Unformatted text preview: FINC 202 2009 Lecture 23
Shortterm Finance 1 Problem 1
Gopher Ltd Erratum to Lecture 22: The discount should have been 1% as for the rest of the questions (a) What if the terms were 1/10, net 30, but Gopher believes it can get away with not paying till the end of day 45?
2 Solution 1 (c) In this case the opportunity cost of foregoing the discount is tiny! • So take the 10 days of free credit and the ensuing 35 days of cheap credit And ignore the discount enticement 0.01 360 ICGOPHER = 1 − 0.01 45 − 10 = 10.39% Superior to early payment financed by overdraft by 10.39 − 21 = −50.53% 21
3 i.e., 50.53% cheaper Solution 1 (c) 2/10, net 45 Problem 1(c) should have been “1/10, net 30” and not “2/10, net 30”.
• But , running with 2/10, net 30 paid on day 45: 0.02 360 ICGOPHER = 1 − 0.01 45 − 10 = 20.99% One would be indifferent , edging slightly in favour of ignoring the discount 4 Comment on Nominal Interest Cost {360 / (NPDP)} converts: • Periodic interest rate to Nominal But this actually understates the true cost…
• Hence… 5 The Value of Taking a Supplier’s The Discount (2) Discount
• Effective Interest Cost (EIC) method: Better than Nominal 360 NP − DP D% EIC = 1 + 100% − D% −1 Rule: Borrow and take promptpayment discount • If EIC > cost of funds. 6 Effective Annual Interest Rate (EAR) Note that we have to compare apples with apples • so we cannot compare an EIC with a nominal bank interest rate • We use the EAR _______________ ________________ rNOMINAL EAR = 1 + −1 m where : m = periods per year ⇒ EAR = ( 1 + rPERIODIC ) − 1
m m where : rPERIODIC rNOMINAL = m
7 Example 2: EIC treatment of same problem A firm is offered terms of 2/10, net 30. its (a) Should the firm take the discount if overdraft rate is 16% per annum
• Calculated daily (360day year) (a) What if the firm has an overdraft rate of 16% calculated daily and chooses not to pay its accounts payable till day 30? Use 360day year 8 Solution to Discount Example 2 (a) 360 30 −10 2% EICDISCOUNT = 1 + 100% − 2% = 0.16 EAROD = 1 + 360 =
360 −1 −1 Therefore use __________________________________ 9 Problem 2: Gopher Ltd’s EIC
Gopher Ltd (as in Problem 1) is offered terms of 1/10, net 30. Using the EIC calculation: (a) Should the firm take the discount if it could put it on an overdraft at 21% per annum or delay payment till Day 30? What if the terms were 1/15, net 30? What if the terms were 1/10, net 30, but Gopher believes it can get away with not paying till the end of day 45?
• Please use 360day year
10 (b) (c) Solution 2 (a) 11 Solution 2 (b) 12 Solution 2 (c) But note in all of these answers our dependence on the 360day year assumption 13 Free v costly trade credit Firm should:
• Always take the free component (i.e. 10 days) of trade credit • Only take the costly component if ________ ____________________________________ 14 Simple Income Statement Example Simple
(with nonsense ad hoc figures) (with With Discount taken and Shortterm debt Discount received is greater than interest on shortterm debt Trade Credit Relied upon and No discount Taken Sales 200 Less Purchases 100 Add Discount Rec. 2 EBIT 102 Less Interest _ EBT Less tax @ 40% ___ NPAT ___ Sales 200 Less Purchases 100 Add Discount Rec. 0 EBIT 100 Less Interest _ EBT Less tax @ 40% ____ NPAT ____ 15 Negotiated Shortterm Debt: Negotiated Notes Payable
• A general term in Balance sheet for Promissory notes Commercial papers Shortterm funds on Revolving Credit • Etc. 16 Negotiated Financing Bank Overdraft • Firm can overdraw a/c up to certain level • Interest rate set at a margin above base rate • Interest calculated daily on overdrawn balance • Usually ____________________________ • Penalty interest charged if limit exceeded • Bank also charges upfront and annual fees 17 Promissory Note (Defined) (Defined) Document specifying terms and conditions of a loan: Amount borrowed Maturity
For instance : 30 days, 90 days, 120 days …______________________________________ Interest rate • Loan must be paid or renewed at maturity • Indexed to either: (in increasing scale!) the bank’s prime rate The Tbill rate LIBOR ___________________________________ • With either 360 or 365day year specified 18 Promissory Note (Continued) (Continued) Repayment schedule Collateral Restrictive covenants Loan guarantees • May be as lump or in instalments • May be interestonly Like a bond • …or may be amortised Joint Interest & Capital payments as in a table mortgage • Or may have all interest deducted at time zero “Discount Interest Loan” • Small company may be required _____________ _________________________________________
