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Unsecured Short-term Financing

Short-Term Financing refers to financing that will be repaid in 1 year or less. Maybe
used to meet seasonal and temporary fluctuations in a companys funds position as
well as to meet permanent needs of the business. It may be used to provide extra net
working capital , finance current assets, provide interim financing for a long-term
project.
Advantages:
1. It is easier to arrange.
2. It is less expensive.
3. It affords the borrower more flexibility.
Disadvantages:
1. Interest rate fluctuates more often.
2. Refinancing is frequently needed.
3. Delinquent repayment may be detrimental to the credit rating of a borrower who
is experiencing a liquidity problem.
Two Main Types of Short-Term Financing:
1. Unsecured
2. Secured
Some Sources of Unsecured Short-Term Financing:
1. Accruals
2. Trade credit
3. Short-term bank loans
4. Commercial papers
5. Commercial finance company loans
Some Factors in the Selection of the Source of Short-Term Financing:
1. Cost
2. Effect on companys credit rating.
3. Risk reliability of the source of funds for possible future borrowing
4. Restrictions
5. Flexibility
6. Expected Money Market Conditions
7. Corporate profitability and liquidity positions.
8. Stability of the firms operations.
Accruals
- spontaneous source of financing
- most common for wages and taxes
- these represent cost-less or interest-free source of financing

Trade Credit
- refers to balances owed to suppliers, also a spontaneous source of financing
- some benefits: readily available because suppliers want business; collateral not
required; interest is typically not demanded; convenient to obtain; creditors
frequently lenient in the event of corporate financial problems.

Two Ways of Using Trade Credit as a Source of Financing:


1. Payment on the Final Due Date
- If no cash discount is offered, there is no cost for the use of trade credit. If the
firm takes the discount, there is no cost for the use of trade credit during the
discount period. If a cash discount is offered but not taken, there is a definite
opportunity cost.
- Computation of Interest Cost of Trade Credit (Annual Cost of Foregone Discount)
Annual Cost of Foregone Discount

No. of Days in a Year


Discount%
x
(100% Discount%) ( Days Credit Outs tan ding Discount Period )

Point: Cost of trade credit will decrease as net period (length of time between the end
of discount period and the final due date) increase.
2. Payment Beyond the Net Period
- Called as stretching accounts payable or leaning on the trade.
- Twofold Cost:
a. Cost of cash discount foregone
b. Possible deterioration in credit rating
- Periodic and reasonable stretching of payables is not necessarily bad per se. If a
firm does stretch its payables, an effort should be made to keep suppliers fully
informed of its situation.
Short-Term Bank Loans
- Typically are self-liquidating as assets purchased with the proceeds generate
sufficient cash flows to pay off the loan eventually.
- Not a spontaneous financing as borrowers must apply for this loans and lenders
must grant them.
- Interest charge is usually based on the prime rate. Prime rate is the rate charged
on business loans to financially sound companies.
Three Ways by Which Unsecured Short-Term Bank Loans can be Given:
a. Line of Credit
- Informal arrangement between a bank and its customer specifying the maximum
amount of unsecured credit the bank will permit the firm to owe at any one time.
- Yearly renewal dependent on the companys past performance and credit needs
in the future.
- Designed to be for seasonal or temporary financing and is not a legal obligation
of a bank.
b. Revolving Credit Agreement
- A formal committed line of credit extended by a bank or other lending
institutions. The bank charges a commitment fee on the unused portion of the
revolving credit and this is over and above the interest on the used part.
- This is a legal obligation of the bank.
c. Transaction Basis
- Appropriate when the firm needs short-term funds for only one purpose.
- Bank evaluates each request by the borrower as a separate transaction.
Commercial Paper
- The two components of the commercial paper market:
a. Dealer market (sells commercial papers in behalf of the issuer, dealers
purchase it first and charges a service fee in the form of commission)

b. Direct placement market (sells commercial papers directly to investors)


-

Main advantage of commercial paper is that it is generally cheaper than a short


term business loan from a commercial bank.

Commercial Finance Company Loans


- Alternative source of finance when credit is unavailable from a bank.
- Generally charges a higher interest rate than a bank.

