9)Short-term MaxMarkViney
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Question 1: Sparko Electrical Services purchases electrical cable, switches and fittings on credit.
The company receives an invoice from the supplier that states 2/10, n/30. What does this note on
the invoice mean?
A: The the date is 2nd October and the company has 30 days to pay in full.
B*: If if payment is made in 10 ten days a two 2% per cent discount applies; otherwise, full
payment is due in 30 days.
C: This this is the second time in 10 ten months that the company has been 30 days late.
D: If if payment is made in two days a 10% per cent discount applies; otherwise, full payment is
due in 30 days.
Feedback: The note means that if Sparko pays the account within 10 days there is a two %2 per cent
discount; otherwise, the full amount shown on the invoice is payable within 30 days.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.12, p. 35803.
Most commonly, the terms of trade credit are specified on the invoice attached to the goods. The
invoice typically contains information describing the goods supplied, price, total amount due and
the terms of settlement. If the terms include provisions other than cash on delivery, the purchaser is
effectively being granted a short-term loan. Suppliers who offer trade credit may encourage early
payment by providing a discount for early settlement of the account. For example, the terms may be
2/10, n/30. The 2/10 indicates that if payment is made within ten days, the invoice price will be
discounted by two %; n/30, or net 30 days, signifies that if payment has not been made within 10
days, then the full invoice price is payable within 30 days.
The terms of trade credit are usually specified on the invoice attached to the goods. The
invoice typically contains information describing the goods supplied, the price, the total
amount due and the terms of payment. If the terms include provisions other than cash on
delivery, the purchaser is effectively being granted a short-term loan. Suppliers who offer
trade credit may encourage early payment by providing a discount for early payment of the
account. For example, the terms may be 2/10, n/30. The 2/10 indicates that if payment
is made within ten days the invoice price will be discounted by 2 per cent; n/30, or net
30 days, signifies that if payment has not been made within ten days the full invoice price
is payable within thirty days.
Question 2: DLK Plumbing Contractors has received an invoice for goods purchased on credit. The
invoice states 2/10, n/60. If DLK pays the account within 10 ten days and receives the discount,
what annual rate of return does it earn by doing so?
A: 17.3% per cent
B*: 14.9% per cent
C: 22.36% per cent
D: 12.41% per cent
Feedback: If DLK pays early and receives the discount, it earns a return of 2two % per cent over 50
fifty days. The corresponding annual rate of return is:
(2/98) (365/50) = 0.14897 or 14.9% per cent.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.12, p. 35803.
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If a credit period and early settlement period with discount are provided, the purchaser has a choice:
either pays early and receives the discount, or pays in full by the later specified date and obtains a
longer period of credit. The choice should be determined by calculating the opportunity cost
attached to the discount versus the benefit of the extended credit period. If the offer of the discount
is taken, the purchaser will need to fund the purchase of the goods at that date. The purchaser needs
to consider the opportunity cost associated with two alternative situations: the after-tax cost of other
available types of short-term credit, and the return that could be obtained from investing surplus
cash over that period. For example, if the invoice provides for payment net in 30 days, or a one %
discount applies if it is paid in seven days (1/7, n/30), then the opportunity cost of forgoing the
discount is:
If a credit period and early settlement period with discount are provided, the purchaser
has a choice: either pay early and receive the discount, or pay in full by the later specified
date and obtain a longer period of credit. The choice should be determined by calculating
the opportunity cost of the discount versus the benefit of the extended credit period. If the
offer of the discount is taken, the purchaser will need to have the funds available to pay for
the goods at that date. The purchaser needs to consider the opportunity cost associated with
two alternative situations: the after-tax cost of other available types of short-term credit,
and the return that could be obtained from investing surplus cash during that period. For
example, if the invoice provides for payment net in thirty days, or a 1 per cent discount if
paid in seven days (1/7, n/30), the opportunity cost of not accepting the discount is:
Refer to the Eequation 9.1in the text.
If the purchasing company can obtain funds at an after-tax rate of less than 16.03%, the account
should be settled within seven days. Similarly, if it has surplus cash that has alternative uses, but
none of which return an after-tax rate of 16.03% or greater, the cash should be used for early
settlement of the invoice.
If the purchasing company can obtain funds at an after-tax rate of less than 16.03 per
cent, the account should be paid within seven days. Similarly, if it has surplus cash that has
alternative uses, but none of which return an after-tax rate of 16.03 per cent or greater, the
cash should be used for early payment of the invoice.
Question 3: Black Limited is negotiating an overdraft facility with its bank. The bank loan officer
has sent the company a letter of offer that includes the terms and conditions shown below. Which of
these terms and conditions would usually apply to an overdraft facility?
I. .
II. .
III. .
IV. .
V. .
VI. .
Interest interest is payable on the daily outstanding debit balance that is monthly in arrears
The the account balance is to be fully fluctuating
The the overdraft limit is subject to periodic review
The the overdraft is repayable on demand
Bank bank approval is required to draw cheques using the overdraft facility
An an establishment fee will be charged
A*: I, II, III, IV, VI
B: I, II, III, V, VI
C: II, III, IV, V, VI
D: All all of the above
Feedback: One of the major attractions of an overdraft facility is that it provides the flexibility to
draw on the account without obtaining bank approval, provided that the agreed overdraft limit is not
exceeded. All the conditions, other than V, usually apply, so A is the correct answer.
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MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.23, pp. 3590436005.
The overdraft facility is a major source of short-term finance. An overdraft facility is especially
suited to meeting a firms day-to-day working capital requirements, and the monthly or seasonal
mismatch between its cash inflows and outflows. A business needs to meet its expense
commitments when they fall due. Often this may occur before the business has received cash flows
associated with the related business activities. For example, a manufacturer will have fixed costs,
such as equipment and administration, and variable costs, such as inventories, necessary in the
manufacturing process. Many of these costs will need to be paid before sales are generated. This is
described as a mismatch in the timing of the cash flows of a business. An overdraft facility enables
a business to smooth out the problems associated with cash flow timing mismatches.
The convenience of the overdraft facility derives from the fact that the facility attaches directly to a
firms current operating account. A firms operating account is usually a cheque account with a
bank. An overdraft arrangement allows the firm to put its operating cheque account into deficit, up
to an agreed overdraft limit. The limit is negotiated with the bank and is subject to regular review. If
the bank is not satisfied with the financial performance of the borrower the overdraft may be
repayable on demand.
The interest charge payable on an overdraft is negotiated between the bank and the firm. The
interest rate will usually be at a margin above a periodically published indicator interest rate. The
margin charged above the indicator interest rate will relate directly to the banks determination of
the credit risk of the borrower. For example, a large company that has an established credit history
with a bank will usually be charged a lower margin than a new client that does not have an
established relationship with the bank. The particular indicator rate used by a bank will be specified
in the overdraft agreement. The indicator rate may be the banks own prime rate, or it may be a
published market rate. Each country tends to have its own published reference rates. For example in
the United Kingdom it may be LIBOR, in the USA it may be USCP, or in Australia it may be
BBSW. These indicator rates are published daily by Reuters, the major provider of information to
the financial markets. The agreed interest charge is calculated on the daily debit balance outstanding
on the overdraft. Deposits into the operating account reduce the overdraft, and thus reduce the daily
interest charge. Deposits to reduce the outstanding debit balance, or overdraft, can be made at any
time; that is, an overdraft facility does not require a regular repayment schedule.
Generally, in addition to the interest charge on the balance outstanding, the lender will impose an
establishment fee, a monthly account service charge, and a fee on the unused overdraft limit. The
latter fee compensates the lender for effectively committing funds for the borrowers use, at a time
determined by the borrower. That is, once the overdraft limit has been established, the firm can use
that facility at any time without notice, up to the limit. The bank in effect has to maintain a
contingency fund to meet the demands of the borrower should the borrower decide to go into
overdraft to the extent of the agreed limit. There is a cost to the bank in having funds available, and
that cost is reflected in the unused limit charge. The unused limit fee will be much less than the
actual overdraft interest rate.
Other than the overdraft limit, the interest rate and other charges, there are usually no additional
formal requirements placed on overdraft borrowings. However, banks generally require overdraft
facilities to be operated on a fully fluctuating basis; that is, the borrower is expected to reduce or
bring the overdraft back into credit as and when future cash flows are received by the company. In
some countries, banks require that the overdraft borrower maintain a compensating credit balance,
or maintain, over a specified period, an agreed credit average balance. Where such additional
requirements are imposed, the effective cost of the overdraft must take into account interest that
may be forgone on the compensating credit balance, since such compensating and credit average
balances often attract a lower rate of interest than is available on other forms of deposit.
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The overdraft facility is a major source of short-term business finance. An overdraft facility
is especially suited to meeting a firms day-to-day working-capital requirements and the
monthly or seasonal mismatch between its cash inflows and cash outflows. A business
needs to pay expense commitments when they fall due. Often this may occur before the
business has received cash revenue flows associated with its business activities. For example,
a manufacturer will have fixed costs, such as salaries, equipment and administration, and
variable costs, such as stock and inventories, necessary in the manufacturing process.
Many of these costs will need to be paid before sales are generated. This is described as
a mismatch in the timing of the cash flows of a business.
An overdraft facility enables a
business to smooth out problems associated with cash-flow timing mismatches.
An overdraft facility is convenient in that it attaches directly to a firms current operating
account. A firms operating account is usually a cheque account with a bank. An overdraft
facility allows a firm to put its operating account into deficit up to an agreed overdraft
limit. The limit is negotiated with the bank and is subject to regular review. If the bank is
not satisfied with the financial performance of the firm the overdraft may be repayable on
demand.