19 Commercial paper A form of Promissory Note • Issued by large, strong firms With annual borrowing > $10m in US Mainly financial institutions • Bought by Other business firms Insurance companies superannuation funds Other funds operating in financial markets Banks… • Unsecured notes issued in denominations of $100,000 or more Slightly larger market for this in the USA than for bank loans Market _____________________________________ Cheaper interest than __________________________ 20 Usually sold thru tender organised by major banks Line of Credit An arrangement in which a bank agrees to lend funds
• up to a specified maximum amount • during a specified period. • Can be informal or formal Example of an informal line of credit: • XYZ Bank agrees to give Gopher Ltd $100,000 line of credit for year 1st October 2009 – 30th September 2010 • Gopher signs promissory note on 8th October for $20,000 for 90 days. XYZ Bank puts $20,000 into Gopher’s cheque account Gopher can still borrow another $80,000 anytime • But not more, ______________________________ 21 Revolving Credit Agreement Formal, committed line of credit for a specified period Interest rate pegged to • • • the Prime Rate or Treasury Bill rate or LIBOR Note that “pegged” does not mean “set equal to” _______________________________________ Commitment fee • Rate of interest on unused portion of credit Bank or other lending institution has legal obligation to lend up to limit
22 Example of Revolving Credit Agreement Texas Petroleum firm in 2005 negotiated with a group of banks:
• $100m line of credit for 4 years • Commitment fee of 0.25% (i.e, 0.0025) on the unused portion If nothing used: • then ________________________________ _________________________________ If $50m drawn down (borrowed) immediately • then annual commitment fee = $125,000 • Interest rate on funds drawn down = banks’ Prime rate less 0.5% 23 Useful Vocabulary (1) Prime rate • Published interest rate charged by commercial banks to large borrowers With strong credit ratings • Other rates _________________________________ Interestonly loan • Only Interest is paid on periodic basis Face value (principal) repaid at the end Bonds (longterm) Bills or Notes (shortterm) • Typically calculated on daily basis and paid monthly 24 Useful Vocabulary (2) Amortised loan • Interest and principal are repaid in instalments Table mortgages Discount Interest Loan • Loan issued at less than face value Ie, the face value is deemed to be the amount you want to borrow PLUS the interest The interest is deducted at time zero • Repaid at face value Increases _____________________________ • This is like a zerocoupon bond.
25 Useful Vocabulary (3) Addon Basis Instalment Loans • The face value is deemed to be the amount you want to borrow PLUS the interest. • You pay off this face value in equal instalments • May be of interest if you take out a loan for a second hand car. Example: • Borrow $10,000 for one year at 12% • Repay in 12 equal instalments
26 Principal = $10, 000 Interest nPER = ( $10, 000 ) ( 0.12 ) = $1, 200 = 12 ( per year !) ($10, 000 + $1, 200) Instalment = = $933.33 12 IRR = rd PER = 1.7880% ⇒ rd NOM = 21.456% ≈ 21.46% Effective Annual Rate = 1 + rd PER ( ) nper −1 = 1.0178812 − 1 = 0.2369694 ≈ 23.70% 27 Secured Financing Accounts receivable as Collateral
• Firm pledges debtors as security for loan Promissory Note • Bank evaluates debtors and lends 5090% of face value of “acceptable debtors” • Bank has ___________________________ • Usually only available when large volumes of debtors involved • Potential problems of priority with other secured creditors 28 Inventory as Collateral
• Firm pledges inventory as security for shortterm loan • Lender evaluates marketability/perishability of inventory What if the inventory was fresh fruit as distinct from microwave ovens? • Lender usually ____________________ __________________________________ • Potential problem of priority with other secured creditors 29 Floor plan (bailment) finance
• Supplier/lender holds title to inventory pending sale to customers • Method popular with goods that can be identified by serial no. eg. cars, appliances • Supplier/lender usually advances 80100% of cost of identified inventory • Complex form of finance lien filed and discharges on each item 30 Off Balance Sheet Financing Factoring accounts receivable
• Firm sells debtors to factor at discounted price • Debtors make payments to factor • Factoring can be withrecourse or nonrecourse to the firm If _______________________________________ • Discount represents factor’s charge for collection risk • Factoring usually an expensive form of shortterm finance 31 ...
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 Spring '09
 WarwickAnderson
 Annual Percentage Rate, Promissory note, Revolving credit

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