Long-term Financing : Debt (Cont.
)
Evaluation as a source of fund :
• Tax deductible interest payments / Tax shield benefit i(1-t).
If interest rate is 15% and corporate tax rate is 40%, Tax shield benefit will be
15%(1-40%) = 9%
• Clearly specified and fixed nature financial obligations.
• Debt may be paid back with “cheaper dollars”.
• Prudent use of debt may lower the cost of capital to the firm.
Long-term means more than 5 years. Money loses its value due to inflation, the value of dollar lows.
WACC (Weighted Average Cost of Capital) :
Capital, E+P+B (E= Equity Share, P= Preferred Stock, B= Borrowed Capital)
Cost of Capital, Ke + Kp + Kb Ke= Cost of Equity , Kp= Cost Preferred Stock , Kb= Cost of Borrowed Capital
Farm Value = Cash flow / Weighted Average Cost of Capital if Cash flow Farm value
if Weighted average cost of capital Farm Value
How much borrowed capital firm should use?
If firm can prudently use borrowed capital, weighted average cost of capital will be low.
Cost of equity is always higher. On the other hand, borrowed capital is not so risky. That’s why, the cost of borrowed capital is low.
• Interest and principal payment obligations are set regardless of the economic position of the firm. Any failure of this
obligation raises default risk (bankruptcy) of the firm.
• Indenture agreements may place burdensome restrictions on the firm.
• Utilized beyond a given point, debt may depress outstanding common stock value.
Bond Indenture
In the share market, there is a rating system which affects the price of share and the management systems efficiency.
Short-term Financing
Sources of short term financing :
• Trade Credit from suppliers
• Bank Loans
• Corporate Promissory Note
• Foreign Borrowing
• Loan against Receivable and inventory
Short-term Financing : Trade Credit
• Manufacturers or sellers of goods and services are the provider
• In the form of accounts payable
• Spontaneous source of funds
Trade Credit : Payment Period
• Usually for 30 to 60 days
• Firms attempt to “stretch the payment period”
• Determining the payment period depends on existence of a cash discount
Trade Credit : Cash Discount Policy
• A reduction in price if payment is made within a specified time period
• As for example, a 2/10, net 30 cash discount
Cost of falling to take a cash discount = [Discount% / (100%–Discount%] × [360 / (Final due date–Discount period)]
Short-term Financing : Trade Credit
❖ Regis Clothiers can borrow from its bank at 17 percent to take a cash discount. The terms of the cash discount are 3/19, net
45. Should the firm borrow the fund?
Cost of falling to take cash discount = [3%/(100%–3%)]×[360/(45–19)] = 3.09%×13.85 = 42.78%
Since money can be borrowed at 17 percent, Regis Clothiers should borrow the funds and take the discount.
Net Credit Position
The difference between account receivables and account payable.
Short-term Financing : Bank Credit
✓ Finances seasonal needs, product line expansion, and long-term growth
✓ Bankers prefers a self-liquidating loan or a built-in or automatic repayment scheme.
✓ Banking is centered on the concept of “full-service banking”, trust and investment, a credit card, real estate, data
processing, cash management, pension fund management etc.
✓ Banking has become more international to accommodate increased world trade and international corporations.
✓ Therefore, it has been focused on –
• Prime interest rate
• LIBOR
• Compensating balances
• Maturity Provisions
Prime rate and LIBOR :
• The rate a bank charges its most creditworthy customers, and a premium is added as a customers credit risk gets higher
• LIBOR means London Interbank Offered Rate. International companies use London Eurodollar market for loans.
Compensating Balances :
• A fee or a minimum average account balance required by the bank in providing loans and other services.
• Amount to be borrowed = Amount needed / (1–c)
c= compensation rate
❖ Digital Access Inc. needs $400,000 in funds for a project. With a compensating balance requirement of 20 percent, how
much will the firm need to borrow?
Amount to be borrowed = 400,000/(1–.20) = 500,000
Maturity Provisions :
• Credit is extended (term loan) for one to seven years in the last decade.
• Superior credit applicants
• Interest rate on a term loan may be tied to the prime rate or LIBOR
• Often loans will be priced at a premium over one of these two rates reflecting the risk of the borrowed fund.
