CASH FLOW TIMELINE &

FINANCING
Cash is collected and cash is disbursed
If the ending balance is positive then investment
opportunity arises
If the ending balance is negative then the deficit
need to be financed
Working capital policy of the firm need to be
reevaluated
Even the most efficient working capital policy
may have deficit.

FINANCING STRATEGY
Firms always have some or permanent amount
of inventory or receivable on book. They do turn
over. This minimum level of ongoing inventory
and receivable is referred to as Permanent
Current assets.
The temporary component of current assets
represents inventory that is accumulated in
anticipation of sales and the resulting A/C
receivable generated by increasing sales.

ALTERNATIVE FINANCING
STRATEGIES
Aggressive Financing Strategy
Conservative Strategy
Moderate strategy

AGGRESSIVE STRATEGY
Aggressive policy is basically a maturity
matching strategy.
Expected life of the assets is matched with the
expected life of the source of funds raised to
finance the assets.
Long term finance will be used to finance fixed
assets and permanent current assets and short
term finance to finance temporary current assets.

FINANCING STRATEGIES:
AGGRESSIVE
Short-Term Financing
$
Temporary Current Assets

Permanent Current Assets

Long-Term
Financing

Fixed Assets

Time

CONSERVATIVE POLICY
It

uses only long term sources for meeting

the financing needs.
As total assets increase as a result of build
up of inventory and receivables, the firm
draw down its excess liquidity stored in
short term investment.
Excess cash is reinvested in short term
investment.
More expensive strategy.
Provide greater solvency position.

FINANCING
STRATEGIES:CONSERVATIVE
Excess Liquidity
$
Temporary Current Assets

Long-Term
Financing

Permanent Current Assets

Fixed Assets

Time

FINANCING STRATEGIES:
MODERATE
Excess
Liquidity

Short-Term
Financing

$
Temporary Current Assets

Permanent Current Assets

Long-Term
Financing

Fixed Assets

Time

TYPES OF CREDIT

Single payment loan/note

Granted for specific financial purpose.
Can be discount or add on note
Definite beginning and ending time

DISCOUNT NOTE
Interest rate is fixed. Why??
- loan amount = $ 100000
- loan period = 60 days, rate 7 % annually
- Amount received from the Bank
= 100000 X [1- .07(60)/360]
= $ 98833.
Amount need to repaid at maturity = $ 100000

ADD ON NOTE
Interest

is added to the principal at maturity

Rate of interest can be fixed/variable over the
life of the loan.
- loan amount = $ 100000
- loan period = 60 days, rate 7 % annually(fixed)
- Amount received from the Bank = $ 100000
Amount need to be paid
= 100000 X [{1+.07(60)/360]
= $ 101167

LINE OF CREDIT
A line of credit is a short term source of fund in
that it represents a fund that a bank stands
ready to lend a corporate client on demand at
anytime during a given period, generally a year.
Clean up feature
Compensating balance The firm cannot use the
full amount of loan.

PURPOSES
To meet seasonal short term need of the
borrower. What is clean up period?
Can be used as a backup to cover the maturing
commercial paper. What is back up line?
To work as liquidity cushion in case of
contingencies.

UNCOMMITTED CREDIT LINE

Simply a verbal or informally written statement
from the banker, that with fulfillment of terms
and conditions , the bank is prepared to lend the
potential borrower upto the stated amount.
Can be cancelled or terms may be altered but
bank rarely do it. Why??
Used to initiate relationship with potential
clients.

COMMITTED CREDIT LINE

Formal legal agreement covering the terms and
conditions
Bank requires compensation for commitment
Bank is legally bound to follow the agreement.

COMMITTED VS. UNCOMMITTED

LINE OF CREDIT
Committed Formal written agreement contractually
binding the bank to provide the fund when requested
Commitment fee
Covenants
Uncommitted Line of credit Is not binding on the
Bank, although it is always honored
Attractive to customers
- Who rarely use credit line
- Who maintain short term financial position
- Dont need to pay for unused balances
- Banks like it. It frees the Bank from obligation to
honor commitment to borrowers who credit
worthiness has recently been deteriorated.

COMPENSATION FOR CREDIT LINE

Commitment

fee
- Price for the bank commitment to keep the
line available
- Amount may be on total credit line or unused
portion of credit line
- Most widely used for compensation
Compensating balances
- Need to keep a certain amount of deposit.
- Specified in dollar amount or as a percentage
of the lines.

PROBLEM: COMPENSATING BALANCE VS.