The interest rate payable on an overdraft is negotiated between the bank and the firm,
and will normally be at a margin above a periodically published indicator interest rate.
The margin charged above the indicator interest rate will relate directly to the banks
determination of the credit risk of the borrower. For example, a large company that has an
established credit history with a bank will usually be charged a lower margin than a new
client that does not have an established relationship with the bank. The particular indicator
rate used by a bank will be specified in the overdraft agreement. The indicator rate may be
the banks own prime rate or it may be a published market rate.
Each country tends to have its own published reference rates. For example in the
United Kingdom it may be LIBOR, in the United States it may be USCP or in Australia it
may be BBSW. These indicator rates are published daily by Reuters, a major provider of
information to the financial markets.
The agreed interest charge is calculated on the daily debit balance outstanding on the
overdraft. Deposits into the operating account reduce the overdraft, and thus reduce the
daily interest charge. Deposits to reduce the outstanding debit balance, or overdraft, can
be made at any time; that is, an overdraft facility does not require a regular repayment
schedule.
Generally, in addition to the interest rate that will be charged on the balance outstanding,
the lender will impose an establishment fee, a monthly account service charge and a fee on
the unused overdraft limit. The latter fee compensates the lender for effectively committing
funds for the borrowers use, at a time determined by the borrower. That is, once the
overdraft limit has been established, the firm can use that facility at any time without
notice, up to the limit. The bank in effect has to maintain a contingency fund to meet the
demands of the borrower should the borrower decide to go into overdraft up to the agreed
limit. There is a cost to the bank in having those funds available, and that cost is reflected
in the unused-limit fee. The unused-limit fee will be much less than the actual overdraft
interest rate.
A characteristic of an overdraft facility is that banks generally require an overdraft to be
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operated on a fully fluctuating basis; that is, the borrower is expected to reduce or bring
the overdraft back into credit as and when future cash flows are received by the company.
Question 4: Mills Enterprises Limited is seeking to raise funds by issuing a bill of exchange. The
company has been advised to have the bill accepted by a bank. Why should the company obtain
bank acceptance for the bill?
A: The the acceptor will provide the funding by purchasing the bill.
B*: Bank bank acceptance improves the bills credit status and lowers the yield.
C: The the acceptor undertakes to repay the holder of the bill at maturity if the drawer defaults.
D: Banks banks do not charge a fee to accept bills for established customers.
Feedback: A bill of an exchange must have an acceptor and the yield on the bill depends on the
credit status of the acceptor. Since the credit ratings of banks are generally very high, bank bills
trade at lower yields in comparison to non-bank bills.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.34.1, p. 36307.
The acceptor is the party to whom the bill is addressed and who undertakes to pay the face value
of the bill to the person presenting the bill at the maturity date. That is, a bank as an acceptor
places its name on the face of the bill and thereby takes primary liability to repay the face value
of the bill to the holder at maturity date. A bank usually carries out the role of acceptor on a bill.
In Figure 9.2, ABC Bank Ltd is the acceptor. A bank will carry out this role on a fee-for-service
basis; that is, the bank generates income by acting as an acceptor. The drawer of the bill will be
comfortable with paying the fee and adding the bank as an acceptor, as this gives the bill added
credit status and makes it easier to sell or discount the bill in the money markets.
The acceptor is the party to whom the bill is addressed and who undertakes to pay
the face value of the bill to the person presenting the bill at the maturity date. That
is, a bank as an acceptor places its name on the face of the bill and thereby takes
primary liability to repay the face value of the bill to the holder at maturity date. A
bank usually carries out the role of acceptor on a bill. In Figure 9.2, ABC Bank Ltd is
the acceptor. A bank will carry out this role on a fee-for-service basis; that is, the bank
generates income by acting as an acceptor. The drawer of the bill is willing to pay the
fee and add the bank as an acceptor, as this gives the bill a higher credit status; that is,
it is regarded as being less risky. This makes it easier to sell, or discount, the bill in the
money markets.
Question 5: A bank is often involved in the issuance of a bill of exchange, as acceptor of the bill. In
addition, banks can have other involvements in the bills market A provider of trade credit incurs an
opportunity cost. Which of the following statements are correct changes does not increase that
opportunity cost?
A: Ooffering a larger discount for early paymentBanks earn fee income by accepting bills.
B*: Rreducing the length of the discount periodBanks can lend money by acting as the discounter of
bills drawn by customers.
C: Eextending the discount periodBanks can make a profit by purchasing a non-bank bill and then
selling it a short time later.
D*: Eextending the total credit periodAll of the above.
Feedback: The opportunity cost of providing trade credit may be calculated using Equation 9.1. If
the length of the discount period is reduced while all other terms remain the same, then the number
of days difference between early and late settlement will increase. Equation 9.1 shows that this
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change will reduce the opportunity cost, so B is the correct answer.It should be clear that A and B
are true. If a bank purchases a non-bank bill and then sells it again, the bank will have to endorse
the bill. Bank endorsement improves a bills credit status and lowers its yield, which means that the
price of the bill must increase (giving the bank a profit), so C is also true making, D the correct
answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.14.2, pp. 3580935910.
From the perspective of the provider of the trade credit, there is clearly also an
opportunity cost to be considered. It must consider the cost of the discount offered for
prompt payment relative to the provision of a longer, zero discount, payment period. The
calculation of the opportunity cost is complicated by the fact that the terms of trade credit
are a marketing tool for a business. More generous terms may increase demand for its
products; less generous terms may result in a loss of market share to competitors.
The calculation of the opportunity cost is further complicated in that a supplier that
offers generous trade credit terms may experience an increase in accounts receivable and
bad debts. For example, a relaxation of trade credit standards may attract more customers,
but it may also increase the likelihood of bad debts in that some less creditworthy
purchasers may not pay. Similarly, extensions of the discount period and/or the total credit
period are likely to be accompanied by increased accounts receivable and increased risk of
bad debts. From the providers point of view, the advantages of increased sales volumes that
may be generated from the provision of attractive trade credit conditions must be weighed
against the potential costs associated with:
the increased discount and/or the increased length of the discount period
the increased total credit period and the increase in accounts receivable
the increased risk of bad debts and associated recovery costs.
the increased discount and/or the increased length of the discount period
the increased total credit period and the increase in accounts receivable
the increased risk of bad debts and associated recovery costs.
Another method of funding through commercial bills is through the bill endorsement facility
offered by banks. Under this arrangement the bill is drawn by the borrower, accepted by another
party other than a bank, and is subsequently endorsed by a bank without any commitment by the
bank to discount the bill. The banks endorsement may be on behalf of the drawer, or the acceptor,
or even (where the bill has been rediscounted) on behalf of the most recent endorser. The addition
of the banks endorsement raises the credit standing of the bill and reduces its risk, and therefore the
bill can be traded at less of a discount from its face value. A banks endorsement, however, has a
smaller effect on the credit status of the bill than acceptance by a bank; as a result, bank-endorsed
bills tend to trade at a slightly deeper discount than bank-accepted bills.
Question 6: Finance through a bill facility has advantages over other forms of short-term debt
including flexibility for the borrower. Which of the following is not an advantage of bill finance?
A: The the cost of bill finance is generally lower than the cost of an overdraft.
B: Bill bill finance has a known cost that is fixed for the life of a bill.
C*: Bills bills can be used to borrow small amounts such as $50 000.
D: A a bill facility can provide longer-term funding by rolling over the bills as they mature .
Feedback: The statements in A, B and D are true but the minimum face value of a bill is $100 000,
so C is not true.
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MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.34.34, pp. 366 and
Section 9.3.4, p. 367.11.
The bank will then advise the firm whether or not it will, for a
fee, act as acceptor to bills issued by the firm as drawer. If the facility is to be offered, bills
will normally be drawn with a maturity ranging from 30 days to 180 days. A bill usually
has a minimum face value of $100 000.
9.3.4 Advantages of commercial bill financing
A major advantage of bill financing over other forms of short-term debt is that the cost is
generally lower than the cost of alternative forms of business finance such as overdrafts and
term loans. The primary reason for the lower cost of borrowing with bill financing is that a
bank does not have to fund the bill on its balance sheet. For example, a bank can accept a
bill for a customer and generate income from the fee. At the same time it may discount the
bill and provide the debt funds to its customer. However, the bank does not need to retain
the bill on its balance sheet. Typically, the bank will sell the bill into the money markets.
The bank will make a margin on the sale of the bill and can then use the funds to issue
further loan facilities.
Not only does the bill facility potentially provide cheaper finance, it also provides
a certain known cost of funds for the life of the bill. Once the bill has been drawn and
discounted, the borrower has the use of the funds and has agreed on the yield, being the
difference between the face value due at maturity and the discounted amount received
at the issue date. The borrower is not affected by any subsequent movements in current
interest rates throughout the term of the bill.
Bills also offer considerable funding flexibility for the borrower. Once a firm has
established a bill line with a bank, it can draw on that approved facility as required. A
bill line is an arrangement with a bank whereby the bank agrees to discount bills up to
an agreed amount. The bills are usually issued progressively over time. If the line is fully
utilised, the firm can roll over the current bills outstanding at their maturity. In effect, a
short-term funding instrument can be rolled over through successive periods and is thus
converted into a longer-term funding arrangement. At each rollover date the new bill issue
will be priced, or discounted, at the current market yield at that time. This rollover feature
of the bill market makes bill financing particularly attractive to both borrowers and banks.
