LG 4 16.2 Unsecured Sources of Short-Term Loans

LG 3 LG 4 16.2 Unsecured Sources of Short-Term Loans

Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short- term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are available to firms of all sizes; commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions.

BANK LOANS Banks are a major source of unsecured short-term loans to businesses. The major

short-term, self-liquidating type of loan made by banks to businesses is the short-term, self-liquidating loan. loan

These loans are intended merely to carry the firm through seasonal peaks in

An unsecured short-term loan

financing needs that are due primarily to buildups of inventory and accounts

in which the use to which the

receivable. As the firm converts inventories and receivables into cash, the funds

borrowed money is put provides the mechanism

needed to retire these loans are generated. In other words, the use to which the

through which the loan is

borrowed money is put provides the mechanism through which the loan is

repaid.

repaid—hence the term self-liquidating.

Banks lend unsecured, short-term funds in three basic ways: through single- payment notes, lines of credit, and revolving credit agreements. Before we look at these types of loans, we consider loan interest rates.

prime rate of interest (prime Loan Interest Rates rate) The lowest rate of interest

The interest rate on a bank loan can be a fixed or a floating rate, typically based

charged by leading banks on

on the prime rate of interest. The prime rate of interest (prime rate) is the lowest

business loans to their most

rate of interest charged by leading banks on business loans to their most important

important business borrowers.

business borrowers. The prime rate fluctuates with changing supply-and-demand

CHAPTER 16

Current Liabilities Management

relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although most unsecured short-term loans carry premiums of less than

2 percent.

Fixed- and Floating-Rate Loans Loans can have either fixed or floating fixed-rate loan

interest rates. On a fixed-rate loan, the rate of interest is determined at a set incre-

A loan with a rate of interest

ment above the prime rate on the date of the loan and remains unvarying at that

that is determined at a set

fixed rate until maturity. On a floating-rate loan, the increment above the prime increment above the prime rate rate is initially established, and the rate of interest is allowed to “float,” or vary,

and remains unvarying until maturity.

above prime as the prime rate varies until maturity. Generally, the increment above the prime rate will be lower on a floating-rate loan than on a fixed-rate

floating-rate loan loan of equivalent risk because the lender bears less risk with a floating-rate loan.

A loan with a rate of interest

As a result of the volatile nature of the prime rate during recent years, today most

initially set at an increment above the prime rate and

short-term business loans are floating-rate loans.

allowed to “float,” or vary, above prime as the prime rate

Method of Computing Interest Once the nominal (or stated) annual rate is

varies until maturity.

established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to

Interest

Amount borrowed

Most bank loans to businesses require the interest payment at maturity. When interest is paid in advance, it is deducted from the loan so that the bor- rower actually receives less money than is requested (and less than they must repay). discount loan

Loans on which interest is paid in advance are called discount loans. The effective

Loan on which interest is paid

annual rate for a discount loan, assuming a 1-year period, is calculated as

in advance by being deducted from the amount borrowed.

Interest

Amount borrowed - Interest

Paying interest in advance raises the effective annual rate above the stated annual rate.

Example 16.8 3 Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid

at maturity, the firm will pay $1,000 (0.10 * $10,000) for the use of the $10,000 for the year. At the end of the year, Wooster will write a check to the lender for $11,000, consisting of the $1,000 interest as well as the return of the $10,000 principal. Substituting into Equation 16.3 reveals that the effective annual rate is therefore

PART 7

Short-Term Financial Decisions

If the money is borrowed at the same stated annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 - $1,000). The effective annual rate in this case is

In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).

Single-Payment Notes

single-payment note

A single-payment note can be obtained from a commercial bank by a credit-

A short-term, one-time loan

worthy business borrower. This type of loan is usually a one-time loan made to a

made to a borrower who

borrower who needs funds for a specific purpose for a short period. The resulting

needs funds for a specific

instrument is a note, signed by the borrower, that states the terms of the loan,

purpose for a short period.

including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.