Three Methods of Charging Interest Rates:


1. Collect Basis interest is paid at the maturity of the note or loan.
2. Discount Basis interest is deducted from the initial loan.
3. Add-on Basis interest and principal constitute the face value of a loan, usually
used on installment loans.
Cost of Borrowing Formula (for bank loans, commercial papers and other loans):
% Annual Interest

Interest Cost All Other Costs


Amount Actually Re ceived

No. of Days in a Year


Days Credit is Outs tan ding

Sample Problems:
1. The Dud Company purchases raw materials on terms 2/10, net 30. A review of the
companys records by the owner, Mr. Dud, revealed that payments are usually made
15 days after purchases are received. When asked why the firm did not take
advantage of its discounts, the bookkeeper, Mr. Grind, replied that it cost only 2
percent for these funds, whereas a bank loan would cost the firm 12 percent.
a. What mistake is Grind making?
b. What is the real cost of not taking advantage of the discount?
c. If the firm could not borrow from the bank and was forced to resort to the use of
trade credit funds, what suggestion might be made to Grind that would reduce the
annual interest cost?
2. Mendez Metal Specialties, Inc., has a seasonal pattern to its business. It borrows
under a line of credit from Central Bank at 1% over prime. Its total asset
requirements (now at year end) and estimated requirements for the coming year are:
Time
Amount

Now
$4.5M

1st Qtr.
$4.8M

2nd Qtr.
$5.5M

3rd Qtr.
$5.9M

4th Qtr.
$5M

Assume that these requirements are level throughout the quarter. Presently, the company
has $4.5 M in equity capital plus long-term debt plus the permanent component of
current liabilities, and this amount will remain constant throughout the year.
The prime rate presently is 11%, and the company expects no change in this rate
for the next year. Mendez Metal Specialties is also considering issuing intermediate term
debt at an interest rate of 13.5%. In this regard, three alternative amounts are under

consideration: 0, $500,000 and $1M. All additional funds requirements will be borrowed
under the companys bank line of credit.
a. Determine the total dollar borrowing costs for short- and intermediate- term debt
under each of the three alternatives for the coming year. (Assume there are no
changes in current liabilities other than borrowings.) Which is lowest?
b. Are there other considerations in addition to expected cost?
3. The Fox Company is able to sell $1M of commercial paper every 3 months at a rate
of 10% and a placement cost of $3,000 per issue. The dealers require Fox to maintain
bank lines of credit demanding $100,000 in bank balances, which otherwise would
not be held. Fox has a 40% tax rate. What do funds from commercial paper cost Fox
after taxes?
4. Commercial paper has no stipulated interest rate. It is sold on a discount basis, and
the amount of the discount determines the interest cost to the issuer. On the basis of
the following information, determine the percentage interest cost on an annual basis
for each of the following issues:
Issue
A
B
C
D
E

Face Value
$25,000
$100,000
$50,000
$75,000
$100,000

Price
$24,500
$96,500
$48,800
$71,300
$99,100

Time to Maturity
60 days
180
90
270
30

5. The Sphinx Supply Co. needs to increase its working capital by $10 million. It has
decided that there are essentially 3 alternatives of financing available:
a. Forgo cash discounts, granted on a basis of 3/10, net 30.
b. Borrow from the bank at 15%. This alternative would necessitate maintaining a
12% compensating balance.
c. Issue commercial paper at 12%. The cost of placing the issue would be $100,000
each 6 months.
6. Castellanos Company wishes to borrow $100,000 for 1 year. It must choose one of
the following alternatives.
a. 9% loan on a collect basis, with face value due at the end.
b. 8.4% loan on a discount basis, with face value due at the end.
c. 6% loan on an add-on basis, with equal quarterly payments required on the initial
face value.
Which alternative has the lowest effective yield, using annual compounding for the first
two and quarterly compounding for the last?
7. The Eng Mfg. Co. will need funds this fall to finance an increase in inventory. Kuo
Eng anticipates a need of $160,000 for 90 days but wants to have available $250,000
in case more funds are needed. The Mercantile Bank is willing to extend this line of

a.
b.
c.
d.

credit provided that Kuo leaves a compensating balance of 20% of the amount
actually borrowed. The account that holds the compensating balance earns no
interest. The simple interest rate on the loan is 14%. Assume a 360-day year.
If Kuo borrows $160,000, how much if this amount is usable?
How much would Kuo have to borrow to get $160,000 of usable funds?
What line of credit must Kuo establish to have available $250,000 in usable funds?
What annual interest rate is Kuo paying if he borrows an amount sufficient to
generate $160,000 in usable funds?