9.4.4 Advantages of commercial bill financing
A major advantage of bill financing over other forms of short-term debt is that its cost is generally
lower than the cost of alternative forms of business finance such as overdrafts, term loans or fullydrawn advances. The primary reason for the lower cost of borrowing with bill financing is that a
bank does not have to fund the bill on its balance sheet. For example, a bank can accept a bill for a
customer and generate income from the fee. At the same time it may discount the bill and provide
the debt funds to its customer. However, the bank does not need to retain the bill (which can be
easily sold in the money market) on its balance sheet. The bank will make a margin on the sale of
the bill, and can then use the funds to issue further loan facilities. Clearly there are cost savings
available to the bank in not having to hold the bill on its balance sheet as a fully-funded asset. These
savings can, in part, be passed on to the bill issuer.
Not only does the bill facility provide cheaper finance, it also provides a certain known cost of
funds for the life of the bill. Once the bill has been drawn and discounted, the borrower has the use
of the funds and has agreed on the yield, being the difference between the face value due at the
maturity and the discounted amount received at the issue date. The borrower is not affected by any
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subsequent movements in current interest rates that may affect the market price of the bill
throughout the term of the bill.
Bills also offer considerable funding flexibility for the borrower. Once a firm has established a bill
line with a bank, it can draw on that approved facility as required. If the line is fully utilised, the
firm can roll over the current bills outstanding at their maturation. In effect, a short-term funding
instrument can be rolled over through successive periods and is thus converted into a longer-term
funding arrangement. At each rollover date the new bill issue will be priced, or discounted, at the
current market rate at that time. This rollover feature of the bill market makes bill financing
particularly attractive to both borrowers and banks. Though the rate is fixed throughout the term of
the bill, it can be adjusted at each rollover, and shorter terms allow more frequent rate adjustments.
A borrower who wishes to add certainty to the cost of funds at the future rollover dates can achieve
this through the use of derivative interest rate risk management products such as forward rate
agreements, bank bill futures contracts, options or swaps (discussed in Part 6).
Question 7: Bills are discount securities that provide a single cash flow that is equal to the face
value at maturity. A company issues a $500 000, 90-day bill with a yield of 7.36% per cent pa per
annum. What amount would the company raise?
A: $490 966.22
B: $491 078.77
C: $490 926.03
D*: $491 087.77
Feedback: The amount raised is the present value of the future cash flow of $500 000 and using
Equation (9.21) the present value is equal to $500 000 365/(365 + 0.0736 90) = $491 087.77.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.1 (including Equation
[9.1]), p. 36912.
9.4.1 Calculating the price where the yield is known
Bills are issued and sold at a price that represents a discount from the face value of the bill.
One formula used to calculate the price of a bill, where the yield on the bill is known, is:
9.5.1 Calculating the price where the yield is known
From the discussion above it should be clear that bills are issued and sold at a price that represents a
discount from the face value of the bill. One formula used to calculate the price of a bill, where the
yield on the bill is known, is:
Refer to equation above Equation (9.21)
Alternatively, the formula can be written as:
Refer to Equation (9.1).
Question 8: Financial Enterprises Limited issued a 90-day bill with a face value of $500 000. The
bill was discounted at 7.68% per cent pa per annum giving an issue price of $490 707.48. After 30
days, the discounter sold the bill for $493 630.14. What is the yield to the original discounter?
A: 7.68% per cent
B*: 7.25% per cent
C: 7.85% per cent
D: 7.52% per cent
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Feedback: The yield may be calculated using Equation (9.53) and is equal to [(493 630.14 490
707.48)/490 707.48] (36 500/30) = 7.25% per cent.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.3 (including Equation
[9.53]), p. 37114.
9.4.3 Calculating the yield
The yield referred to in the formula refers to the rate of interest, expressed as per cent
per annum, on the amount outlaid to purchase the discount security. The formula for
calculating the yield is given in Equation 9.5:
9.5.3 Calculating the yield
The yield referred to in the formula above refers to the rate of interest, expressed as % pa, on the
amount outlaid to purchase the bill or any other discount security. The formula for calculating the
yield is given in Equation (9.3). At the maturity date of a discount security the sell price equals the
face value:
Refer to Equation (9.53).
Note that (1) at the maturity date of a discount security, the sell price equals the face
value; and (2) to calculate the holding period yield when a security is not held to maturity,
use days held in Equation 9.5.
Example 6
An investor is planning to purchase a 180-day bill with a face value of $100 000. The
price of the bill is currently $92 000. The investor needs to determine the yield on the
investment:
Refer to calculations in Example 6.
Example 7
In Example 3, a company issued a 30-day bank-accepted bill with a face value of $500 000. The bill
was discounted at a yield of 9.48% pa, representing a price of $496 134.23. After seven days the
discounter sells the bill in the short-term money market for $497 057.36. Assume the bill is not
traded again in the market, calculate the yield to the original discounter and to the holder at
maturity.
Yield to original discounter:
Refer to the first equation in Example 7.
Yield to holder at maturity:
Refer to the second equation in Example 7.
Question 9: Financial Enterprises Limited issued a 90-day bill with a face value of $500 000. The
bill was discounted at 7.68% pa giving an issue price of $490 707.48. After 30 days the discounter
sold the bill for $493 630.14. The bill was not traded again in the market. What is the yield to
maturity for the second discounter Which of the following is not correct?
A*: Tthe drawer of a bank-accepted bill has no obligation to pay the holder of the bill at
maturity.7.58%
B: Tthe acceptor of a bill has the primary liability to pay the holder at maturity.7.68%
C*: Bbanks generate income by accepting bills.7.85%
D: Aat maturity, the drawer of a bill has a secondary liability after the acceptor.7.25%
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Feedback: The primary responsibility for paying the face value of a bill at maturity rests with the
acceptor of the bill. If, for some reason, the acceptor fails to pay then the drawer is liable to make
the payment so A is the correct answer.The yield may be calculated using Equation (9.3) and is
equal to [(500 000 493 630.14)/493 630.14] (36 500/60) = 7.85%.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.35.13, p. 36314.
In order to clarify the structure of a bank-accepted bill, the roles of these parties are defined as
follows:
The drawer is the party that issues the bill. In Figure 9.2 this is Borrowing Corporation Ltd.
With a bank-accepted bill the drawer has a liability to repay the face value to the acceptor bank.
The acceptor bank will pay the face value of the bill to the holder. If, however, the bill was
dishonoured by the acceptor at maturity, the drawer would then be responsible for the
compensation of the holder of the bill; that is, the drawer has a secondary liability, after the
acceptor.
The acceptor is the party to whom the bill is addressed and who undertakes to pay the face
value of the bill to the person presenting the bill at the maturity date. That is, a bank as an
acceptor places its name on the face of the bill and thereby takes primary liability to repay the
face value of the bill to the holder at maturity date. A bank usually carries out the role of
acceptor on a bill. In Figure 9.2, ABC Bank Ltd is the acceptor. A bank will carry out this role
on a fee-for-service basis; that is, the bank generates income by acting as an acceptor. The
drawer of the bill is willing to pay the fee and add the bank as an acceptor, as this gives the bill
a higher credit status; that is, it is regarded as being less risky. This makes it easier to sell, or
discount, the bill in the money markets.
The drawer is the party that issues the bill. In Figure 9.2 this is Borrowing
Corporation Ltd. With a bank-accepted bill the drawer has a liability to repay the face
value to the acceptor bank. The acceptor bank will pay the face value of the bill to the
holder. If, however, the bill was dishonoured by the acceptor at maturity, the drawer
would then be responsible for the compensation of the holder of the bill; that is, the
drawer has a secondary liability, after the acceptor.
The acceptor is the party to whom the bill is addressed and who undertakes to pay
the face value of the bill to the person presenting the bill at the maturity date. That
is, a bank as an acceptor places its name on the face of the bill and thereby takes
primary liability to repay the face value of the bill to the holder at maturity date. A
bank usually carries out the role of acceptor on a bill. In Figure 9.2, ABC Bank Ltd is
the acceptor. A bank will carry out this role on a fee-for-service basis; that is, the bank
generates income by acting as an acceptor. The drawer of the bill is willing to pay the
fee and add the bank as an acceptor, as this gives the bill a higher credit status; that is,
it is regarded as being less risky. This makes it easier to sell, or discount, the bill in the
money markets.
Example 7
In Example 3, a company issued a 30-day bank-accepted bill with a face value of $500 000. The bill
was discounted at a yield of 9.48% pa, representing a price of $496 134.23. After seven days the
discounter sells the bill in the short-term money market for $497 057.36. Assume the bill is not
traded again in the market, calculate the yield to the original discounter and to the holder at
maturity.
Yield to original discounter:
Refer to the first equation in Example 7.
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Yield to holder at maturity:
Refer to the second equation in Example 7.
Question 10: Bill pricing calculations may be carried using the yield on the bill or the bills discount
rate. Which of the following statements is correct?
A: If if calculated correctly, the yield and the discount rate will be the same.
B: The the discount rate for a bill will always be greater than its yield.
C: The the discount rate may be greater or less than the yield, depending on the bills term to
maturity.
D*: The the discount rate for a bill will always be less than its yield.
Feedback: The yield and discount rate applicable to a bill will not be the same. The yield is a
measure of the rate of return on a bill as a percentage of the bills market value. The discount rate is
expressed as a percentage of the bills face value. Since the market value of a bill is always less than
its face value, the yield will be numerically larger than the discount rate, and D is correct.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.5, pp. 37215316.
The discount rate is expressed in terms of the face value of the security, while the yield is expressed
in terms of the purchase price, or current price. The securities are identical, yet the discount rate and
yield differ. This was illustrated above. Examples 6 and 9 considered two identical bills, each with a
$100 000 face value, 180 days to maturity and a current price of $92 000. From Example 6, the bill
had a yield of 17.63% pa. In Example 9 the same bill had a discount rate of 16.22%. It is therefore
important to be certain of the information to be analysed or evaluated.