Cost of Commercial Bank Financing :
The effective interest rate on a loan is based on
• the loan amount
• the dollar interest paid
• the length of the loan and
• the method of repayment
Effective interest rate= [Interest /Principal] × [Days in a year(360) / Days loan is outstanding]
❖ Your bank will lend you $4,000 for 45 days at a cost of $50 interest. What is your effective rate of interest?
Effective interest rate = [50/4,000]×[360/45] = 10%
Discounted Loan :
• The way interest is charged is also important
• Bank deducts the interest in advance
Effective interest rate= [Interest / (Principal–Interest)] × [Days in a year(360) / Days loan is outstanding]
❖ Sol Pine borrows $5,000 for one year at 13 percent interest What is the effective rate of interest if the loan in discounted?
Effective interest rate = [650/(5,000–650)]×[360/360] = 14.94%
❖ Dr. Ruth is going to borrow $5,000 to help write a book. The loan is for one year and the money can be borrowed at either
the prime rate or the LIBOR rate. Assume the prime rate is 11 percent and LIBOR 1.5 percent less. Also assume there will be
a $45 transaction fee with LIBOR (this amount must be added to the interest cost with LIBOR). Which loan has the lower
effective interest cost?
Effective Interest Rate (based on Prime Rate) = (550/5,000)×(360/360) = 11%
Effective Interest Rate (based on LIBOR) = [(475+45)/5,000]×[360/360] = 10.40%
So, money borrowed under LIBOR has the lower effective interest cost.
Interest Costs with Compensating Balances :
Effective Rate with compensating balances = Interest / (1–c)
❖ Maxim Air Filters Inc. plans to borrow $300,000 for one year. Northeast National Bank will lend the money at 10 percent
interest and requires a compensating balance of 20 percent. What is the effective rate of interest?
Effective Rate with compensating balances = 10%/(1–.20) = 12.50%
If dollar amounts are used and the stated rate is unknown –
Effective Rate with Compensating balances
= [ Interest / (Principal – Compensating balances) ] × [ Days in a year (360) / Days loan is outstanding ]
Rate on Installment Loans :
• A series of equal payments over the life of the loan.
Effective Rate on Installment Loan :
= [ 2× Annual no. Payments × Interest ] / [ (Total no. of payments +1 ) × Principal ]
❖ Lewis and Clark Camping Supplies Inc. is borrowing $51,000 from Western State Bank. The total interest is $15,700. The loan
will be paid by making equal monthly payments for the next three years. What is the effective rate of interest on this
Installment loan?
Effective Rate on Installment Loan = [2×12×15,700] / [(36+1)×51,000] = 19.97%
Short-term Financing : Accounts Receivable
Accounts receivable financing : includes
• Pledging account receivable
• Factoring
Pledging Account Receivable
• Quality A/R serves as collateral for a loan
• Borrowing limit up to 60 to 90 percent to collateral
• Lender has full recourse if any accounts go bad
• Interest rate of borrowing is well excess of the prime rate
Factoring Receivable :
• Factor is an financial intermediary agent that purchase A/R and provide cash immediately to the seller after accepting the
accounts
• Absorbs risk and advances funds earlier than normally received
• Factor does part or full credit analysis to ensure quality of receivable
• Factoring firm does not have recourse against the seller if any accounts go bad
❖ Factoring firm is paid on :
▪ Fee or Commission 1% to 3%
▪ A lending rate for advancing the fund early
Short-term Financing : Inventory
Extends of inventory financing depends on :
• Marketability of pledged the goods
• Associated price stability, and
• Perishability of the product
• Degree of physical control over the product exercised by the lender
These factor can be related to :
a. Stages of production :
• Raw materials of finished goods quality for a loan of 70-80 percent
• Goods in progress quality small portion of loan
b. Nature of lender control
Methods for controlling pledged inventory are:
i. Blanket inventory liens
• Legal interest is all of the debtor's assets serving as collateral
ii. Trust Receipts
• An instrument acknowledging that the borrower holds the inventory
• Borrower holds the inventory and transferred sales proceeds to the lender
• Popular among auto and industrial equipment, dealers, television and home appliance industries
• Not give the lender direct physical control over inventory but a better and more legally enforceable system of
tracing the goods
iii. Warehousing :
• An independent warehousing company identifies, segregates, and stores goods
• This firm issues a warehouse receipt to the lender and goods moved only with the lenders approval
• Types :
– Pubic warehousing : Warehousing firm premises
– Field warehousing : Borrowers premises