Example 16.9 3 Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks—bank A and bank B. The loans were incurred

on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate

was set at 1 1 / 2 % above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at 7 1 / 2 % (6% prime rate + 1 1 / 2 % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1,849

2 % * 90 , 365) 4 , which means that the 90-day rate on this loan is 1.85% ($1,849 , $100,000). Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate by using Equation 5.17. Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is,

365 ⫼ 90) and then subtract 1:

Effective annual rate = (1 + 0.0185) 4.06 - 1

= 1.0773 - 1 = 0.0773 = 7.73% The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.

Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5%, and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the

first 30 days (7% * 30 , 365), 0.616% for the next 30 days (7.5% * 30 , 365), and 0.596% for the last 30 days (7.25% * 30 , 365). Its total interest cost will be $1,787 3$100,000 * (0.575% + 0.616% + 0.596%)4 , resulting in a 90-day rate

CHAPTER 16

Current Liabilities Management

Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:

Effective annual rate = (1 + 0.01787) 4.06 - 1 = 1.0746 - 1 = 0.0746 = 7.46%

Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.

Personal Finance Example 16.10 3 Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the

down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.

Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable- rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:

60 days from today the prime rate will rise by 1%

90 days from today the prime rate will rise another 1 / 2 %

150 days from today the prime rate will drop by 1%

Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.

Fixed-Rate Loan: Total interest cost over 180 days

= $30,000 * (0.08 + 0.02) * (180 , 365) = $30,000 * 0.04932 L $1,480

Variable-Rate Loan: The applicable interest rate would begin at 9% (8% + 1%) and remain there for 60 days. Then the applicable rate would rise to 10% (9% + 1%) for the next 30 days, and then to 10.50% (10% + 0.50%) for the next 60 days. Finally the applicable rate would drop to 9.50% (10.50% - 1%) for the final 30 days.

Total interest cost over 180 days

= $30,000 * 3(0.09 * 60 , 365) + (0.10 * 30 , 365) + (0.105 * 60 , 365) + (0.095 * 30 , 365) 4 = $30,000 * (0.01479 + 0.00822 + 0.01726 + 0.00781) = $30,000 * 0.04808 L $1,442

Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, Megan should take the variable-rate loan. By doing this she will save about $38 ($1,480 line of credit - $1,442) in

An agreement between a

interest cost over the 180 days.

commercial bank and a business specifying the amount Lines of Credit of unsecured short-term borrowing the bank will make

A line of credit is an agreement between a commercial bank and a business, spec-

available to the firm over a

ifying the amount of unsecured short-term borrowing the bank will make avail-

PART 7

Short-Term Financial Decisions

which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is not a guaranteed loan but indicates that if the bank has sufficient funds avail-

able, it will allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is the maximum amount the firm can owe the bank at any point in time.

When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma bal- ance sheet, and recent financial statements. If the bank finds the customer accept- able, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the credit- worthiness of a customer each time it borrows money within the year.

Interest Rates The interest rate on a line of credit is normally stated as a floating rate—the prime rate plus a premium. If the prime rate changes, the interest rate charged on new as well as outstanding borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the pre- mium (interest increment) above prime, and vice versa.

Operating-Change Restrictions In a line-of-credit agreement, a bank may operating-change

impose operating-change restrictions, which give it the right to revoke the line if restrictions

any major changes occur in the firm’s financial condition or operations. The firm

Contractual restrictions that a

is usually required to submit up-to-date, and preferably audited, financial state-

bank may impose on a firm’s

ments for periodic review. In addition, the bank typically needs to be informed of

financial condition or operations as part of a line-of-

shifts in key managerial personnel or in the firm’s operations before changes take

credit agreement.

place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the pro- posed changes and the firm makes them anyway, the bank has the right to revoke the line of credit.