The discount rate is expressed in terms of the face value of the security, while the yield
is expressed in terms of the purchase price, or current price. The securities are identical,
yet the discount rate and yield differ. It is therefore important to be certain about which
calculation is being used.
Question 11: The finance manager of a company recommends to the managing director that the
companys immediate funding needs could be met by issuing a 180-day bill with a face value of $1
million. The finance manager has obtained quotes from two banks at yields of 6.85% pa and 7.10%
pa. The managing director wishes to know the amount of funds the company will raise, based on the
best quote.
Commercial bills may be classified as bank bills or non-bank bills. Which of the following is
correct?
A: Tthe classification depends on whether the drawer of the bill is a bank or a non-bank.$966
170.79
B*: Tthe classification depends only on whether the acceptor of the bill is a bank or a non-bank.
$967 323.03
C*: Aa bill that is accepted or endorsed by a bank is a bank bill.$965 717.04
D: Aa bill accepted by a commercial bank or a merchant bank is a bank bill.$966 884.22
Feedback: The statements in A, B and D all contain errors. A bill that is either accepted by or
endorsed by a commercial bank is regarded as a bank bill so C is correct.The lower yield should be
preferred, as it will result in a larger sum being raised. Using Equation (9.1) the present value of the
bill is equal to
$1 000 000 365/(365 + 0.0685 180) = $967 323.03
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MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.35.21 (including
Equation [9.1]), p. 36612.
The term bank in the above discussion refers to a commercial bank. Merchant and
investment banks also provide acceptance, endorsement and discount facilities. The
market refers to bills accepted or endorsed by APRA-authorised banks as bank bills, and
bills accepted or endorsed by other institutions, such as merchant or investment banks, as
non-bank bills.
9.5.1 Calculating the price where the yield is known
From the discussion above it should be clear that bills are issued and sold at a price that represents a
discount from the face value of the bill. One formula used to calculate the price of a bill, where the
yield on the bill is known, is:
Refer to equation above Equation (9.1)
Alternatively, the formula can be written as:
Refer to Equation (9.1).
Question 12: Transnational Corporation is to offer the next tranche of a 90-day promissory note
issue to investors at a yield of 6.95% per cent pa per annum. Each note has a face value of $100
000. What is the price of each promissory note to the investors?
A: $98 835.17
B*: $98 315.17
C: $100 000
D: $101 713.70
Feedback: Using Equation (9.21) the present value of each note is equal to $100 000 365/(365 +
0.0695 90) = $98 315.17.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.1 (including Equation
[9.21]), p. 36912.
9.4.1 Calculating the price where the yield is known
Bills are issued and sold at a price that represents a discount from the face value of the bill.
One formula used to calculate the price of a bill, where the yield on the bill is known, is:
9.5.1 Calculating the price where the yield is known
From the discussion above it should be clear that bills are issued and sold at a price that represents a
discount from the face value of the bill. One formula used to calculate the price of a bill, where the
yield on the bill is known, is:
Refer to equation above Equation (9.21)
Alternatively, the formula can be written as:
Refer to Equation (9.1).
Question 13: A 180-day bill with a face value of $500 000 is issued at a yield of 8.25% pa. Exactly
30 days later, the bill is sold at a discount rate of 7.95% pa. Which of the followingat is the price of
the bill correct?
A: aA commercial bill usually has a face value of at least $1 000 000.$484 181.20
B*: Aa borrower that wishes to eastablish a bank-accepted bill facility must have a rating provided
by an external credit rating agency.$483 664.38
C: Bbills normally have a term to maturity of at least 180 days.$483 603.84
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D*: Bbanks provide rollover facilities which allow the term of a bill financing arrangement to
exceed the term of an individual bill.$483 446.38
Feedback: The statements in A, B and C all contain errors but as stated in D, banks do provide
facilities where they agree to accept or discount additional bills once existing bills reach maturity. At
the date of the sale the bill has 150 days to maturity. Using Equation (9.1) the present value of the
bill is equal to $500 000 365/(365 + 0.0795 150) = $483 664.38.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.35.31 (including
Equation [9.1]), p. 36612.
The starting point in establishing a bank-accepted bill facility would be for a business to
approach a bank and outline its financing requirements. The bank will use its own credit
risk assessment procedures to assess the projected cash flows and general credit standing
of the business. It may also use information obtained from external credit rating agencies
such as Standard & Poors. The bank will then advise the firm whether or not it will, for a
fee, act as acceptor to bills issued by the firm as drawer. If the facility is to be offered, bills
will normally be drawn with a maturity ranging from 30 days to 180 days. A bill usually
has a minimum face value of $100 000. A bank will also indicate whether it is willing to
discount the bill and the yield at which it will discount the bill. A bank therefore provides
both a bill acceptance facility and a bill discount facility.
The issue of a commercial bill represents short-term finance, with a typical maximum
term to maturity of 180 days. In reality a business may require funding for a longer period
of time. By establishing a rollover facility with a bank, a business is able to extend the
overall term of a bill financing arrangement. A rollover facility is an arrangement whereby
a bank agrees to accept and discount new commercial bills for an issuer at each maturity
date.
9.5.1 Calculating the price where the yield is known
From the discussion above it should be clear that bills are issued and sold at a price that represents a
discount from the face value of the bill. One formula used to calculate the price of a bill, where the
yield on the bill is known, is:
Refer to equation above Equation (9.1)
Alternatively, the formula can be written as:
Refer to Equation (9.1).
Question 14: Promissory notes and bills of exchange have many similarities, but they also have
some important differences. Which of the following statements is not correct?
A: Both both bills and notes are discount securities.
B: There there is an active secondary market in both bills and notes.
C*: Both both bills and notes require an acceptor.
D: Promissory promissory notes are commonly known as one name paper.
Feedback: Both bills and notes are discount securities with active secondary markets. While bills
require an acceptor, this is not the case with notes. The issuer of a note is solely responsible for
paying the face value at maturity, which explains why notes are often referred to as one name
paper.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.56, p. 37316.
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This definition indicates that a P-note is similar to a bill of exchange, except that there is no
acceptor involved. P-notes are often described as one-name paper. Another difference between a Pnote and a bill is that, when a P-note is sold in the market, unlike the bill, there is no requirement
that the seller endorse the note. This gives P-notes a decided advantage over bills, since any owner
of the note can sell it into the money market without incurring a future contingent liability (which is
the case with a bill). This feature of P-notes makes participation in P-note transactions more
attractive to both corporations and financial intermediaries, because once the P-note is sold, it is
completely off the books.
This definition indicates that a P-note is similar to a bill of exchange, except that there is no
acceptor involved. P-notes are often described as one-name paper. Another difference between a Pnote and a
bill is that, when a P-note is sold in the market, unlike the bill there is no requirement for
the seller to endorse the note. This gives P-notes a decided advantage over bills, since any
owner of a P-note can sell it into the money market without incurring a future contingent
liability (which is the case with a bill). This feature of P-notes makes participation in P-note
transactions more attractive to both corporations and financial intermediaries, because
once the P-note is sold it is completely off the books.
Question 15: The yield on a bill will depend on the credit rating of the parties that incur a liability
under a bill. Which of the following statements is correct?
A*: Bankbank-accepted bills trade at a lower yield than non-bank bills.
B: The the yield on a bill will depend mainly on the credit rating of the drawer.
C: Bankbank-accepted bills trade at a higher yield than non-bank bills.
D: The the yield on a bill is unrelated to the credit standing of the acceptor.
Feedback: The acceptor of a bill is primarily responsible for payment of its face value at maturity
so the risk of, and yield on, a bill depends on the credit rating of the acceptor. Since banks generally
have higher credit ratings than other acceptors, bank bills trade at lower yields than non-bank bills.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.34.3, pp. 36610311.
In addition to those factors that determine the general level of interest rates in the
economy, the yield at which a particular bill is discounted will depend on the credit rating
of the parties that incur a liability under the bill. Bank-accepted bills incorporate the higher
credit standing of the bank acceptor and are able to discount a bill at a smaller discount
than a drawer with a lower credit rating. This is to be expected, since there is a lower risk
associated with a bill that has a bank as one of the parties responsible for honouring the
bill at maturity.
In addition to those factors that determine the general level of interest rates in the economy, the rate
at which the particular bill trades will depend on the credit rating of the parties that incur a liability
under the bill. High-quality borrowers are able to discount a bill at a smaller discount than can less
known, or poorer credit risk, borrowers. Therefore, bank-accepted bills trade at a smaller discount
than that applying to non-bank bills. This is to be expected since there is a lower risk associated
with a bill that has a bank as one of the parties responsible for honouring the bill at maturity.
Question 16: The cost of bill finance is greater than the yield on a bill because bill facilities are
subject to a range of fees. Which of the following is not correcttypes of fees usually apply?
A: Aa bill of exchange is a negotiable instrument supported by a legal structure.Establishment fee
B: Bbills of exchange may be categorised as trade bills and commercial bills.activation fee
C: Bbills of exchange may be categorised as bank-accepted, bank-endorsed or non-bank.facility fee
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D*: Aa bank-endorsed bill carries the name of the endorsing bank from the time the bill is issuedall
of the above.
Feedback: Banks that provide bill facilities usually charge all of the fees listed, A, B and C are all
true. A bill is endorsed by the seller when it is sold, not when the bill is issued, so the statement in
D is not true, making it the correct answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.34.3, pp. 3611-362.
The first of these securities is the bill of exchange. The bill of exchange market has
grown because the bill is a negotiable instrument that is supported by a legal structure.
