Years
Lower dashed line would be more aggressive.
16-3
Conservative financing
policy
Marketable
$ securities
Zero S-T
Debt
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
16-4
Short-term credit
Any debt scheduled for repayment within
one year.
Major sources of short-term credit
Accounts payable (trade credit)
Bank loans
Commercial loans
Accruals
From the firm’s perspective, S-T credit is
more risky than L-T debt.
Always a required payment around the
corner.
May have trouble rolling over loans.
16-5
Advantages and disadvantages
of using short-term financing
Advantages
Speed
Flexibility
Lower cost than long-term debt
Disadvantages
Fluctuating interest expense
Firm may be at risk of default as a result
of temporary economic conditions
16-6
Accrued liabilities
Continually recurring short-term
liabilities, such as accrued wages or
taxes.
Is there a cost to accrued liabilities?
They are free in the sense that no
explicit interest is charged.
However, firms have little control over
the level of accrued liabilities.
16-7
What is trade credit?
Trade credit is credit furnished by a
firm’s suppliers.
Trade credit is often the largest
source of short-term credit,
especially for small firms.
Spontaneous, easy to get, but cost
can be high.
16-8
The cost of trade credit
A firm buys $3,000,000 net ($3,030,303
gross) on terms of 1/10, net 30.
The firm can forego discounts and pay
on Day 40, without penalty.
16-9
Breaking down net and gross
expenditures
Firm buys goods worth $3,000,000.
That’s the cash price.
They must pay $30,303 more if they
don’t take discounts.
Think of the extra $30,303 as a
financing cost similar to the interest
on a loan.
Want to compare that cost with the
cost of a bank loan.
16-10
Breaking down trade
credit
Payables level, if the firm takes discounts
Payables = $8,219.18 (10) = $82,192
Payables level, if the firm takes no discounts
Payables = $8,219.18 (40) = $328,767
Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575
16-11
Nominal cost of costly trade
credit
The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain
$246,575 in extra trade credit:
16-13
Effective cost of trade
credit
Periodic rate = 0.01 / 0.99 = 1.01%
Periods/year = 365 / (40-10) =
12.1667
Effective cost of trade credit
EAR = (1 + periodic rate)n – 1
= (1.0101)12.1667 – 1 = 13.01%
16-14
Commercial paper (CP)
Short-term notes issued by large,
strong companies. B&B couldn’t
issue CP--it’s too small.
CP trades in the market at rates just
above T-bill rate.
CP is bought with surplus cash by
banks and other companies, then
held as a marketable security for
liquidity purposes.
16-15
Bank loans
The firm can borrow $100,000 for
1 year at an 8% nominal rate.
Interest may be set under one of
the following scenarios:
Simple annual interest
Discount interest
Discount interest with 10%
compensating balance
Installment loan, add-on, 12 months
16-16
Must use the appropriate EARs
to evaluate the alternative loan
terms
Nominal (quoted) rate = 8% in all cases.
We want to compare loan cost rates and
choose lowest cost loan.
We must make comparison on EAR =
Equivalent (or Effective) Annual Rate
basis.
16-17
Simple annual interest
“Simple interest” means no discount or
add-on.
INPUTS 1 92 0 -100
N I/YR PV PMT FV
OUTPUT 8.6957
16-19
Raising necessary funds with
a discount interest loan
Under the current scenario, $100,000 is borrowed
but $8,000 is forfeited because it is a discount
interest loan.
Only $92,000 is available to the firm.
If $100,000 of funds are required, then the amount
of the loan should be:
Amt borrowed = Amt needed / (1 – discount)
= $100,000 / 0.92 = $108,696
16-20
Discount interest loan with a
10% compensating balance
Amountneeded
Amountborrowed=
1 - discount- comp.balance
$100,000
= = $121,951
1 - 0.08- 0.1
16-21
Add-on interest on a 12-
month installment loan
Interest = 0.08 ($100,000) = $8,000
Face amount = $100,000 + $8,000 = $108,000
Monthly payment = $108,000/12 = $9,000
Avg loan outstanding = $100,000/2 = $50,000
Approximate cost = $8,000/$50,000 = 16.0%
To find the appropriate effective rate, recognize that
the firm receives $100,000 and must make monthly
payments of $9,000. This constitutes an annuity.
16-22
Installment loan
From the calculator output below, we have:
kNOM = 12 (0.012043)
= 0.1445 = 14.45%
INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043
16-23
What is a secured loan?
In a secured loan, the borrower
pledges assets as collateral for the
loan.
For short-term loans, the most
commonly pledged assets are
receivables and inventories.
Securities are great collateral, but
generally not available.
16-24