(0.12)
= RM1,200
•
Compensating balance
= RM10,000(0.10)
= RM1,000
•
Net proceeds
Effective Interest Rate
= RM10,000 – RM1,000 = RM9,000 = RM1,200 / RM9,000
= 13.33%
For 6 months
162 | P a g e
•
Interest
=
= RM600
•
Compensating balance
=
= RM1,000
•
Net proceeds
=
= RM9,000
Effective Interest Rate
=
= 13.33%
Short-Term Financing
Chapter 7
In the event that the firms on the average maintain the amount required in its account, the funds for compensating balance is not required. For example, if the firm maintains on average RM1,500 in current account with the bank, the RM1,000 for compensating balance can be ignored as the current balance is enough to meet the CB requirements. Therefore, net proceeds will remains at RM10,000.
4.
Discounted
loans
and
compensating
balance. balance. From above, let the
compensating balance of 10 percent and the loan is discounted. For 1 year •
Interest
= RM10,000(0.12)
= RM1,200
•
Compensating balance
= RM10,000(0.10)
= RM1,000
•
Net proceeds
= RM10,000 – RM1,000 – RM1,200 = RM7,800
Effective Interest Rate
= RM1,200 / RM7,800 = 15.54%
For 6 months Interest
=
= RM600
•
Compensating balance
=
= RM1,000
•
Net proceeds
=
= RM8,400
=
= 14.29%
•
Effective Interest Rate
The present of discounted interest and compensating balance balance will actually increase the amount borrowed. This is particularly true in event if the firm really needs RM10,000 and no less for the above illustration. For example in the case of compensating balance of 8% and discounted interest of 10%: Amount of Loan
= (Funds Needed) / (1 – CB% - Interest rate ) = (RM10,000)/(1 – 0.08 – 0.10) = RM12,195.12
The firm must pay is RM1,219.51 (=RM12,195.12 x 10%) in interest for one year and maintain RM975.61 (=RM12195.12 x 8%) in compensating balance. Therefore, the firm will only get use of RM10,000 (=12,195.12 – 1,219.51 – 975.61) , with the rest
163 | P a g e
Short-Term Financing
Chapter 7
going to meet the discounted interest and the compensating balance requirements of the bank. The effective rate of interest can be calculated as follows:
EIR
= (Interest Paid)/(Funds Actually Used) = RM1,219.51 / RM10,000 = 12.20%
Let’s Try The Following Exercise Charles Corporation borrows RM 70,000 at 19%annual interest.
Principal and
interest is due in one year. What is the effective interest rate? i)
Effective interest rate is calculated based on simple interest rate. Therefore: a)
b)
c)
Amount of Interest
The proceeds
Time period
EIR
ii)
=
Principal x rate x time
= =
70,000 x 19% x 360 360 13,300
=
Total loan
=
RM 70,000
=
1/Time
=
1/360/360
=
1/1
=
Amount of Interest x 1/Time Proceeds
=
13,300 x 1/1 70,000
=
19%
If the interest is deducted in advance (discounted), what is the new EIR? EIR
=
70,000 X 19% X 1 X 1/1 70,000 – (70,000 X 19%)
=
13,300 X 1 X 1/1 56,700
=
23.5%
The interest rate is higher because we have to pay the interest in advance. Therefore the amount of proceeds becomes less.
164 | P a g e
Short-Term Financing
iii)
Chapter 7
In order to ensure that the borrower will be a good customer, most short-term unsecured bank loans require the borrower to maintain a compensating balance in a checking account balance equal to a certain percentage of the amount borrowed (normally between 10% - 20%) Let’s say from the above example now we assume the bank requires a 20% compensating balance. So the new EIR will be: EIR
=
70,000 x 19% x 1 70,000 – (20% X 70,000)
=
13,300 x 1/1 56,000
=
23.75%
If the firm normally maintains a balance of RM 14,000 (i.e. 20%) or more in the checking accounts, then the effective interest rate is more than the stated interest rate i.e. 19%, so the borrower is at a disadvantage. The best option is where EIR = stated interest rate.