In many countries, particularly those deriving from the English legal system, legislation
has been enacted establishing the legal nature and structure of a bill of exchange. In
countries without supporting legislation, a bill of exchange may take the form of a bankers
acceptance.
Bills of exchange may be categorised as trade bills and commercial bills. Trade bills are
issued in conjunction with specific international trade transactions. Commercial bills are
simply another form of borrowing and do not relate to a specific transaction or purpose;
that is, the borrower does not need to state the specific use of those funds. Commercial bills
may be further categorised into bank-accepted bills, bank-endorsed and bills non-bank
bills. A commercial bill issued by a corporation is said to be a bank-accepted bill when a
bank also puts its name on the face of the bill to increase the bills creditworthiness. A bankendorsed
bill is one where the bank, as a previous holder of the bill, has signed the reverse
of the bill when selling it in the money markets. (Note that most endorsement these days
is by way of an electronic record of the transaction.)
Bill facilities are subject to establishment fees. In addition, there usually is a facility fee, plus an
activation fee that operates when the bill facility is actually utilised. These fees will add to the
overall cost of the bill financing facility. The borrower must be careful when comparing the costs of
various offers available from the numerous institutions. This is not a matter of simply adding
together the apparent fees; if the fees are due at different times, all calculations must be in present
value terms. The concept of present value and its calculation was discussed in Chapter 8.
Question 17: Mega Bank issues negotiable certificates of deposit (CDs) with a maturity of 180 days
and a face value of $1 million. The notes are purchased by institutional investors at 20 basis points
above BBSW. At the time, BBSW was 6.95% per cent pa per annum. What is the price of the CDs?
A: $1 000 000
B*: $965 940.67
C: $966 861.81
D: $1 035 260.27
Feedback: With the margin of 20 basis points, the yield on the CDs will be 7.15% per cent pa per
annum. Certificates of deposits are a discount security, so the price can be found using Equation
(9.21) and is equal to ($1 000 000 365)/(365 + 0.0715 180) = $965 940.67.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.67, p. 37719.
Negotiable certificate of deposit
A negotiable certificate of deposit (CD) is a short-term discount security, issued by a bank, typically
with an initial term to maturity up to 180 days.
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A CD is an investment product offered by banks in the money markets to attract institutional
investors. Banks use the issue of CDs, in part, to manage their liabilities and liquidity. As part of
their liability management banks issue CDs to raise additional short-term funds to meet loan
commitments. Furthermore, as part of liquidity management, CDs may also be issued to raise cash
to meet a banks day-to-day operational liquidity requirements. Within the money markets there is
an active secondary market in CDs.
Pricing of CDs is also based on the discount securities formulae discussed in Section 9.5. The price,
yield, discount amount and face value calculations of a CD use the same formulae as for other
discount securities.
A negotiable certificate of deposit (CD) is a short-term discount security, issued by a bank,
typically with an initial term to maturity up to 180 days.
Pricing of CDs is also based on the discount securities formulae discussed in Section 9.4.
Therefore, the price, yield, discount amount and face value calculations of a CD use the
same formulae as for other discount securities.
Question 18: A fund manager is considering the purchase of a large tranche of promissory notes (Pnotes). WAdvise which of the following statements about promissory notes is not correct? in
relation to a promissory note issue.
A: Tthe majority of issuers have an investment grade credit ratingWhen a P-note is sold, the seller is
not required to endorse the note.
B: Aan issue often involves both a tender panel and an underwriting syndicateP-notes are issued at a
discount to face value based on current market yields.
C*: The acceptor takes primary responsibility to repay the face value of the P-notes are usually
issued on a large scale at maturity.
D*: Tthe costs associated with a P-note issues are usually unsecured financial instruments very low.
Feedback: The statements in A, B and CD are true but a promissory note does not have an acceptor
the issuer is the only party who is responsible for repaying the face value.issue involves several
parties: a manager, members of a tender panel and an underwriting panel. Therefore, the issue costs
are significant rather than very low as stated in D.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.5.26, pp. 375-37616.
The issuer may therefore wish to guarantee that all the P-notes will be sold and that the
required funds will be raised by arranging for the issue to be underwritten. This is usually
arranged through a commercial bank, an investment bank or a merchant bank, which will
arrange both an underwriting syndicate and a tender panel. The bank, as manager of the
issue, typically receives a management fee of about 0.02 per cent on the funds that the
underwriters commit.
Members of the underwriting syndicate will agree to purchase notes up to an agreed
limit and at a prearranged price, should they be called upon. Generally, the members of
the underwriting syndicate do not wish to purchase large amounts of the P-note issue
themselves, and therefore they will actively promote the issue to investors in the market.
The price agreed will reflect the credit standing of the borrower and the underwriting fee.
The underwriters fee is typically about 0.1 per cent per annum on the amount of their
commitment.
It is apparent that costs associated with a P-note issue can be significant, and therefore
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P-notes are typically issued only on a large scale.
Promissory notes (P-notes) are discount securities. A P-note is issued with a face value payable at
maturity, but is sold today by the issuer for less than the face value. The P-note is discounted at the
current market yield. This means that the issuer raises an amount of funds that is less than the face
value. The difference between the amount raised on issue and the face value payable at maturity is
the discount amount, and represents the cost of borrowing to the issuer.
This definition indicates that a P-note is similar to a bill of exchange, except that there is no
acceptor involved. P-notes are often described as one-name paper. Another difference between a Pnote and a bill is that, when a P-note is sold in the market, unlike the bill, there is no requirement
that the seller endorse the note. This gives P-notes a decided advantage over bills, since any owner
of the note can sell it into the money market without incurring a future contingent liability (which is
the case with a bill). This feature of P-notes makes participation in P-note transactions more
attractive to both corporations and financial intermediaries, because once the P-note is sold, it is
completely off the books.
Question 19: Inventory finance commonly adopts a system known as bailment. Which of the
following statements relating to bailment is correct?
A: Bailment bailment is a system that is often used in providing floor plan finance for motor
vehicles.
B: Assets assets are purchased from a distributor by a finance company (bailor).
C: A a bailor grants possession of assets to a bailee for display purposes.
D*: All all of the above.
Feedback: In general, inventory finance involves a bank or finance company (bailor) providing a
loan to finance the inventory of a dealer (bailee) in goods, such as motor vehicles, where the
inventory is used as security for the loan. Floor plan finance is a form of inventory finance that uses
a system known as bailment. In this case the financier owns the inventory and allows a retailer to
have possession of the goods to display them for sale. In summary, the statements in A, B and C are
true, making D the correct answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.79.1, pp. 377-37820.
The most common form of this type of financing is floor plan finance. It is designed
particularly to meet the needs of motor vehicle dealers to finance their inventories of
vehicles. The key feature of this arrangement, from the point of view of the financier, is that
it is part of a larger financial relationship between the dealer and the financier. It is expected
that the dealer, when selling the vehicles, will promote demand for the financiers consumer
finance services. That is, the dealer encourages buyers to borrow from the financier to
pay for the vehicle purchase. Indeed, the primary initial business of many general finance
companies was the provision of floor plan financing. As they acquired a market presence
through their financing of vehicle purchases, the finance companies expanded into more
general personal financing. The more successfully the dealer promotes the financier to the
end consumer, the lower will be the rate charged on the floor plan finance. Most frequently
the cost of floor plan finance is below the current market rates on other types of loans.
A system known as bailment is commonly used to secure the financiers commitment
of funds. Under this arrangement, the vehicles are purchased from the manufacturer or
distributor by the finance company (the bailor), and possession is granted to the dealer (the
bailee) for display purposes. The dealer then seeks to sell the vehicles by receiving offers
to purchase from retail customers; however, the dealer effectively has no right to sell the
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vehicles without the approval of the financier. The financier may choose to pass ownership
of the vehicle to the dealer who can then pass ownership to the customer.
As well as retaining ownership of the vehicles, financiers use other measures to ensure
that their interests are protected. These include:
establishing dollar limits on the dealers financial exposure
establishing limits on the ratio of new to used vehicles
prompt settlement once a sale has been effected
regular physical audit of stock that is subject to floor plan financing
inspection of the dealers financial position to ensure that sales are being made on a profitable
basis.
establishing dollar limits on the dealers financial exposure
establishing limits on the ratio of new to used vehicles
prompt settlement once a sale has been effected
regular physical audit of stock that is subject to floor plan financing
inspection of the dealers financial position to ensure that sales are being made on a
profitable basis.
The most common form of this type of financing is floor plan finance. It is designed particularly to
meet the needs of motor vehicle dealers to finance their inventories of vehicles. The key feature of
this arrangement, from the point of view of the financier, is that it is part of a larger financial
relationship between the dealer and the financier. It is expected that the dealer, when selling the
vehicles, will promote demand for the financiers consumer finance services. Indeed, the primary
initial business of many general finance companies was the provision of floor plan financing. As
they acquired a market presence through their financing of vehicle purchases, the finance
companies expanded into more general personal financing. The more successfully the dealer
promotes the financier to the end consumer, the lower will be the rate charged on the floor plan
finance. Most frequently the cost of floor plan finance is below the current market rates on other
types of loans.
A system known as bailment is commonly employed to secure the financiers commitment of funds.
Under this arrangement the vehicles are purchased from the manufacturer or distributor by the
finance company (the bailor), and possession is granted to the dealer (the bailee) for display
purposes. The dealer then seeks to sell the vehicles by receiving offers to purchase from retail
customers; however, the dealer effectively has no right to sell the vehicles without the approval of
the financier. The financier may choose to pass ownership of the vehicle to the dealer who can then
pass ownership to the customer.
