Q.1 Compute the cost of not taking the following cash discounts:a.  2/10, net 40.b.  2/15, net 30.c.  2/10, net 45d.  3/10, net 90Q.2Regis Clothiers can borrow from its bank at 17 percent to take

 Author's Overview

The instructor has the opportunity to cover the various sources of short-term financing with an eye toward the borrower's size and the relative cost of doing business.  Since banking is such a rapidly changing area, the instructor may wish to highlight some of the changes that are taking place.  The student should also get some exposure to the various considerations in computing interest costs.  Throughout the chapter, there are ample opportunities to indicate the advantages and drawbacks of trade credit, bank credit, commercial paper, foreign borrowing and collateralized borrowing arrangements.

                                                            Chapter Concepts

*          Trade credit from suppliers is normally the most available form of short-term financing.

*          Bank loans are usually short-term in nature and should be paid off from the normal operations of the firm.

*          Commercial paper represents a short-term, unsecured promissory note issued by the firm.

*          Through borrowing in foreign markets, a firm may lower its borrowing costs.

*          By using accounts receivable and inventory as collateral for a loan, the firm may be able to borrow larger amounts.

                                              Annotated Outline and Strategy

1. Trade Credit

1. Usually the largest source of short-term financing

1. A spontaneous source of financing that increases as sales expand or contract

1. Credit period is set by terms of credit but firms may be able to "stretch" the payment period.

2. Cash discount policy

1. Suppliers may provide a cash discount for early payment.

2. Foregoing discounts can be very expensive. The cost of failing to take a discount is computed as follows:

1. Whether a firm should take a discount depends on the relative costs of alternative sources of financing.

1. Net Credit Position

1. The relationship between a firm's level of accounts receivable and its accounts payable determines its net credit position.

2. If the firm's average receivables exceed average payables, it is a net provider of credit. If payables exceed receivables, the firm is a net user of trade credit.

1. Bank Credit

1. Banks prefer short-term, self-liquidating loans

Perspective 8-1: Before going into the technical aspects of banking, the instructor may wish to enliven the discussion by talking about changes going on in the banking and savings and loan industry.  Deregulation has caused increased competition between all financial institutions (and with some non-financial institutions as well).  Highlight institutions such as CitiGroup who now provide full service (commercial banking, investing, investment banking, life insurance and retail banking.

1. Bank loan terms and concepts

1. Prime rate: The interest rate charged the most credit-worthy borrowers

1. The prime rate serves as a base in determining the interest rate for various risk classes of borrowers.

2. The prime rate of New York banks receives much attention from government officials in managing the economy.

3. The prime rate has been more volatile in the last couple of decades than in previous decades.

PPT 8-10         Movement of the Prime Rate versus LIBOR (Figure 8-1)

1. The London Interbank Offer Rate (LIBOR) on U.S. dollar deposits is being used worldwide as a base lending rate on dollar loans.

1. Compensating Balances

1. As a loan condition, a borrower may be required to maintain an average minimum account balance in the bank equal to a percentage of loans outstanding or a percentage of future commitments and/or pay a fee for services.

2. Compensating balances raise the cost of a loan and compensate the bank for its services.

3. If a compensating balance is required, the borrower must borrow more than the amount needed.

1. Maturity Provisions

1. Most bank loans are short-term and mature within a year.

2. In the last decade more banks have extended intermediate-term loans (one to seven years) that are paid in installments.

1. Costs of Commercial Bank Financing

1. The effective interest rate depends on the loan amount, interest paid, length of the loan, and method of repayment.

Perspective 8-2: The instructor should review formulas 8-2 through 8-6 with the students.  The discussion can include a comparison of the effective costs of a loan under varying assumptions.  Many students have borrowed money for college expenses or auto loans so they can readily relate to the calculations.

1. Annual Percentage Rate

1. The Truth in Lending Act enacted by Congress in 1968 requires that the annual percentage rate (APR) be given to the borrower. The thrust of the legislation was to protect unwary individuals from paying more than the stated rate without his or her knowledge. 

2. The APR requires the use of the actuarial method of compounded interest and corresponds to the effective rate used throughout the text.

1. Bank Credit Availability Tends to Cycle

1. Credit crunches seem to appear every 3-5 years.

2. The pattern of the credit crunch has been as follows:

1. The Federal Reserve tightens the money supply to fight inflation.

2. Lendable funds shrink, interest rates rise.

3. Business loan demand increases due to price-inflated inventories and receivables.

4. Depositors withdraw savings from banks seeking higher return elsewhere, further reducing bank credit availability.

5. In the early 1990s, the U.S. saw a different kind of credit crunch from too many bad loans. The supply of funds dwindled and caused record bankruptcies for bank and savings and loans.