Compensating Balances To ensure that the borrower will be a “good cus- compensating balance

tomer,” many short-term unsecured bank loans—single-payment notes and lines

A required checking account

of credit—require the borrower to maintain, in a checking account, a

balance equal to a certain percentage of the amount

compensating balance equal to a certain percentage of the amount borrowed. borrowed from a bank under a Banks frequently require compensating balances of 10 to 20 percent. A compen- line-of-credit or revolving

sating balance not only forces the borrower to be a good customer of the bank

credit agreement.

but may also raise the interest cost to the borrower.

Example 16.11 3 Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of- credit agreement. It must pay a stated interest rate of 10% and maintain, in its

checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 * $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 , $800,000), 2.5% more than the stated rate of 10%.

If the firm normally maintains a balance of $200,000 or more in its checking

CHAPTER 16

Current Liabilities Management

none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 , $900,000). Thus a compensating balance raises the cost of bor- rowing only if it is larger than the firm’s normal cash balance.

Annual Cleanups To ensure that money lent under a line-of-credit agree- ment is actually being used to finance seasonal needs, many banks require an annual cleanup

annual cleanup. This means that the borrower must have a loan balance of

The requirement that for a

zero—that is, owe the bank nothing—for a certain number of days during the

certain number of days during

year. Insisting that the borrower carry a zero loan balance for a certain period

the year borrowers under a

ensures that short-term loans do not turn into long-term loans.

line of credit carry a zero loan balance (that is, owe the bank

All the characteristics of a line-of-credit agreement are negotiable to some

nothing).

extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of main- taining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce

a line of credit that is suitable to both borrower and lender. revolving credit agreement

Revolving Credit Agreements

A line of credit guaranteed to

A revolving credit agreement is nothing more than a guaranteed line of credit. It

a borrower by a commercial bank regardless of the scarcity

is guaranteed in the sense that the commercial bank assures the borrower that a

of money.

specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of

commitment fee credit. It is not uncommon for a revolving credit agreement to be for a period

The fee that is normally charged on a revolving credit

greater than 1 year. 2 Because the bank guarantees the availability of funds, a

agreement; it often applies to

commitment fee is normally charged on a revolving credit agreement. This fee

the average unused portion of

often applies to the average unused balance of the borrower’s credit line. It is nor-

the borrower’s credit line.

mally about 0.5 percent of the average unused portion of the line.

Example 16.12 3 REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past

year was $1.5 million. The bank charges a commitment fee of 0.5% on the average unused balance. Because the average unused portion of the committed funds was $500,000 ($2 million - $1.5 million), the commitment fee for the year was $2,500 (0.005 * $500,000). Of course, REH also had to pay interest on the actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 7.67% 3($112,500 + $2,500) , $1,500,0004 . Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint, because the availability of funds is guaranteed.

2. Many authors classify the revolving credit agreement as a form of intermediate-term financing, defined as having a maturity of 1 to 7 years. In this text, we do not use the intermediate-term financing classification; only short-term and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-

COMMERCIAL PAPER Commercial paper is a form of financing that consists of short-term, unsecured

promissory notes issued by firms with a high credit standing. Generally, only large firms of unquestionable financial soundness are able to issue commercial paper. Most commercial paper issues have maturities ranging from 3 to 270 days. Although there is no set denomination, such financing is generally issued in multiples of $100,000 or more. A large portion of the commercial paper today is issued by finance companies; manufacturing firms account for a smaller portion of this type of financing. Businesses often purchase commercial paper, which they hold as marketable securi- ties, to provide an interest-earning reserve of liquidity. For further information on recent use of commercial paper, see the Focus on Practice box.

Interest on Commercial Paper Commercial paper is sold at a discount from its par, or face, value. The size of the

discount and the length of time to maturity determine the interest paid by the

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PART 7 Short-Term Financial Decisions

commercial paper A form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing.

focus on PRACTICE The Ebb and Flow of Commercial Paper

the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers.

Even with the CPFF up and run- ning, companies that were worried about their ability to roll over their out- standing commercial paper every few weeks turned to long-term debt to meet their liquidity needs. Merrill Lynch & Co. and Bloomberg data showed that, to manage short-tem liability risk, com- panies were paying as much as $75 million in additional annual interest to swap long-term debt for $1 billion of 30-day commercial paper.