As well as retaining ownership of the vehicles, financiers use other measures to ensure their
interests are protected. These include:
establishing dollar limits on the dealers financial exposure
establishing limits on the ratio of new to used vehicles
prompt settlement once a sale has been effected
regular physical audit of stock that is subject to floor plan financing
inspection of the dealers financial position to ensure that sales are being made on a profitable
basis.
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Question 20: Accounts receivable financing is the extension of a loan to a business against the
security of its receivables. Which of the following statements relating to accounts receivable
financing is not correct?
A: The the main suppliers of accounts receivable financing are finance companies.
B: Generallygenerally, only some of the receivables on a companys books will be acceptable as
security.
C*: The the lender will takeover the management of the borrowers receivables.
D: The the borrower remains liable for any bad debts.
Feedback: Accounts receivable financing is short-term finance, where accounts receivables serve as
security for the loan. The lender only provides finance and the borrower continues to issue invoices
and manage its receivables in the usual way, so the statement in C is incorrect.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.79.2, p. 37820.
Accounts receivable financing is the extension of a loan to a business against the security of the
businesss receivables; that is, its debtors. The main suppliers of this type of funding are finance
companies. Before granting finance to a firm on the basis (or security) of its accounts receivable,
the financier will review the structure of the debt held by the firm. Not all debtors on the books of
the borrowing company will be acceptable as security to the loan. Common exclusions are debts
that have been outstanding beyond a specified number of days, typically 90 days, and debts that for
other reasons may be suspected of being doubtful or bad debts. Under the facility the lending
company takes a registered charge over the firms accounts receivable. The borrower remains
responsible for managing its debtor book, and is solely liable for any future bad debts (customers
that do not pay their accounts outstanding).
Accounts receivable financing is the provision of a loan to a business against the security
of the businesss accounts receivables, that is, its debtors. The main suppliers of this type of
funding are finance companies. Before granting finance to a firm on the basis of its accounts
receivables, the financier will review the structure of the debt held by the firm. Not all
debtors on the books of the borrowing company will be acceptable. Common exclusions
are debts that have been outstanding beyond a specified number of days, typically 90 days,
and debts that for other reasons may be suspected of being doubtful or bad debts. Under the
facility, the lending company takes a registered charge over the firms accounts receivables.
The borrower remains responsible for managing its debtor book and is solely liable for any
future bad debts, that is, customers that do not pay their outstanding accounts.
Question 21: A funding arrangement that is adopted by some businesses is known as factoring.
Which of the following statements in relation to factoring is not correct?
A*: In in the case of a with-recourse facility, the factor has no claim against the vendor business .
B: The the factor is responsible for the collection of accounts receivables.
C: Most most factoring arrangements are established on a notification basis.
D: Factoring factoring allows the vendor business to substitute cash for receivables.
Feedback: Factoring involves a business obtaining cash by selling its accounts receivables. The
factoring company is responsible for collection of the receivables but if the factoring is withrecourse, the factor can claim against the selling firm in the event that some of the receivables
cannot be collected.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.79.2, p. 37921.
Characteristics of factoring finance include:
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Accounts receivable are purchased outright by the factoring company and therefore the funds
received by the firm are the proceeds from the sale of an asset.
The factoring arrangement is commonly of an ongoing nature; that is, as the firm accumulates
more accounts receivable, these are also sold to the factoring company.
The factoring company, having bought the accounts receivable, is responsible for the collection
of the outstanding receivables.
Accounts receivable are purchased outright by the factoring company and therefore
the funds received by the firm are the proceeds from the sale of an asset.
The factoring arrangement is commonly of an ongoing nature; that is, as the firm
accumulates more accounts receivable, these are also sold to the factoring company.
The factoring company, having bought the accounts receivable, is responsible for the
collection of the outstanding receivables.
The factoring agreement will specify which parties are liable for future bad debts, and
to what extent. For example, the factoring company may be liable for bad debts up to an
amount equivalent to, say, 7 per cent of the total amount. Thereafter, the firm is liable for
any bad debts. There are two types of factoring arrangements: with-recourse factoring and
non-recourse factoring. The with-recourse arrangement means that the factoring company
can make a claim against the firm in the event of an accounts receivable debt subsequently
not being recoverable. A non-recourse arrangement, as the name suggests, means that the
factor has no claim against the firm in the event of bad debts being incurred.
the factoring company, having bought the accounts receivables, is responsible for the collection
of the outstanding receivables. The factoring agreement will specify which parties are liable for
future bad debt, and to what extent. For example, the factoring company may be liable for bad
debts up to an amount equivalent to, say, seven % of the total funding arrangement. Thereafter,
the firm would be liable for any higher levels of bad debts.
There are two types of factoring arrangements: with-recourse factoring and non-recourse factoring.
The with-recourse arrangement means that the factoring company can make a claim against the firm
in the event of an accounts receivable debt subsequently not being recoverable. A non-recourse
arrangement, as the name suggests, means the factor has no claim against the firm in the event of
bad debts being incurred.
Irrespective of whether the agreement is with-recourse or non-recourse, most agreements are on a
notification basis. In this arrangement the factoring company notifies the firms customers that
payment is to be made directly to, and in favour of, the factoring company. This gives the factoring
company a greater degree of control in the management of the outstanding accounts receivable.
Some arrangements are on a non-notification basis, where payment is addressed not to the factor,
but to a post office box controlled by the factoring company. This arrangement affords the firm
some protection from any possible adverse perception that a customer may have in relation to the
firm selling the debt to another party (the factoring company).
Question 22: Accounts receivable financing and factoring are similar in that both involve the use of
accounts receivables to obtain funds, but there are differences between these financing techniques.
Which of the following are differences between accounts receivable financing and factoring?
Which of the following statements about commercial bills is not correct?
A: Accounts receivable financing involves borrowing; whereas, factoring involves the sale of assets
Tthe face value of a commercial bill is payable at a specified future date.
B: Aa commercial bill pays no interestFactoring is generally an ongoing arrangement while
accounts receivable finance is often for a short term.
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C: The factoring company becomes responsible for managing the debtors book and collecting
outstanding receivables Aa commercial bill is a discount security.
D*: Ccommercial bills are an important source of long-term finance for large and medium-sized
firmsAll of the above.
Feedback: The statements in A, B and C are all valid but bills provide short-term finance so D is
untrue, making it the correct answer.Factoring involves the sale of accounts receivables, as distinct
from borrowing against them, and it is generally carried out on an ongoing basis. Where a company
borrows against accounts receivables, the company remains responsible for collection and
management of the receivables; but, a factor, having bought the receivables, takes responsibility for
collection. In summary, A, B and C are all true, making D the correct answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.39.12, p. 36221.
A commercial bill is a discount security: a financial instrument that is issued into the debt
markets with a face value that is payable at a specified date in the future. The issuer sells
the bill today in order to raise funds. A commercial bill pays no interest; therefore the issuer
needs to sell the bill for less than its face value in order to attract a buyer. The face value
of the bill will be discounted by the current rate of return, or yield, payable in the market
on that type of security. Hence the term discount security. The return to the holder of the
bill at maturity is the difference between the discounted purchase price and the face value.
Commercial bills are an important form of short-term finance for large- and medium-sized
firms that are able to access the wholesale money markets.
Other differences between factoring and accounts receivable financing include:
the accounts receivable are purchased outright by the factoring company and therefore the funds
received by the firm are the proceeds from the sale of an asset, rather than a loan
the factoring arrangement is commonly of an ongoing nature; that is, as the firm accumulates
more accounts receivable these are also sold to the factoring company. Accounts receivable
finance is often for a short term only
the factoring company, having bought the accounts receivable, is responsible for the collection of
the outstanding receivables. The factoring agreement will specify which parties are liable for
future bad debt, and to what extent. For example, the factoring company may be liable for bad
debts up to an amount equivalent to, say, seven % of the total funding arrangement. Thereafter,
the firm would be liable for any higher levels of bad debts.
Question 23: A company needs to raise $1 million to fund an increase in purchases. The funds will
be raised by issuing a 180-day bill at a yield of 7.5% per cent pa per annum. What should be the
face value of the bill?
A: $1 000 000
B*: $1 036 986.30
C: $964 332.89
D: $963 013.70
Feedback: The face value must be greater than $1 million and can be found using Equation (9.42).
The calculation is face value = $1 000 000 [(365 + 0.075 180)/365] = $1 036 986.30.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.2 (including Equation
[9.42]), pp. 37013314.
In many instances a company needs to raise a specific amount of funds from a bill issue.
In this situation the price at which the bill will be sold is predetermined and, based on the
yield at which the bill will be discounted, it is necessary to calculate the face value of the
MaxMark t/a Financial Institutions, Instruments and Markets 5e by Viney
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bill, that is, the amount to be paid to the holder at maturity.
The formula is transposed to:
9.6.2 Calculating the face value where the issue price and yield are known
In many instances a company needs to raise a specific amount of funds from a bill issue. In this
situation the price at which the bill will be sold is predetermined, and, based on the yield at which
the bill will be discounted, it is necessary to calculate the face value of the bill, that is, the amount
to be paid to the holder at maturity.
The formula is transposed to:
Refer to Equation (9.42)
Example 4
A company needs to obtain additional funding of $500 000 to purchase inventory. The
company has decided to raise the funds through the issue of a 60-day bank-accepted
bill rollover facility. The bank has agreed to discount the bill at a yield of 8.75 per cent.
At what face value will the initial bill be drawn?
Example 4
A company needs to raise additional funding of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The
bank has agreed to discount the bill at a yield of 8.75%. At what face value will the initial bill be
drawn?
Refer to the equation in Example 4.