LINE OF CREDIT

Line of credit $ 2000000

- Existing average cash balance=$200000
- Opportunity cost = 8% annually
- Option A
Cash fee 3/8% of the line
so, 20000000 X 3/8% = $ 75000
- Option B
- Compensating balance 5 % of the amount of the line
so 20000000 X 5% = $ 1000000
Increased amount of compensating balance
= 1000000- 200000 = 800000
800000 X 0.08 = $ 64000, so the option is Choice B

COMMITMENT FEE FOR UNUSED

LINE OF CREDIT
Credit line $5000000
Commitment fee % of the unused portion of
the loan
- For 1st six months it borrowed $3000000
- For 2nd six months it borrowed $1000000
Fee 1st half= .0025/2 (5000000 3000000)
=$2500
Fee 2nd half= .0025/2 (5000000 1000000)
=$5000

COMMITMENT FEE FOR UNUSED

LINE OF CREDIT
Credit line $5000000
Commitment fee % of the unused portion of
the loan
- For 1st six months it borrowed $3000000
- For 2nd six months it borrowed $1000000
Fee 1st half= .0025/2 (5000000 3000000)
=$2500
Fee 2nd half= .0025/2 (5000000 1000000)
=$5000

LETTER OF CREDIT

A Letter of Credit is a promise , generally by a

Bank to make commitment to make payment to a
party on presentation of draft provided that the
party complies with certain documents
requirement as stated in the Letter of Credit
agreement.

BANKERS ACCEPTANCE

A bankers acceptance is a time draft drawn

against a deposit in a commercial Bank but with
payment at maturity guaranteed by the Bank.

COMMERCIAL PAPER
Unsecured

promissory notes of an
organization issued for specific amount and a
fixed maturity.
Issued to the provider of fund.
It does not need to be registered with SEC if
its maturity is less than 270 days and it
fulfills one of the three conditions mentioned
below:
- Proceeds are used to finance current
transactions
- Notes are guaranteed by an bank
- Not offered to public

MATURITY: COMMERCIAL
PAPER & DENOMINATION
Most

of the commercial papers have a

maturity of 30 days or less, so they must be
rolled over. Why?
Unlike a commercial bank, the replacement
commercial paper is sold to different
purchasers
Commercial paper can be issued in any
denomination. Majority of the issues have
value of $100000 or more but it can also be
issued as little as $ 25000
Commercial paper is generally discount note
but it can be interest bearing. However
interest rate and fees are same for both loans.

UNSECURED BORROWING
Made on the basis of financial strength of the
borrower
Also referred to as Financial statement lending
In case of default the Bank becomes general
creditor
Usually granted to firms having long stable
history of strong financial performance

SECURED BORROWING
Gives the lender to right to claim a specific asset
in case of default by the borrower
It can be a collateralized loan or an asset based
loan.

COLLATERALIZED LOAN
Collateral must be adequate to cover the loan
but the Bank does not view it as a means of
repaying the loan
A/C receivable may loose value when the bank
wants to collect it later
Inventory may fail to obtain its full value when
it is sold
Raw materials Commodity value
WIP Very little value
Finished goods may have reasonable value
Difficulty in generating cash flows arises
because sales are below projections Obtaining
full value for inventory is rare occurrence.

FACTORING
Sale

of A/C receivable without recourse to

another party (factor)
Once the account has been purchased it is
the property and responsibility of the
factor.
Three major types of factoring
arrangement
- Maturity factoring
- Conventional factoring
- Maturity factoring with an assignment of
equity

INVENTORY FINANCING
Floating Lien- Borrower pledges its inventories
without particular specification. Relatively small
fraction of total value of inventory is pledged
Trust Receipt- Lender has a direct lien on a
specific inventory item. Suitable for relatively
expensive and low turnover item

Warehouse receipts- Field Warehousing a

segregated area of the borrowers facility housing
the facility. A third party is responsible for
issuing the receipts, which ensures that pledged
items are physically located on the premises
Terminal warehouse receipts

PROBLEM: INVENTORY VALUATION

Suppose

a company has $ 1,000,000 in

inventory pledged as collateral. The break
up of the inventory is as follows:
Finished goods - $ 500000
WIP
- $ 400000
Raw materials - $ 100000
If the Bank applied 50% factor to Finished
goods, 40% to raw materials and 0% to
WIP
then maximum amount of loan the Bank
will get
= .5X 500000 + 0 X 100000 + .4 X 400000
= $ 410,000

PROBLEM: A/C RECEIVABLE

VALUATION

A/C receivable also face problem in obtaining full value.

Qualified receivable = total receivable- 3 months older
receivable receivable from companies facing
bankruptcy
Bank then determines the loan amount by multiplying
QR by factor.
If total receivable = $ 5,000,000
$ 500000 older than 90 days
$ 100000 from firms facing Bankruptcy
If factor = 70% then
maximum loan =0.7(5,000,000-500000-100000)
= 30,8000
What is psychological value of collateral?

