Sources of short term financing

Limitations on the Issuance of Commercial Paper

-The possibility of default -The potential for a liquidity freeze -A lack of loyalty or ongoing commitment (as opposed to a banking relationship)

Disadvantage of commercial paper

-This certificate could be lost, stolen, misplaced, or damaged, and in rare cases, someone could fail to cash it in at maturity. -Although the investments are fairly sound, there is increasing clearing and settlement risk from the increased volume of transactions in the money markets.

Advantages of Commercial Paper

-Generally, it is cheaper (funds are raised in the wholesale market). -Compensating balances are not required (although banks offer standby lines of credit). -It is prestigious to float paper in a somewhat exclusive market. -Asset‐backed paper can free up a firm's balance sheet. (Assets are sold into a separate legal entity, a trust, and the firm receives cash).

Credit shortage results

-Tightening of money supply growth by the Bank of Canada to curb inflation -Increased risk aversion of bankers and businesses following speculative excesses Both of these cause a decrease in available funds for lending, triggering higher interest rates.

Instalment loan process

. Financial institutions provide these fixed‐rate loans for up to several years by matching the required funds with a fixed‐rate obligation on funds they have borrowed by way of term deposits. This reduces the financial institution's risk.

Prime rate characterstics

1. In competitive markets, banks may actually charge top customers less than the published prime rate. 2. The average customer can expect to pay 1 or 2 percent above prime, but in tight money periods a speculative borrower may pay 5 or more percentage points over prime. 3. is competitively set by the chartered banks above the Bank of Canada rate.

50% of short term payable

Account payable & trade credit

Payable balance formula

Annual purchase x (credit period/365)

Term loan procedure

Bankers are hesitant to affix a single interest rate to a term loan. The more common practice is to allow the interest rate to change with market conditions. Thus, the interest rate on a term loan may be tied to the prime rate, and changes (floats) with it. A good customer may have its rate set at prime plus 1 percent

Formula I = Prt

I = interest or monies paid, P = principal or net capital borrowed, r = annual interest rate, and t = time in years.

How interest rate determined?

Interest rates are determined by the supply of and demand for money in the marketplace, and these forces naturally cause interest rates to move up and down over time. The prime rate is no exception, and this results in the interest rate charged on demand loans changing on a regular basis. Therefore, if the money supply tightens and interest rates go up, the interest charges on bank loans will become more expensive.

Eurodollar loans

Loans from foreign banks denominated in U.S. dollars (the most common currency); at LIBOR rates and are usually short term to intermediate term in maturity.

Discounted loan

Not only is the time dimension of a loan important, but also is the way in which interest is charged. We have assumed interest would be paid when the loan comes due. If the bank deducts the interest in advance (discounted loan), the effective rate of interest will increase. Example: Loan is $200. Interest is $20. The borrower will receive $180. But borrower pays $200 in the end.

Amount to borrow

The amount that must be borrowed to end up with the desired sum of money is simply calculated by taking the needed funds and dividing by (1 − c), where c is the compensating balance expressed as a decimal.

Factorizing or asset securitization

The firm finance its current asset positions through it

Short term financing

The firm relies on trade credit, bank or government financing, and borrowing in the wholesale money markets by way of commercial paper or LIBOR- based loans (international).

Compensating balance process

The required amount of balance is usually computed as a percentage of customer loans outstanding or as a percentage of bank commitments toward future loans to a given account. fees for services or compensating balances are charged by banks on a cost‐ plus‐profit basis

Use of Banker's acceptance

Their main use has been to finance inventories of finished goods in transit to the buyers. companies engaged in foreign trade find this form of financing especially helpful given the long lead times involved.

Commercial papers process

To the borrower, commercial paper usually carries an effective interest rate below that available through borrowing from the banks. Bypassing the bank's function as intermediary, commercial paper allows more direct contact between the borrower and lender of funds without the overhead. Rather than paying interest, commercial paper is sold at a discount from the maturity value, with the depth of the discount determining the rate of return.