Question 24: A 90-day bill with a face value of $500 000 is issued at a yield of 9.85% per cent pa
per annum. Fifteen days later the bill is sold by the original discounter at a discount rate of 9.75%
per cent pa per annum. At what price does the original discounter sell the bill?
A: $488 144.12
B: $500 000
C*: $489 982.88
D: $489 167.93
Feedback: When the bill is sold it has 75 days to maturity. The price can be found using Equation
(9.64). The calculation is price = $500 000 [1 (75 0.0975/365)] = $489 982.88.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.4, pp. 371-37215.
9.4.4 Calculating the price where the discount rate is known
An alternative way of referring to a bill, and to any other discount security, is to identify it
in relation to its current discount from face value. This method is used in the US markets
and the euromarkets, but is not used in Australia. Where the discount rate is given, the
price of the bill is derived using the following formula:
9.5.4 Calculating the price where the discount rate is known
An alternative way of referring to a bill, and to any other discount security, is to identify it in
relation to its current discount from face value. Where the discount rate is given, the price of the bill
is derived using the following formula:
Refer to Equation (9.64).
Example 8
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The price of a 180-day bill, with a face value of $100 000, selling at a discount of
14.75 per cent, would be:
Example 8
The price of a 180-day bill, with a face value of $100 000, selling at a discount of 14.75%, would
be:
Refer to the equation in Example 8.
Question 25: Overdraft facilities provided by banks are an important source of finance. Which of
the following statements relating to overdrafts is not correct?
A: An overdraft applicant with longer-term funding needs will probably be redirected into a fully
drawn advance Tthe interest rate on an overdraft is usually equal to a published indicator rate plus a
margin.
B*: Banks have little concern for the ability of overdraft borrowers to service the loan, because the
bank ensures that assets are pledged as security Eeach country usually has its own indicator rates.
C*: The the interest charge on an overdraft is usually calculated by applying the agreed interest rate
to the balance at the end of each montheffective cost of overdraft finance is greater than the stated
interest rate.
D: AaThe fees on an overdraft facility does not have a regular repayment scheduleusually include
an unused limit fee.
Feedback: The statements in A, BC and D are all true. While a bank is likely to require that The
interest on an overdraft should be secured, it does not follow that the bank will have little concern
for the borrowers ability to service the loan from its operating cash flows. overdraft is calculated
daily, not monthly. In accordance, the statement in CB is not true, making it the correct answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.23, p. 36005.
The interest rate payable on an overdraft is negotiated between the bank and the firm,
and will normally be at a margin above a periodically published indicator interest rate.
The margin charged above the indicator interest rate will relate directly to the banks
determination of the credit risk of the borrower. For example, a large company that has an
established credit history with a bank will usually be charged a lower margin than a new
client that does not have an established relationship with the bank. The particular indicator
rate used by a bank will be specified in the overdraft agreement. The indicator rate may be
the banks own prime rate or it may be a published market rate.
Each country tends to have its own published reference rates. For example in the
United Kingdom it may be LIBOR, in the United States it may be USCP or in Australia it
may be BBSW. These indicator rates are published daily by Reuters, a major provider of
information to the financial markets.
The agreed interest charge is calculated on the daily debit balance outstanding on the
overdraft. Deposits into the operating account reduce the overdraft, and thus reduce the
daily interest charge. Deposits to reduce the outstanding debit balance, or overdraft, can
be made at any time; that is, an overdraft facility does not require a regular repayment
schedule.
Generally, in addition to the interest charge on the balance outstanding, the lender will impose an
establishment fee, a monthly account service charge, and a fee on the unused overdraft limit. The
latter fee compensates the lender for effectively committing funds for the borrowers use, at a time
determined by the borrower. That is, once the overdraft limit has been established, the firm can use
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that facility at any time without notice, up to the limit. The bank in effect has to maintain a
contingency fund to meet the demands of the borrower should the borrower decide to go into
overdraft to the extent of the agreed limit. There is a cost to the bank in having funds available, and
that cost is reflected in the unused limit charge. The unused limit fee will be much less than the
actual overdraft interest rate.
Other than the overdraft limit, the interest rate and other charges, there are usually no additional
formal requirements placed on overdraft borrowings. However, banks generally require overdraft
facilities to be operated on a fully fluctuating basis; that is, the borrower is expected to reduce or
bring the overdraft back into credit as and when future cash flows are received by the company. In
some countries, banks require that the overdraft borrower maintain a compensating credit balance,
or maintain, over a specified period, an agreed credit average balance. Where such additional
requirements are imposed, the effective cost of the overdraft must take into account interest that
may be forgone on the compensating credit balance, since such compensating and credit average
balances often attract a lower rate of interest than is available on other forms of deposit.
In establishing an overdraft facility, and in considering a request for an increased limit, the bank
will analyse the credit risk of the borrower. Its analysis will include consideration of at least the
following:
the financial performance and future cash flow forecasts of the company in order to assess its
ability to service the overdraft
the length of the typical mismatch between the companys cash inflows and outflows, and
the adequacy of the collateral, or security, available in the event of default by the borrower.
The bank will also consider whether an overdraft is the appropriate form of funding for the assets
being financed by the business: is it for working capital or for long-term capital expenditure? If it is
for the former, an overdraft may be appropriate. If it is for a longer-term purpose, the borrower may
be redirected into a fully-drawn advance or a term loan (Chapter 10).
Question 26: A 180-day bill with a face value of $500 000 was issued with a yield to maturity of
11.25% per cent pa per annum. Thirty days later, the market price of the bill is $478 000. What is
the current discount rate applicable to the bill?
A: 8.8% per cent
B: 11.25% per cent
C*: 10.71% per cent
D: 10.25% per cent
Feedback: When the face value and current price of a bill are known, the discount rate can be found
using Equation (9.75). In this case the discount rate is equal to [(500 000 478 000)/500 000] [36
500/150] = 10.71% per cent.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.45.5 (including Equation
[9.75]) p. 37215.
9.4.5 Calculating the discount rate
The formula for calculating the discount rate, when the face value and the current price
are known, is:
9.5.5 Calculating the discount rate
The formula for calculating the discount rate, when the face value and the current price are known,
is:
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Discount rate = (face value current price/face value) (days in year 100/days to maturity)
(Equation (9.7)5)
Example 9
A 180-day bill with a face value of $100 000 and selling currently at $92 000, with a full 180 days
to run to maturity, has a discount rate of:
Refer to the equation in Example 9.
Question 27: Corporations can raise funds by issuing discount securities known as promissory notes
or commercial paper. Which of the following statements about these securities is correct?
A: The the minimum face value of a promissory note is $1 million.
B: Promissory promissory notes are issued directly by the borrower and the only role of financial
institutions is to purchase the notes.
C: Any any borrower who could issue bank bills has the alternative of issuing promissory notes.
D*: The the face value of a promissory note is usually at least $100 000.
Feedback: The face value of a promissory note is usually $100 000 or more so A is incorrect and D
is correct. Answer B is incorrect because financial institutions are involved in arranging and
underwriting promissory note issues. Answer C is incorrect because P-notes will be accepted in the
market only if the issuer has a high credit rating. There are many small and lower rated borrowers
who can borrow through bank bills, but they could not issue P-notes.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.56, p. 373-37416.
Not all borrowers can use P-notes as a source of funds. Typically, only those corporations with an
excellent credit reputation in the markets are able to attract investors willing to discount (purchase)
P-notes. This is because:
the sole liability to repay the face value of a P-note at maturity is borne by the issuer. There is no
party that acts as an acceptor to the note, nor is there a series of contingent liabilities established
by endorsement
notes are typically issued as unsecured instruments in that they generally are not supported by
the attachment of any security, collateral, or balance sheet covenants of the issuer.
The face value of a P-note is normally a minimum of $100000; however, each P-note issue will
usually be in millions of dollars, with some international issues in excess of $1 billion. A P-note is a
short-term discount security issued by corporations with a term to maturity generally up to 180
days. A P-note issue will often be established with a rollover facility, which essentially converts a
short-term issue into a longer-term issue.
However, not all borrowers can use P-notes as a source of funds. Typically, only those
corporations with an excellent credit reputation in the markets are able to attract investors
willing to discount P-notes. There are two reasons for this:
The sole liability to repay the face value of a P-note at maturity is borne by the issuer. There is
no party that acts as an acceptor, nor is there a series of contingent liabilities established by
endorsement.
Notes are typically issued as unsecured instruments in that they generally are not supported by
the attachment of any security, collateral or balance-sheet covenants of the issuer. However,
having said that, it is possible to issue P-notes with security attached.
The sole liability to repay the face value of a P-note at maturity is borne by the issuer.
There is no party that acts as an acceptor, nor is there a series of contingent liabilities
established by endorsement.
Notes are typically issued as unsecured instruments in that they generally are not
MaxMark t/a Financial Institutions, Instruments and Markets 5e by Viney
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supported by the attachment of any security, collateral or balance-sheet covenants
of the issuer. However, having said that, it is possible to issue P-notes with security
attached.
The face value of a P-note is normally a minimum of $100 000; however, each P-note
issue will usually be in millions of dollars, with some international issues in excess of
$1 billion. A P-note is a short-term discount security issued by corporations with a term to
maturity generally up to 180 days. An issue will often be established with a rollover facility,
which essentially converts a short-term issue into a longer-term issue.
Question 28: An underwritten issue of promissory notes will involve several parties including a lead
manager, an underwriting syndicate, and a tender panel. Which of the following statements about
the roles of these parties is correct?
A: The the lead manager arranges the note issue and purchases any notes that are not taken up by
the tender panel.
B*: Members members of the tender panel have the first opportunity to buy the notes.
C: The the lead mangers role is essentially to ensure that all necessary documentation is correctly
prepared.