7.2.3 7.2.3
Consum er Revolvi ng Credit
Credit card companies, department stores, and banks grant consumers lines of credit up to specified limits. Interest is calculated each month on the outstanding balance, and this interest is added to the previous balance. Since the interest on this type of credit is normally compounded monthly, the effective rate on the credit will be higher than the stated rate that is in annual terms. 7.2.4 7.2.4
Revol Revol vin g Credit Agr eement eement (RCA) (RCA)
As previously mentioned, it is a formal arrangement between the borrower and the bank. It involves commitment fee charged on the unused portion of the facility granted. The commitment fee is a penalty for not using the total amount allocated, and it is normally 0.25 percent to 0.50 percent on the unused portion. To illustrate, let assume that a firm has been granted a revolving credit amounting RM100,000 at 14 percent annual interest and 0.50% of
165 | P a g e
Short-Term Financing
Chapter 7
commitment fee. It only uses RM80,000 and RM20,000 left unused. Therefore, to calculate the effective cost it will include include a commitment fee. For example:-
1)
A commitment fee is charged to the borrower on the unused balance balance of the credit agreement. So the formula formula of calculating calculating the EIR would fbe adjusted as shown here:
EIR
= Amount of interest + Commitment Fees x 1/Time The Proceeds
Interest
= RM80,000 (0.14)
= RM11,200
= RM20,000 (0.005)
= RM100
= None
= RM0
Commitment fee Compensating balances
EIR
(Interest + Commitment Fee)
=
(Amount Borrowed – Compensating Balances)
2)
=
(RM11,200 + 100) (RM80,000 – 0)
=
14.13%
John Smith Company has RM 2 million RCA with its bank. Its average borrowing under the agreement for the past year was RM 1.5 million, at 10% stated interest rate.
•
The bank charges a commitment fee of ½% of unused portion of the commitment funds. Therefore:
EIR
=
(1,500 x 0.1) + (0.005 x 500,000) x 1/1 1,500
=
152,500 x 1/1 1,500,000
=
166 | P a g e
10.16%
Short-Term Financing
7.2.5
Chapter 7
Overdraft
This is a short-term facility provided by commercial banks to current account holders. It is designed to assists firms or individuals to cover their short-term financial constraint. Before the facility is granted, certain requirements must be meet by the customers. It allows the customer to withdraw more than the current account's balance.
The interest charged is dependent upon the borrower's financial risk above certain point of the bank's base lending rate. The interest is calculated on daily basis and charges a penalty if the borrower does not pay the interest at the end of the month.
7.2.6 7.2.6
Commerci al Paper Paper
Commercial paper is an unsecured promissory note issued by large and financially strong firms. It is sold on discount basis primarily to other business firms, to insurance companies, to pension funds and to banks. Although the amounts of commercial paper outstanding are much smaller than bank loan outstanding, this form of financing has grown rapidly in recent years.
This form of financing has a very short maturity, usually only one to six months. The cost of commercial paper is usually about 0.5% (50 points) to 1.5% (150 points) below the prime rate and there are no compensating balances required. In practice, the use of commercial credit is limited to a comparatively small number of firms that are exceptionally good credit risks. The ultimate suppliers of capital in the market are firms with temporary cash surpluses. A firm can borrow in the commercial paper market one-month, and supply funds to it the next month.
To illustrate the cost of commercial paper, assume that the firm plans to issue RM100,000 commercial paper that can be sold at 94% of its face value. If maturity is 6 months and the issuing cost is 5%, the effective rate:
167 | P a g e
Chapter 7
Short-Term Financing
Interest
= RM100,000 – RM100,000 (0.94)
= RM6,000
Cost
= RM100,000 (0.05)
= RM5,000
EIR
= [Interest / (Face value – Interest – Cost)](12 / maturity) = [RM6,000 / (RM100,000 – RM6,000 – RM5,000)](12 / 6) = 13.48%
Another example, if Renong Corporation, has just issued RM 1 million worth wo rth of commercial paper that has a 90-day maturity and sells for RM980,000. At the end of 90 days, the purchaser of this paper will receive RM 1 million for its RM980,000 investment. Calculate the effective interest rate on the paper, if interest is 2% EIR
=
Amount of interest x 1/Time Proceeds
=
20,000 980,000
x1/90/360
=
20 980
x 1/Time
=
8.16%
Given a choice, it is ordinarily better to borrow on an unsecured basis, as the bookkeeping costs of secured loans are often high. However, weak firms may find that they can borrow only if they put up some kind security to protect the lender, or that by using some security they can borrow at a lower rate. For a firm, the types of assets used most often for securing loans is accounts receivable and inventory. 7.2.7 7.2.7
Acc oun ts Receivable Financi ng Accounts receivable financing involves either t he pledging of receivable or the selling of receivable (called factoring) to secure a loan. The lender (finance company) will evaluate the quality of the receivables to be pledged and the average size of the account pledged. Accounts receivable pledging and factoring services are convenient and advantageous, but they can be costly. The credit-checking commission is 1% to 3% of the amount of invoices accepted by the factor. The cost of money is reflected in the interest rate (usually 2% to 3% over prime) charged on the unpaid balance of funds
168 | P a g e
Short-Term Financing
Chapter 7
advanced by the factor. When the risk to the factoring firm is excessive, it purchases the invoices at discount from the face value. •
Factoring. Factoring . Factoring involves the purchase of account receivable by the lender or the factor and normally without recourse to the borrower or the seller. The factor or the purchaser generally provides at least two of the following services: (1) financing; (2) maintaining the accounts; (3) collections, and (4) risk bearing. The seller can select various combinations of these functions by changing provisions in the factoring agreement. Several types of factoring are: 1.
