SHORT-TERM FINANCIAL MANAGEMENT

Chapter 15

– Short-Term Financing

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Chapter 15 Agenda

S HORT -T ERM F INANCING 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.

Short-Term Financing

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 Firms require some level of temporary and permanent current assets.

 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.

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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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Short-Term Financing

 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

Short-Term Financing – Banks

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 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

Short-Term Financing – Banks

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 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.

S/T Financing – Example

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 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.

S/T Financing – Bank Example

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  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%).

S/T Financing – Bank Example

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Up-front fee x committed amount

Out-of-Pocket Expenses Usable Funds

Back-end fee x unused portion

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

Average balance x prime rate

$322,500 $4,800,000 6.72%

Funds drawn x (1 - 20% compensating balance) 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.

S/T Financing – Bank Example

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 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.

Out-of-Pocket Expenses Usable 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.

S/T Financing – Bank Example

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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.

S/T Financing – Bank Example

16 Out-of-Pocket Expenses Usable Funds × 365 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] [$6,000,000 (1 - 20%)] × 365 90 $79,521 $4,800,000 × 365 90 1.66% × 4.0556

6.72%

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.

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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.

S/T Financing – Alternatives

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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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S/T Financing – Alternatives



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 Usable Funds x 365 Days to Maturity $180,000 + $13,333 + $16,667 $39,820,000 x 365 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

= 3.21%

S/T Financing – Alternatives

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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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S/T Financing – Alternatives

 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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S/T Financing – Alternatives

 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.