III.       Commercial Paper

1. Short-term, unsecured promissory notes issued to the public in minimum units of $25,000.

1. Issuers

1. Finance companies such as General Motors Acceptance Corporation (GMAC) that issue paper directly. Such issued are referred to as finance paper or direct paper. 

2. Industrial or utility firms that issue paper indirectly through dealer. This type of issue is called dealer paper.

1. There has been very rapid growth in the commercial paper market in the last few decades.

PPT 8-21         Total Commercial Paper Outstanding (Figure 8-2)

1. Traditionally, commercial paper has been a paper certificate issued to the lender to signify the lender's claim to be repaid. There is a growing trend among companies that sell and buy commercial paper to handle the transaction electronically.  Actual paper certificates are not created.  Documentation of the transactions is provided by computerized book-entry transactions and transfers of money are accomplished by wiring cash between lenders and commercial paper issuers.

1. Advantages

1. Commercial paper may be issued at below the prime rate at commercial banks.

2. No compensating balances are required, though lines of credit are necessary.

3. Prestige.

1. The primary limitation is the possibility that the commercial paper market might "dry up" unexpectedly as it does whenever an investment grade company has its credit rating lowered by Standard & Poor’s, Moody’s or Fitch.

PPT 8-23         Comparison of Commercial Paper Rate to Bank Prime Rate  (Table 8-1)

1. Foreign Borrowing

1. Loans from foreign banks are an increasing source of funds for U.S. firms.

1. Foreign loans denominated in U.S. dollars are called Euro-dollar loans. These loans are usually short to intermediate term in maturity.

1. A possibly cheaper alternative to borrowing Euro-dollars is the borrowing of foreign currencies which are converted to dollars and forwarded to the U.S. parent company.

1. The Use of Collateral in Short-Term Financing

1. The lending institution may require collateral to be pledged when granting a loan.

1. Lenders lend on the basis of the cash-flow capacity of the borrower. Collateral is an additional but secondary consideration.

1. Accounts Receivable Financing

1. Pledging accounts receivable as collateral

1. Convenient means of financing. Receivables levels are rising as the need for financing is increasing.

2. May be relatively expensive and preclude use of alternative financing sources.

3. Lender screens accounts and loans a percentage (60% - 80%) of the acceptable amount.

4. Lender has full recourse against borrower.

5. The interest rate, which is usually well in excess of the prime rate, is based on the frequently changing loan balance outstanding.

1. Factoring Receivables

1. Receivables are sold, usually without recourse, to a factoring firm.

2. A factor provides a credit-screening function by accepting or rejecting accounts.

3. Factoring costs.

1)         Commission of 1% - 3% of factored invoices

2)         Interest on advances

1. Asset-backed public offerings

1. Public offerings of securities backed by receivables as collateral is a recently employed means of short-term financing.

1. Several problems must be resolved:

1)         Image:  Historically, firms that sold receivables were considered to be in financial trouble.

2)         Computer upgrading to service securities.

3)         Regulatory roadblocks limiting bank participation.

Finance in Action:  Liquid Assets as Collateral—Punch Taverns Securitizes Liquid Assets

This example should catch the student’s attention.

It goes through a fund raising event by a British company that uses the cash flow from its pubs to secure a loan. The pub literally is using its beer sales to borrow money.

1. Inventory Financing

1. The collateral value of inventory is based on several factors.

1. Marketability

1. Raw materials and finished goods are more marketable than goods-in-process inventories.

2. Standardized products or widely traded commodities qualify for higher percentage loans.

1. Price Stability

2. Perishability

3. Physical Control

1. Blanket inventory liens: Lender has general claim against inventory of borrower.  No physical control.

2. Trust receipts: Also known as floor planning; the borrower holds specifically identified inventory and proceeds  from sale in trust for the lender.

3. Warehousing: Goods are physically identified, segregated, and stored under the director of an independent warehousing company.  Inventory is released from warehouse openly upon presentation of warehouse receipt controlled by the lender.

1)         Public warehouse -- facility on the premises of the warehousing firm.

2)         Field warehouse -- independently controlled facility on the premises of borrower.

1. Inventory financing and the associated control methods are standard procedures in many industries.

VII.     Hedging to Reduce Borrowing Risk

1. Firms that continually borrow to finance operations are exposed to the risk of interest rate changes.

2. Hedging activities in the financial futures market reduces the risk of interest rate changes.

Perspective 8-3:  Hedging and the use of derivative products is one of the hottest topics in finance.  Although at this point the student may lack the background to appreciate an in depth discussion, the general concept of hedging can be explained through the use of the example in the text. 

                                               Other Supplements to Chapter

Cases for Use with Foundations of Financial Management, Pierce Control System (bank financing)