Confidential factoring or inter-credit factoring. The factor enters into a factoring arrangement with the seller with a recourse or non-recourse without the knowledge of the customers. The supplier continues to collect payments from the customers and forward the money to the factor. The factor will act as a financier and advance immediate payment upon completion of the formal documentation. In addition, the factor will also maintain the ledgers.
2.
Disclosed factoring. Or factoring. Or old-line factoring. The arrangement is similar to the confidential factoring, but customers are notified of the factoring arrangement. Therefore, the customers are required to forward the monthly payments directly to the factor. The factor will act as the financier and the administrator of the debt.
3.
Maturity factoring. factoring. The facility is similar to the disclosed financing except there is no immediate cash advance is given to the seller upon completion of the documentation. Payments are made after collection or at an agreed maturity date, whichever is earlier. This type of factoring is useful for companies with no need for immediate cash, but cannot afford customers delaying the settlement of debts beyond the agreed credit period.
169 | P a g e
Short-Term Financing
Chapter 7
•
Costs of Factoring Factoring costs mainly consists of service charge and interest charge. 1.
Service charge or administrative charge relates to the administering
of
sales
ledger,
credit
management
and
collection services. The charges range form 0.75% to 2.5% of the gross invoice value depending on the factor’s workload and the receivables turnover. 2.
Interest charge or discounted charge is the fixed interest charged on the amount to be received by the firm. The rate may range from 2% to 3.5% above the base-lending rate of the factor.
To illustrate, assume that Silvering Company with an average monthly sales of RM50,000 receivables is trying to obtain factoring financing from a finance company. The receivables carries a 60-day credit terms and the factor required a 2% factor’s fee, 6% reserve and 12% interest per annum on advances. From the information given, the commission, discount charges, maximum advance and the annual percentage rate (APR) can be determined as follows: Let
1.
C
: Monthly commission rate
IV
: Invoice value
r
: Interest rate
n
: Number of months
RE
: Reserve
Face or invoice value = Monthly sales x Credit periods in months = 50,000 x 2 = 100,000
2.
Monthly Commission = C x IV = 0.01 x 100,000 = 1,000
170 | P a g e
Short-Term Financing
3.
Monthly discount charges
Chapter 7
= IV – [IV x (1 + r/12) – n] – 1
= 200,000 – [200,000 x (1 + 12%/12 ]
= 100,000 – 99,010 = 990 Therefore, total monthly charges
= 1,000 + 990 = RM1,990.00
4.
Reserve
= RE x IV = 6% x 100,000 = 6,000
5.
Amount received
= IV – Fees – Reserve = 100,000 – 1,000(2) – 6,000 = 92,000
6.
Interest
= Amount receive x Monthly Interest x Maturity in months = 92,000(12%/12)2 = 1,840
7.
Maximum advance
= Amount receive – Interest = 92,000 – 1,840 = 90,160
8.
Total charges
= Fees + Interest = 1,000(2) + 1,840 = 3,840
9.
APR
= (Total charges / Maximum advance) (12 / Maturity in months) = (3,840 / 90,160)(12 / 2) = 25.55%
Reserve does not represent a cost of factoring, and therefore the factor will return the reserve to the borrower if the factor has collected all the debts from the customers, less interest and fees. Beside the higher costs of factoring, the company can reduce the overhead costs,
171 | P a g e
Short-Term Financing
Chapter 7
improves cash flows, reduce bad debts and increase return on capital by utilizing the factoring facilities. An ot her exam pl e, if S.A. Berhad, a producer of children’s rainwear, has recently factored a number of accounts. The factor holds an 8 percent reserve, charges on and deducts from the book value of actored accounts a 2 percent factoring commission, and charges I 1 percent month interest (12 (12 percent per year) on advances.