Cash discount

allows for a reduction in price if payment is made within a specified time period. Ex: pay within 10 days and I will give you 2% discount.

Demand loan

also known as short term & self liquidating loan; are generally repayable at any time by the borrower, or full payment can be "demanded" by the bank at any time. These loans, tied to a prime rate, most often carry a variable interest rate that fluctuates with interest rate levels in the economy. Ex: bank oversraft

Providing loans and other services procedure

banks will often charge setup, commitment, administration, or review fees. These are usually charged when the loan proceeds are advanced. In effect, the proceeds of the loan are reduced by the amount of the fees.

Annual percentage rate

expresses interest rates on an annual basis. Nevertheless, an APR may be expressed on a nominal basis (simple interest) or effective basis (with compounding).

compensating balance

firms or individuals maintain a minimum average account balance in chequing accounts. Example: for a $200 loan, you need to keep at least $80 in account (show money to get loan)

Risk of foreign borrowing

foreign exchange exposure risk associated with these loans. This can be offset if the loan is balanced or hedged with foreign currency revenue streams.

spontaneous source of funds

growing as the business expands on a seasonal or long‐term basis, and contracting in like fashion. Ex Trade payable (buy now and pay later)

Term loan (negotiable loan)

in which credit is extended for 1 to 7 years. The loan is usually repaid in monthly or quarterly instalments over its life rather than in one single payment. Only superior credit applicants, as measured by working capital strength, potential profitability, and competitive position, can qualify for term‐loan financing. Ex: Organization negotiated with bank to get loan to build a factory & the life of the loan is 10 years with a 7% interest rate.

commercial paper

is a short‐term, unsecured promissory note issued to the public, usually in denominations of $100,000 or more. Ex: payroll, and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note.

Line of credit

is an agreement whereby the bank sets out the maximum amount it allows the firm to owe it at any one time.

The annual interest rate on a loan

is based on the loan amount, the dollar interest paid, the length of the loan, and the method of repayment.

A paper certificate of commercial paper

is issued to the lender to signify the lender's claim to be repaid.

Banker's acceptance

is short‐term debt financing; the term is used, to signify the accepted draft once it has been sent by the exporter to the importer's bank.

Bank rate

is the rate the Bank of Canada charges the chartered banks on loans.

Prime rate

is the rate the bank charges its most creditworthy customers, and it is scaled up proportionally to reflect the credit risk of the borrower. Example: market interest rate is 4% but borrower receive 2%.

Lender's primary concern

is whether the borrower's capacity to generate cash flow is sufficient to liquidate the loan as it comes due.

Finance or direct paper

issued by finance companies (Household Finance Corporation, Ford Credit, Dell Financial Services) primarily to institutional investors such as pension funds, insurance companies, and money market mutual funds to fund their ordinary course of business

collateral

merely a stopgap device to protect the lender when all else fails.

instalment loan

most confusing borrowing arrangement to the average bank customer or consumer is the instalment loan. calls for a series of equal payments over the life of the loan. Ex: $100 loan with 12% interest & needs to be paid within 12 month by paying minimum of $10 per month

Administration fees

must be paid upfront can be considered in the same way as a compensating balance, since the firm does not get full use of the borrowed funds.

Functions of bank

providing investment services, a credit card operation, real estate lending, data processing services, trust services, and helpful advice in cash management or international trade.

Dealer paper

sold by industrial or utility firms using an intermediate dealer network to distribute their paper, and often issuing it to fund seasonal fluctuations in inventory or accounts receivable

The largest short term loan provider

the manufacturer or seller of goods and services.

Self liquidation loan

the use of which generates cash flows that form a built‐in, or automatic, repayment scheme. Ex: purchase extra inventory in anticipation of the holiday shopping season. The revenue generated from selling that inventory would be used to repay the loan.

Reason of bank or finance company in business

to collect interest, not to repossess and resell assets.

2/10 net 30 cash discount strategy

we can deduct 2 percent if we remit our funds within 10 days after billing, but failing this, we must pay the full amount by the 30th day.