With the recession in the rearview mirror and short-term credit markets working again, the CPFF was closed on February 1, 2010. As of mid- 2010, the U.S. commercial paper mar- ket appeared to be hitting bottom at around $1.06 trillion and showing signs of recovering.

3 What factors contribute to an expansion of the commercial paper market? What factors cause a con- traction in the commercial paper market?

for other strategic activities—mergers and acquisitions and long-term capital invest- ments, among others. According to Federal Reserve Board data, at the end of July 2004, total U.S. commercial paper outstanding was $1.33 trillion.

By 2006, commercial paper surged to $1.98 trillion—an increase of 21.5 percent over 2005 levels. However, after peaking at $2.22 trillion, the tide changed in response to the credit crisis that began in August 2007. According to Federal Reserve data, as of October 1, 2008, the commercial paper market had contracted to $1.6 trillion, a reduc- tion of nearly 28 percent, and new issues virtually dried up for several weeks. With much of the commercial paper outstanding at the start of the credit crisis coming up for renewal, the Federal Reserve began operating the Commercial Paper Funding Facility (CPFF) on October 27, 2008. The CPFF was intended to provide a liquidity backstop to U.S. issuers of commercial paper and, thereby, increase the avail- ability of credit in short-term capital mar- kets. CPFF allowed for the Federal Reserve Bank of New York to finance

The difficult economic and credit environment

in the post–September 11 era, com- bined with historically low interest rates and a deep desire by corporate issuers to reduce exposure to refinancing risk, had a depressing effect on commercial paper volumes from 2001 through 2003. According to the Federal Reserve, U.S. nonfinancial commercial paper, for example, declined 68 per- cent over the 3-year period, from $315.8 billion outstanding at the beginning of 2001 to $101.4 billion by December 2003. In addition to lower volume, credit quality of commer- cial paper declined over the same period, with the ratio of downgrades outpacing upgrades 17 to 1 in 2002.

In 2004, signs emerged that the vol- ume and rating contraction in commer- cial paper was finally coming to an end. The most encouraging of these was the pickup in economic growth, which spurs the need for short-term debt to finance corporate working capital. Although commercial paper is typically used to fund working capital, it is often boosted by a sudden surge of borrowing activity

in practice

CHAPTER 16

Current Liabilities Management

issuer of commercial paper. The actual interest earned by the purchaser is deter- mined by certain calculations, illustrated by the following example.

Example 16.13 3 Bertram Corporation, a large shipbuilder, has just issued $1 million worth of com- mercial paper that has a 90-day maturity and sells for $990,000. At the end of 90

days, the purchaser of this paper will receive $1 million for its $990,000 invest- ment. The interest paid on the financing is therefore $10,000 on a principal of $990,000. The effective 90-day rate on the paper is 1.01% ($10,000 , $990,000). Assuming that the paper is rolled over each 90 days throughout the year (that is,

4.06 times per year), the effective annual rate for Bertram’s commercial paper, found by using Equation 4.24, is 4.16%

3(1 + 0.0101) 4.06 - 1 4 . An interesting characteristic of commercial paper is that its interest cost is

normally 2 percent to 4 percent below the prime rate. In other words, firms are able to raise funds more cheaply by selling commercial paper than by borrowing from a commercial bank. The reason is that many suppliers of short-term funds do not have the option, as banks do, of making low-risk business loans at the prime rate. They can invest safely only in marketable securities such as Treasury bills and commercial paper.

Although the stated interest cost of borrowing through the sale of commercial paper is normally lower than the prime rate, the overall cost of commercial paper may not be less than that of a bank loan. Additional costs include various fees and flotation costs. In addition, even if it is slightly more expensive to borrow from a commercial bank, it may at times be advisable to do so to establish a good working relationship with a bank. This strategy ensures that when money is tight, funds can be obtained promptly and at a reasonable interest rate.

Matter of fact

Lending Limits