The
company wishes to obtain an advanced on a factored account having a book value of RM1,000 due in in 30 days.
Calculate the cost of
factoring these accounts.
1st:
Calculate the proceeds to the company. RM
Book value of account
1,000
Less: Reserve (8% x 1,000)
80
Less: Factoring commission (2% x 1000)
20
Funds available for advance
900
Less: Interest on advance (1% x 900)
9
Proceeds from advance
891
2nd:
Calculate the effective annual cost of factoring
E/R
=
Amount of Interest + Commission x 1/Time Proceeds
=
RM9 + RM20
x
=
29 891
x
=
39%
1/30/360 12
Even though the cost of factoring looks high, it provides some advantages to the firms.
First, it gives the firm the ability to turn
accounts receivable immediately into cash. Secondly, it ensures a known pattern of cash flows. In addition, if factoring is undertaken on
172 | P a g e
Short-Term Financing
Chapter 7
a continuous basis, the firm can eliminate its credit and collection departments.
7.2.8
Pledging When account receivables are used as collateral for loan, it is called Pledging of receivables. The pledging of account receivable is characterized by the fact that the lender is not only has a claim against the receivables but also has recourse to the borrower or the seller. If the receivables are uncollectible, the selling firm will bear the loss. The borrower only pledges the account receivable as collateral for a loan obtained from finance companies, and consequently the finance company has the right to assess the creditworthiness of each of the accounts pledged. Pledging receivables can be on: a.
Notification basis. The borrower notifies its accounts that payments on the receivables are to be made directly to the lender or factor.
b.
Non-notification basis. The accounts are not informed of the financial agreements made between the borrower and the lender .
7.2. 7.2.9 9
Costs of pledging The costs of Pledging include interest levied on advances and processing fees or services charges to cover the administrative costs. The lender normally advance up to 75% of the face value of the receivables pledge and charge certain percentage for processing fess and interest on the advanced. To illustrate, let assume Andalusia Berhad pledges all its receivable amounting to RM500,000 with a 60-day credit terms. The finance company charges 1% processing fees every month, 10% interest per annum and is willing to advance 70% of the face value of the receivables pledged. From the information given, the maximum advance and the annual percentage rate (APR) can be determined as follows:
173 | P a g e
Short-Term Financing
Chapter 7
The face value
RM500,000
Maximum advance
= Face value x Rate of advance = 500,000(0.70) = 350,000
Interest
= (Monthly rate)(maturity in months)(Advance) = (0.10/12)(2)350,000 = 5,833.33
Processing fees
For 2 months
= (Monthly fees)(Maturity in months)(Face value) = (0.01)(2)500,000 = 10,000.00
APR
For 2 months
= [(Interest + Processing fees) / Advance] (12 / Maturity on months)
= [(5,833.33 + 10,000.00) / 350,000] (12 / 2) = 27.14% As shown in the above example, the cost of pledging 27.14% is relatively high but it provides several advantages. Pledging is flexible and provides continuous source of financing as long as new account receivables are created. In addition, it will reduces the firm’s overhead dealing with the receivables given that the lender provides billing and collection services.
Let’s loo k at another example: Bobby needs RM5 million million for the two month period. The company has made an arrangement with WIRA Bank for RM5 million loan secured by account receivable. Bank has agreed to advanced advanced 80% of the pledged receivable (Book Value) at a rate of 12% per annum and 1% processing fees on all receivables pledged.
1st
You have to determine the Book Value, where:
Amount of loan = 80% x Book Value RM5 mil X
= 80% x X = RM 5 mil 0.8 = RM6,250,000 (Book Value)
174 | P a g e
Short-Term Financing
2nd
Therefore Processing fee can be calculated, that is Fees
3rd
Chapter 7
=
1% x Book Value
=
1% x 6,250,000
=
RM62,500
Determine the interest, where: Interest
=
12% x RM5 mil x 2/12
=
RM100,000
To calculate the effective cost of pledging: ER
=
Interest + Processing fees x 1/Time Proceeds
ER
= =
RM100,000 + RM62500 x 1/60/360 RM5 million 0.0325 x 6
=
19.5%
7.2.10 Inventory Financing A rather large volume of credit is secured by inventories. If a firm is a relatively good credit risk, the mere existence of the inventory may be a sufficient basis for receiving an unsecured loan. Types of inventories that can be used to secure short-term loans are not perishable, readily marketable and have price stability. Inventory financing may occur through: 7.2.11 Floating Lien Arrangement The lender receives a security interest or general claim on the firm’s entire inventory that may include present and future inventory. Frequently used for inventories with low average value and or with high turnover. 7.2.12 Trust Receipts Under this agreement, the firm holds the inventory for the lender. Any proceeds from the inventory must immediately forward to the lender. Mostly used for large items with identifiable serial numbers for ease of control.