ASSET BASED LOAN

Difference between collateralized loan and asset

based loan
Primary repayment source of collateralized loanCash flow generating potential
Primary repayment source of asset based loanAsset value that represents loan
Probability of failure to repay is high
Asset value will be stable during the time of the
loan

COMPARING THE EFFECTIVE COST

OF FUNDS
Single Payment Loan
Interest at maturity
Total payment to be made at maturity,
MP = Principal + Interest + loan fees at maturity
Net proceeds of the loan,
PR = net proceeds of the loan
t = # of days the loan is outstanding
Effective rate, I = (MP-PR)/MP X 365/t

COMPARING THE EFFECTIVE COST

OF FUNDS: SINGLE PAYMENT LOAN
(EXAMPLE)
Interest at maturity
60 day single payment loan,
loan amount = $ 500000, interest rate 12%
Loan originating fee = $ 500 paid in advance
The amount paid at maturity
= 500000 [1+.12(60/365)] = 509863
I = (509863-499500)/509863 X 365/60
= 12.36%

COMPARING THE EFFECTIVE

COST OF FUNDS:
SINGLE
PAYMENT LOAN
Discount loan
60 day discount loan of $600000
(EXAMPLE)
interest rate 12%
The proceeds of the loan are,
PR = 600000[1-.12(60/365)] = 588164
I = (600000 - 588164)/588164 X 365/60
= 12.24%

COMPARING THE EFFECTIVE

COST OF FUNDS:
LINE
OF
CREDIT
Why it is
difficult
to calculate effective interest

rate for line of credit?

Credit line obtained may include a buffer
Borrowing varies with cash flow needs
Commitment fee or compensating balances may
be based on total amount of the line or unused
portion of the line

COMPARING THE EFFECTIVE COST OF

FUNDS:
LINE OF CREDIT (PROBLEM - WHEN
COMMITMENT FEE IS BASED ON
COMPENSATING BALANCE

COMPARING THE EFFECTIVE COST OF

FUNDS:
LINE OF CREDIT (PROBLEM - WHEN
COMMITMENT FEE IS BASED ON UNUSED
LINE OF CREDIT

CHAPTER 16 PROBLEM 4
Ralph,

treasurer for M and M products

recently updated his firms short term cash
forecast only to discover that the firm will
suffer a cash shortage of $ 12 million for a
period of 30 days. One option is to liquidate a
portion of his marketable securities portfolio,
but with interest rate up this is not a good
alternative. Ralph just learned from one of
his commercial paper dealers that paper in
the 30 days range is in demand and that
asked discount rate are comparably good at
about 9 percent.

CHAPTER 16 PROBLEM 4

a.

b.

The dealers annual fee is 20 basis point and

the annual commitment fee on a back up line
of credit is 50 basis point.
Estimate the effective cost of the commercial
paper assuming that this is the only
commercial paper issue planned for the year.
Estimate the effective cost of the commercial
paper assuming that there will be recurring
issues of commercial paper all year long.

CHAPTER 16 PROBLEM 4
M&M Products, Inc. - estimating the cost of
commercial paper.
ASSUMPTIONS:

Face amount =
$12,000,000
Discount rate =
9.00%
Maturity (days) = 30
Dealer annual fee= 0.20%
Commitment fee = 0.50%

CHAPTER 16 PROBLEM 4
a.)
Assume this is the only commercial paper
issue planned for the year.

Issue price =
Face - (Discount rate *
(Days/360) * Face Amount)

Issue Price =$11,910,000

Interest paid =
Face - Issue price

Interest paid =

$90,000

CHAPTER 16 PROBLEM 4
Commitment

fee =
Face * (Commitment
fee * (360/360))

Commitment fee =
$60,000
(Assuming only CP issue this year.)

Dealer fee =
Face * rate * (30/360)

Dealer fee =
$2,000

Out of pocket cost =

Interest + Dealer
fee + Commitment fee

CHAPTER 16 PROBLEM 4

Out of pocket cost =

$152,000

Usable Funds =

Issue price - Interest

Usable funds =

$11,910,000

Effective rate =
(Out of pocket cost /
Usable funds) * (365/Days)

Effective rate =
15.53%

b.) Assume there will be recurring issues of

commercial paper all year long.
Assuming the issue of CP is recurring throughout
the year adjusts commitment fee to just 30 days
of usage allocated to this CP issue.

Commitment fee = Face * (Commitment fee

* (30/360))

Commitment fee = $5,000