D: Members members of the underwriting syndicate will be chosen for their willingness to buy and
hold a large proportion of the issue.
Feedback: A is incorrect because it is the underwriters, not the lead manager, who purchase any
notes that are not taken up by the tender panelwho have the first opportunity to buy the notes.
The lead managers role goes well beyond attending to documentation, so C is incorrect. Answer D
is also incorrectmembers of the underwriting syndicate will be active in marketing the notes to
investors and will, generally, not be willing to hold a large proportion of the issue.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.57.2, pp. 3752637627.
9.5.2 Underwritten issues
It has already been mentioned that the majority of P-note issuers have an investment-grade
credit rating. In fact, this is the reason that many large corporations issue P-notes; they are
able to rely on their credit rating and do not need to incur the expense of an acceptor on
a bill facility.
However, at times, and for a number of reasons, investors may be reluctant to purchase
the debt securities issued by a company, and the issuer will be unable to raise the required
funds. A P-note issue may not be successful if:
the issuer does not have a strong name or reputation in the markets
the issue is incorrectly priced
other issuers in the market at the same time represent a more attractive investment opportunity
the credit rating of the issue is below investment grade, that is, less than the equivalent of the
S&P A-3 short-term credit rating
economic and financial market conditions change for the worse after the announcement of the
issue.
the issuer does not have a strong name or reputation in the markets
the issue is incorrectly priced
other issuers in the market at the same time represent a more attractive investment
opportunity
the credit rating of the issue is below investment grade, that is, less than the
equivalent of the S&P A-3 short-term credit rating
economic and financial market conditions change for the worse after the
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announcement of the issue.
The issuer may therefore wish to guarantee that all the P-notes will be sold and that the
required funds will be raised by arranging for the issue to be underwritten. This is usually
arranged through a commercial bank, an investment bank or a merchant bank, which will
arrange both an underwriting syndicate and a tender panel. The bank, as manager of the
issue, typically receives a management fee of about 0.02 per cent on the funds that the
underwriters commit.
Members of the underwriting syndicate will agree to purchase notes up to an agreed
limit and at a prearranged price, should they be called upon. Generally, the members of
the underwriting syndicate do not wish to purchase large amounts of the P-note issue
themselves, and therefore they will actively promote the issue to investors in the market.
The price agreed will reflect the credit standing of the borrower and the underwriting fee.
The underwriters fee is typically about 0.1 per cent per annum on the amount of their
commitment.
It is apparent that costs associated with a P-note issue can be significant, and therefore
P-notes are typically issued only on a large scale.
Another feature of an underwritten P-note issue is that the issuer will often require
the funding for a number of years. In this circumstance the issuer will establish a rollover
facility for the P-notes that may run up to three years. The underwriting commitment
virtually assures the borrower of a line of credit extending beyond the short-term life of
any particular P-note issue.
If the lead manager has arranged a tender panel, members of the panel are given the first
opportunity to buy the P-notes. They do not have any obligation to subscribe to the issue.
Once the tender panel has put in its bids for the notes, the borrower, in conjunction with
the manager, allocates the notes to the successful tenderers. Subject to the underwriting
agreement, the underwriters will purchase any outstanding notes.
9.7.2 Underwritten issues
For a number of reasons, investors may not purchase the debt instruments or securities issued by a
company, and the issuer will be unable to raise the funds it requires. A P-note issue may not be
successful if:
the issuer does not have a strong name, or reputation, in the markets
the issue is incorrectly priced
other issuers in the market at the same time represent a more attractive investment opportunity
the credit rating of the issue is below investment grade (less than a BBB rating)
economic and financial market conditions change for the worse after the announcement of the
issue.
The issuer may therefore wish to guarantee that all the P-notes will be sold and that the required
funds will be raised, by arranging for the issue to be underwritten. This is usually arranged through
a commercial bank, investment bank or merchant bank, which will act as an intermediary and in
most cases will arrange both an underwriting syndicate and a tender panel. The intermediary, as
manager of the issue, typically receives a management fee of about 0.02% on the funds that the
underwriters commit.
Members of the underwriting syndicate will agree to purchase notes, up to an agreed limit and at a
prearranged price, should they be called on. Generally the members of the underwriting syndicate
do not wish to purchase large amounts of the P-note issue themselves, and therefore they will
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actively promote the issue to investors in the market. The price agreed will reflect the credit
standing of the borrower and the underwriting fee. The underwriters fee is typically about 0.1% pa
on the amount of their commitment.
Another feature of an underwritten P-note issue is that the issuer will often require the funding for a
number of years. In this circumstance the issuer will establish a rollover facility for the P-notes that
may run up to three years. The underwriting commitment virtually assures the borrower of a line of
credit extending beyond the short-term life of any particular P-note issue.
If the lead manager has arranged a tender panel, members of the panel are given the first
opportunity to buy the P-notes. They do not have any obligation to subscribe to the issue. Once the
tender panel has put in its bids for the notes, the borrower, in conjunction with the manager,
allocates the notes to the tenderers. Subject to the underwriting agreement, the underwriters will
purchase outstanding notes.
Question 29: Large, highly rated, firms have access to funding from a wide range of sources.
However, small- to medium-size firms do not have access to the same sources. Which of the
following sets of sources (A, B, C or D) are usually available to smaller firms?
I.
II.
III.
IV.
V.
VI.
Bank bank overdraft
Commercial commercial paper
Trade trade credit
Investment investment bank cash advance
Factoringfactoring
Inventory inventory finance
A: I, II, III, V
B: I, III, IV, V
C: II, III, V, VI
D*: I, III, V, VI
Feedback: Commercial paper (promissory notes) can be issued only by large borrowers with very
high credit ratings. Only large firms usually use investment bank cash advance facilities. Smaller
firms may have access to bank overdrafts, trade credits, factoring and inventory finance, so D is the
correct answer.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.79, p. 37719.
The working capital requirements for large firms can be met partly through the financial
arrangements discussed above, but small- to medium-sized companies may be excluded from some
of these sources of funds. The main source of short-term funds for smaller firms is usually restricted
to trade credit or an overdraft facility. There are, however, two other types of funding that are
increasing in importance and, given international experience, can be expected to grow further.
These are:
inventory loans and finance, provided primarily by finance companies, and which are secured by
the borrowers inventory or stock
accounts receivable financing, and factoring.
The working-capital requirements for large firms can be met partly through the financial
arrangements discussed above, but small- to medium-sized companies may be excluded
from some of these sources of funds. The main source of short-term funds for smaller firms
is usually restricted to trade credit or an overdraft facility. There are, however, two other
types of funding that may be considered:
inventory finance
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accounts receivable financing and factoring.
Question 30: Large firms have access to funding from a wide range of sources. Which of the
following sets of sources (A, B, C or D) are usually available to large non-financial (that is,
industrial and mining) firms with credit ratings below investment grade?
I. .
II.
III.
IV.
V.
VI.
Bank bank overdraft
Commercial commercial paper
Bank bank bill facilities
Investment investment bank cash advance
Negotiable negotiable certificates of deposit
Inventory inventory finance
A: I, II, III, IV
B*: I, III, IV, VI
C: I, III, IV, V
D: III, IV, V, VI
Feedback: A large firm can issue commercial paper only if it has a high credit rating, so those with
a rating that is below investment grade would not be able to do so. Only banks issue negotiable
certificates of deposit.
MORE: Financial Institutions, Instruments and Markets 4/e5/e, Section 9.56, pp.37316; and
Section 9.67, p and. 37719.
Not all borrowers can use P-notes as a source of funds. Typically, only those corporations with an
excellent credit reputation in the markets are able to attract investors willing to discount (purchase)
P-notes. This is because:
the sole liability to repay the face value of a P-note at maturity is borne by the issuer. There is no
party that acts as an acceptor to the note, nor is there a series of contingent liabilities established
by endorsement
notes are typically issued as unsecured instruments in that they generally are not supported by
the attachment of any security, collateral, or balance sheet covenants of the issuer.
However, not all borrowers can use P-notes as a source of funds. Typically, only those
corporations with an excellent credit reputation in the markets are able to attract investors
willing to discount P-notes. There are two reasons for this:
The sole liability to repay the face value of a P-note at maturity is borne by the issuer.
There is no party that acts as an acceptor, nor is there a series of contingent liabilities
established by endorsement.
Notes are typically issued as unsecured instruments in that they generally are not
supported by the attachment of any security, collateral or balance-sheet covenants
of the issuer. However, having said that, it is possible to issue P-notes with security
attached.
Negotiable certificate of deposit
A negotiable certificate of deposit (CD) is a short-term discount security, issued by a bank, typically
with an initial term to maturity up to 180 days.
A CD is an investment product offered by banks in the money markets to attract institutional
investors. Banks use the issue of CDs, in part, to manage their liabilities and liquidity. As part of
their liability management banks issue CDs to raise additional short-term funds to meet loan
commitments. Furthermore, as part of liquidity management, CDs may also be issued to raise cash
MaxMark t/a Financial Institutions, Instruments and Markets 5e by Viney
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to meet a banks day-to-day operational liquidity requirements. Within the money markets there is
an active secondary market in CDs.
Pricing of CDs is also based on the discount securities formulae discussed in Section 9.5. The price,
yield, discount amount and face value calculations of a CD use the same formulae as for other
discount securities. A negotiable certificate of deposit (CD) is a short-term discount security,
issued by a bank,
typically with an initial term to maturity up to 180 days.
A CD is an investment product offered by banks in the money markets to attract
institutional investors. Banks use the issue of CDs, in part, to manage their liabilities and
liquidity.
MaxMark t/a Financial Institutions, Instruments and Markets 5e by Viney
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