175 | P a g e
Chapter 7
Short-Term Financing
7.2.13 7.2.13 Terminal Warehouse Receipt Receipt s Under a terminal warehouse arrangement, the inventory forwarded as collateral will be stored in a bonded warehouse operated by a public warehousing company. The Warehouse Company will issue a warehouse receipt listing the specific items received, and will only release the inventory in progress when authorized by the lender as the borrower repays the loan.
7.2.14 7.2.14 Field Warehouse Receipt Receipt s The same procedure is followed as in terminal warehouse receipt, except the inventory is stored in the firm is own warehouse. However, the inventory involved will be separated from the firm's other inventories under the control of a field warehouse company. Only the lender has the authority to release the goods.
7.2.15 7.2.15 Cos ts of secured loan
Example 1 Let assume that Feres Industry Berhad is in need of 60-day loan RM200,000. One of its bankers is willing to offer a secured loan under a floating inventory lien with an interest of 14% per annum. The bank is willing to advance up to 40% of the average book value of the secured inventory. The effective interest rate (EIR) for the loans: Book value of the inventory
= Amount needed / Percentage of advance = 200,000 / 0.4 = 500,000
Interest costs
= Principal x Rate x Time = 200,000(0.14)(2 /12) = 4,666.66
Effective interest rate
= (Interest / net proceeds)(1 / time) = 4,667.66 / 200,000)(12 / 2) = 14.00%
176 | P a g e
Short-Term Financing
Chapter 7
The effective cost of interest is similar to the stated rate as there is no discounted interest, compensating balance and other costs involve.
Example 2 Milda Toy Company, a manufacturer of children’s plastic toys, needs a loan of RM125,000 for 60 days. The company’s primary primary bank has told management that a loan secured under a floating inventory lies is possible. The annual interest rate would be about 14 percent.
Funds would be
advanced up to 40 percent of the average book value of the secured inventory. Calculate the cost of financing the inventory. Book value of inventory as collateral =
RM125,000 0.4
The cost
= =
RM312,500 0.14 x 125,000 x 2/12
(the amount of interest)
=
RM2917
=
RM2917 x 2/12 125,000
=
14%
EIR
177 | P a g e
Chapter 7
Short-Term Financing
QUESTION 1 a)
Mustika Bhd. has a revolving credit agreement with AGS Bank under which it can borrow up to RM15 million. The company must maintain a 10% compensating balance on outstanding loans. Interest on the borrowed fund is 15% and the commitment fee is 1.5% on the unused portion of the credit line. Find the effective interest rate for Mustika Bhd. if the amount borrowed is : i)
RM3 million (4 marks)
ii)
RM15 million (4 marks)
b)
Ratu Bhd. has determined that it needs an additional capital of RM100 million. The Financial Manager of the company has decided to issue a commercial paper to fund the capital. The interest rate is 9.5% and the replacement fee is RM150,000. The commercial paper has 270-day maturity. Calculate the effective rate for this paper. (4 marks)
QUESTION 2 Define the following terms using examples: i)
Permanent asset investment.
ii)
Temporary asset investment.
iii)
Permanent sources of financing.
iv)
Temporary sources of financing. (10 marks)
QUESTION 3 a)
Asahari Industries has a line of credit at Bank Sepuluh which requires it to pay 11 percent interest on its borrowing and maintain a compensating balance equal to 15 percent of the amount borrowed. The firm has borrowed
178 | P a g e
Short-Term Financing
Chapter 7
RM800,000 during the year under the agreement. Calculate the effective annual interest rate of the firm’s borrowing in each of the following circumstances : i)
The firm normally maintains no deposit balances at Bank Sepuluh.
ii)
The firm normally maintains RM70,000 in deposit balances at Bank Sepuluh.
iii)
The firm normally maintains RM150,000 in deposit balances at Bank Sepuluh.
iv)
Compare, contrast and discuss your findings in (i), (ii) and (iii). (15 marks)
b)
Do both trade credit and accruals represent a spontaneous source of capital for financing growth? Explain. (5 marks)
179 | P a g e
Chapter 7
180 | P a g e
Short-Term Financing
