What are the two major sources of spontaneous short-term financing for a firm? How do their balances behave relative to the firm’s sales? The two key sources of spontaneous short-term financing (financing that arises from the normal operating cycle) are accounts payable and accruals. Both of these sources are spontaneous, since their levels increase and decrease directly with increases or decreases in sales. If sales increase, the firm will purchase more new materials, resulting in higher accruals of these items. 16. 2 Is there a cost associated with taking a cash discount?
Is there any cost associated with giving up a cash discount? How do short term borrowing cost affect the cash discount decision? There is no cost stated or unstated associated with taking a cash discount; there Is a cost of giving up a cash discount, By giving up a cash discount, the purchaser pays the full price for merchandise but can make the payment later. The unstated cost of giving up a cash discount Is the Implied rate of interest paid to delay payments. This rate can be used to make decisions with respect to whether or not the discount should be taken.
If the cost of giving up the ash discount is greater than the cost of borrowing short-term funds, the firm should take the discount. Cash discounts can be a source of additional profitability for a firm. 16. 3 What is ;stretching accounts payable”? What effect does this action have on the cost of giving up a cash discount? Stretching accounts payable is the process of delaying the payment of accounts payable for as long as possible without damaging the firm’s credit rating. Stretching payments reduces the Implicit cost of Glenn up a cash discount. 16. How is the prime rate of interest relevant to the cost of short term bank rowing? What is a floating-rate loan? The prime rate of interest, which is the lowest rate charged on business loans to the best business borrowers, is usually used by the lender as a base rate to which a premium is added by the lender, depending upon the risk of the borrower, in order to determine the rate charged. A floating-rate loan has its interest tied to the prime rate. The rate of interest is established at an increment above the prime rate and floats at that increment above prime over the term of the note. 6. 5 How does the effective annual rate differ between a loan requiring Interest aments at maturity and another, similar loan requiring Interest In advance? The effective interest rate is the actual rate of interest paid for the period. The (deducted from the loan so that the borrower receives less than the requested amount). 16. 6 What are the basic terms and characteristics of a single-payment note? How is the effective annual rater n such a note found? A single-payment note is an unsecured loan from a commercial bank.
It usually has a short maturity 30 to 90 days and the interest rate is normally tied in some way to the prime rate of interest. The interest ate on these notes may be fixed or floating. 16. 7 What is a line of credit? Describe each of the following features that are often included in these agreements: (a) operating change restrictions, (b) compensating balance, and (c) annual cleanup. A line of credit is an agreement between a commercial bank and a business that states the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time.
In a line of credit agreement, a bank may retain the right to revoke the line if any major changes occur in the firm’s financial condition or operations. To ensure that the borrower will be a good customer, frequently a line of credit will require the borrower to maintain compensating balances in a demand deposit. In some cases, fees in lieu of balances may be negotiated. To ensure that money lent under the credit agreement is actually being used to finance seasonal needs, banks require that the borrower have a zero loan balance for a certain number of days per year. This is called the annual cleanup period 16. What is a revolving credit agreement? How does this agreement differ from the line of credit agreement? What is a commitment fee? A revolving credit agreement is guaranteed line of credit. Under a line of credit agreement, a firm is not guaranteed that the bank will have funds available to lend upon demand, while under the more formal revolving credit agreement the availability of funds is guaranteed. Since the lender under the revolving credit agreement guarantees the availability of funds, the borrower must pay a commitment fee, a fee levied against the average unused portion of the line. 6. 9 How do firms use commercial paper to raise short-term funds? Who can issue commercial paper? Who buys commercial paper? Commercial paper, which is a short- ERM, unsecured promissory note, can be sold by large, creditworthy firms in order to raise funds. The maturity of commercial paper is generally between 3 to 270 days and is normally issued in multiples of $100,000 or more. The interest rate on CAP is usually 1 to 2 percent below the prime rate and is a less costly source of short-term funds than bank loans.
Commercial paper is purchased by corporations, life insurance companies, pension funds, banks, and other financial institutions and or may be sold through a middleman known as a commercial paper house, which charges a fee to the issuer for its marketing efforts 6. 10 What is the important difference between international and domestic transactions? How is a letter of credit used in financing international trade transactions? How is ;netting” used in transactions between subsidiaries?
