FINANCE MANAGEMENT FIN420 CHP 7

Short-Term Financing Chapter 7
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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.

Learning objectives

After learning this chapter, you should be 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.

Short-Term Financing

GOAL
Chapter 7 Short-Term Financing

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7.0 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 firms current assets.

The use of short-term financing is to meet the seasonal and temporary fluctuation in a
companys 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. 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. Cost of short-term debt is lower. If the yield curve is upward sloping, as it often is,
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 general, the use of short-
term 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

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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 Accrued 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 Accounts 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

Accounts payable - 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

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An example: Tatoo Company purchased RM 1000 worth of merchandise on
February 27
th
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 10
th
.

b. If it foregoes the discount, it will have to pay full amount
RM 1000 on March 30
th
.
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 360
1 0.02 20

= 36.73%

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

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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. 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. It involves credit more than the free credit or
beyond the discount period. This credit has an implicit cost equal to
the foregone discounts.
We could use the following the annualized opportunity cost of not taking
the discount (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.


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7.2 DIRECT BORROWINGS FROM BANKS/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 Short-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 pre-
arranged credit line agreements with their bank and short-term loans may be
practically spontaneous. Several sources of unsecured financing are:

a) Notes payable - it is a single payment loan obtained from a
commercial bank by credit-worthy business
borrower. This 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 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.

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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 short-
term, 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.)


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Most commercial papers have maturities
ranging from 3 to 270 days. 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 dealers for is charged.

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 Annual 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.


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d) Compensating Balances
Deposit that the firm keeps with the bank in a low-interest or non-
interest bearing to compensate for bank loans or services. These
requirements will also reduces the loan proceeds.

The effective interest rates (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 RM10,000 term loan at 12 percent for: (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. 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

Effective Interest Rate =RM1,200 / RM10,000 =12%
For 6 months
Interest =RM10,000 (0.12)(6 / 12) =RM600
Net proceeds =RM10,000 RM0 =RM10,000


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Effective Interest Rate =(RM600 / RM10,000)(12 / 6) =12%

2. Discounted 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

Effective Interest Rate =RM1,200 / RM8,800 =13.64%

For 6 months
Interest = =RM600
Net proceeds = =RM9,400

Effective Interest Rate = =12.77%

3. Compensating 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 =RM10,000 RM1,000 =RM9,000


For 6 months
Interest = =RM600
Compensating balance = =RM1,000


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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. 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


For 6 months
Interest = =RM600
Compensating balance = =RM1,000


The present of discounted interest and compensating 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

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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%

Lets 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) Amount of Interest = Principal x rate x time
= 70,000 x 19% x 360
360
= 13,300

b) The proceeds = Total loan
= RM 70,000

c) Time period = 1/Time
= 1/360/360
= 1/1
EIR = Amount of Interest x 1/Time
Proceeds
= 13,300 x 1/1
70,000
= 19%

ii) 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.


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iii) 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%)

Lets 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 Consumer Revolving 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 Revolving Credit Agreement (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

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commitment fee. It only uses RM80,000 and RM20,000 left unused.
Therefore, to calculate the effective cost it will include a commitment fee.
For example:-

1) A commitment fee is charged to the borrower on the unused balance
of the credit agreement. So the formula of 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
Commitment fee =RM20,000 (0.005) =RM100
Compensating balances =None =RM0

EIR = (Interest +Commitment Fee)
(Amount Borrowed Compensating Balances)
= (RM11,200 +100)
(RM80,000 0)

= 14.13%

2) J ohn 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 % 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
= 10.16%


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7.2.5 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 Commercial 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:


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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
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 x1/90/360
980,000

= 20 x 1/Time
980

= 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 Accounts Receivable Financing

Accounts receivable financing involves either the 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

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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 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 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. 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.


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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 factors 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% factors 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 C : Monthly commission rate
IV : Invoice value
r : Interest rate
n : Number of months
RE : Reserve

1. 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


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3. Monthly discount charges =IV [IV x (1 +r/12)
n
]
=200,000 [200,000 x (1 +12%/12
1
]
=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,

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improves cash flows, reduce bad debts and increase return on capital
by utilizing the factoring facilities.

Another example, if S.A. Berhad, a producer of childrens 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 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 30 days. Calculate the cost of
factoring these accounts.

1
st
: 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

2
nd
: Calculate the effective annual cost of factoring

E/R = Amount of Interest +Commission x 1/Time
Proceeds

= RM9 +RM20 x 1/30/360

= 29 x 12
891

= 39%

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

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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.

7.2.9 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:


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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 For 2 months

Processing fees =(Monthly fees)(Maturity in months)(Face value)
=(0.01)(2)500,000
=10,000.00 For 2 months

APR =[(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 firms overhead dealing with the
receivables given that the lender provides billing and collection services.

Lets look at another example:

Bobby needs RM5 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 80% of the pledged receivable
(Book Value) at a rate of 12% per annum and 1% processing fees on all
receivables pledged.

1
st
You have to determine the Book Value, where:

Amount of loan = 80% x Book Value
RM5 mil = 80% x X
X = RM 5 mil
0.8
= RM6,250,000 (Book Value)

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2
nd
Therefore Processing fee can be calculated, that is

Fees = 1% x Book Value
= 1% x 6,250,000
= RM62,500

3
rd
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 firms 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.


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7.2.13 Terminal Warehouse Receipts

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 Field Warehouse Receipts

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 Costs 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%


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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 childrens plastic toys, needs a loan of
RM125,000 for 60 days. The companys 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

= RM312,500
The cost = 0.14 x 125,000 x 2/12

(the amount of interest) = RM2917

EIR = RM2917 x 2/12
125,000

= 14%


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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

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RM800,000 during the year under the agreement. Calculate the effective
annual interest rate of the firms 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)


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FINANCE MANAGEMENT FIN420 CHP 7

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