International transactions differ from domestic ones because they involve payments made or received in a foreign currency. This results in additional foreign costs and also exposes the company to foreign exchange risk. A letter of credit is a letter written by a company’s bank to a foreign supplier that effectively guarantees payment of an invoiced amount, assuming that all the pacified terms are met. “Netting” occurs when a company’s subsidiaries or divisions located in different countries have transactions that result in interactions receivables and payable.
Rather than pay the gross amount of both the receivables and payable, paying the net amount due which is lower allows the parent to reduce foreign exchange fees and other transaction costs. 16. 11 Are secured short term loans viewed as more risky or less risky that unsecured short term loans? Why? Lenders view secured and unsecured short-term loans as having the same degree of risk. The benefit of the collateral for a secured loan is only beneficial if the firm goes into bankruptcy 16. 12 In general, What interest rates and fees are levied on secured short term loans?
Why are these rates generally higher than the rates on unsecured short term loans? The interest rate charged on secured short-term loans is typically higher than the interest rate on unsecured short-term loans. Typically, companies that require secured loans may not qualify for unsecured debt, and they are perceived as higher- risk borrowers by lenders. The presence of collateral does not change the risk of default; it provides a means to reduce losses if the borrower defaults. In general, lenders require security for less creditworthy, higher-risk borrowers.
Since the negotiation and administration of these loans is more troublesome for the lender, the lender normally requires certain fees to be paid by the secured borrower. The higher rates on these secured short-term loans are attributable to the greater risk of default and the increased loan administration costs of these loans over the unsecured short-term loan. 16. 13 Describe and compare the basic features of the following methods of using accounts receivable to obtain short term financing (a) pledging accounts receivable, ND (b) factoring accounts receivable. Be sure to mention the institutions that offer secure a short-term loan. The lender evaluates the quality of the accounts receivable, selects acceptable accounts, and files a lien on the collateral. After the selection of accounts, the lender determines the percentage advanced against receivables. Typically ranging from 50 to 90 percent of the face value of the acceptable receivables, this amount becomes the principal on the loan. Pledging receivables usually costs 2 to 5 percent above the prime rate due to the nature of the rower and additional administrative costs. Commercial banks offer this type of financing.
Factoring accounts receivable is the outright sale to the factor or other financial institution. The factor sets the conditions of the sale in a factoring agreement. Normally factoring is done on a unrecorded basis (the factor accepts all credit risks), and the customer is usually notified that the account receivable has been sold. Factoring can typically cost from 3 to 7 percent above the prime rate, including commissions and interest. This type of financing is handled by specialized financial institutions called factors; some commercial banks and commercial finance companies factor receivables.
While the cost is high, the advantages include immediate conversion of receivables into cash and also the known pattern of cash flows 16. 14 For the following methods of using inventory as short term loan collateral, describe the basic features of each, and compare their use; (a) floating lien, (b) trust receipt loan and (c) warehouse receipt loan. Floating inventory liens are made by lenders and secured by a claim on general inventory consisting of a diversified and owe cost group of merchandise.
Generally less than 50 percent of the book value of the average inventory is advanced. The interest charge on a floating lien is typically 3 to 5 percent above the prime rate. Trust receipt inventory loans are often made by manufacturers’ financing subsidiaries to their customers. Under this arrangement, merchandise is typically expensive and remains in the hands of the borrower. The lender advances 80 to 100% of the cost of the salable inventory. The borrower is free to sell the merchandise and is trusted to remit the loan amount plus accrued interest to the ender immediately.
The interest charge is generally 2 percent or more above the prime rate. A warehouse receipt loan is an arrangement whereby the lender receives control of the pledged collateral. The inventory may be retained by the borrower in the firm’s warehouse with security administered by a field warehousing company. Or the inventory may be stored in a terminal warehouse located in the geographic vicinity of the borrower. Generally, less than 75 to 90 percent of the collateral’s value is advanced to the borrower at an interest rate from 4 to 8 percent above the prime rate