Chapter 16 Liability Management and Short/Medium-Term Financing

Liability Structure of a Company Imperfections and incompleteness Permanent and temporary financing Maturity of debt Maturity The risk involved The cost trade-off Agency and signaling issues

Imperfections and Incompleteness Imperfections that most affect debt Flotation costs Bankruptcy costs Costs of information Restrictions on lenders The way a firm “packages” its debt financing is important Most important aspect is maturity

Permanent and Temporary Financing Hedging approach to financing The borrowing and payment schedule for short-term financing would be arranged to correspond to the expected swings in current assets Fixed assets and the permanent component of current assets would be financed with long-term debt, equity, and the permanent component of current liabilities

Maturity of Debt Schedule of debt maturities is important in assessing the risk-profitability trade-off Risk involved Unable to meet principal and interest payments Lender may not renew loan at maturity Uncertainty with interest rate Possible covariance of short-term interest costs with operating income Cost trade-off Reduce the risk of cash insolvency by increasing the maturity schedule of its debt Longer the maturity schedule, the more costly the financing is likely to be

Agency and Signaling Issues Agency issues in controlling the underinvestment problem Using short- as opposed to long-term debt Protective covenants Secured as opposed to unsecured debt Signaling effect Associate the issuance of short-term debt with undervaluation and long-term debt with overvaluation

Trade Credit Financing Largest source of short-term financing Small companies rely on trade credit Terms of sale Cash on delivery (COD) Cash before delivery (CBD) Net period-no cash discount Net period with cash discount Datings

Trade Credit as a Means of Financing When trade credit is not a discretionary source of financing Trade credit becomes a built-in source of financing that varies with production Trade credit as a discretionary form of financing Do not take the cash discount and pay on the last day of the net period Pay beyond the net period (stretching)

Payment On Final Due Date If a cash discount is not taken, there is a definite opportunity cost Trade credit can be very expensive The longer the time between the discount date and the time of payment, the lower the cost of discount forgone

Stretching Accounts Payable Costs of stretching accounts payable The cost of the cash discount forgone Possible deterioration in credit rating Opportunity cost to a deterioration in a firm’s credit reputation May be an indirect charge in the form of higher prices

Advantages of Trade Credit Ready availability Restrictions not likely Flexible means of financing The advantages of using trade credit must be weighed against the cost

Who Bears the Cost? Suppliers when demand is elastic In other circumstances suppliers pass on the cost to the buyer A buyer who is bearing the cost may shop around for a better deal

Accrual Accounts as Spontaneous Financing Most common are wages and taxes Tend to expand with the scope of the operation Represent an interest-free source of financing Usually do not represent discretionary financing Accruals are a discretionary form of financing with a one time pay period change

Unsecured Short-Term Loans Self-liquidating Line of credit Specifying the maximum amount of unsecured credit Conditions Creditworthiness Cleanup period Does not constitute a legal commitment Revolving credit agreement Legal commitment to extend credit Transaction loans Short-term funding for only one purpose

Determining Interest Rates Negotiation Creditworthiness of the borrower Money market conditions Bank’s marginal cost of funds Prime rate for better creditworthiness Rate above prime for lower creditworthiness Other business the borrower has with a bank Cost of servicing a loan Size of the loan

Methods of Computing Interest Rates Collect basis Interest is paid at the maturity of the note Discount basis Interest is deducted from the initial loan Add-on basis Interest is added to the funds distributed in order to determine the face value of the note Paid on the initial amount of the loan

Secured Lending Arrangements Two sources of loan payments Cash-flow ability of the firm to service debt Collateral value of the security More costly to administer Cost is passed on to the borrower in the form of fees and higher interest costs Cash flows are segregated with respect to payments to creditors Reduce underinvestment problem

Collateral Value Marketability Life of the collateral Basic riskiness associated with collateral

Uniform Commercial Code (UCC) Lenders protect themselves under Article 9 of the UCC Security interest in the collateral is created by security agreement (security device) Lender must file a copy of the security agreement with a public office to give public notice

Assignment of Accounts Receivable Firm retains title Major difficulties Cost of processing the collateral Risk of fraud Analyze the quality of receivables Higher the quality, the higher the percentage the lender is willing to advance Size of receivables Smaller the average size of accounts, the more it costs per dollar of loan to process

Procedure for Assignment Firm sends in a schedule of accounts Lender requires evidence of shipment, such as an invoice Borrower signs a promissory note and a security agreement Firm receives an agreed upon percent of the face value of the receivables Nonnotification arrangement Notification arrangement

Advantages of the Lending Arrangement Continuous financing arrangement New receivables replace old Security base and amount of loan fluctuate accordingly Flexible means of secured financing Permanent source of financing “Cleanup” not required

Factoring Receivables Sale of receivables to a factor With or without recourse Factoring costs Factoring fee plus an interest charge if the firm draws on its account before the receivables are collected Flexibility Agreement is continuous Borrow on a secured and an unsecured basis Relieves the company of credit checks, the cost of processing receivables, and collection expenses

Inventory Loans Floating lien Chattel mortgage Trust receipt loans Pledge inventories “in general” Chattel mortgage Inventories are specifically identified Trust receipt loans Borrower holds in trust for the lender the inventory and the proceeds from its sale Sometimes known as floor planning Terminal warehouse receipt loans Storing inventory with a public, or terminal, warehousing company Field warehouse receipt loans Secures the inventory loan on property

Intermediate-Term Debt Typically self-liquidating Term loans Repayment in periodic installments Can be fixed or floating rate Equipment financing Lender evaluates the marketability of the equipment Chattel mortgage is a lien on specific equipment With a conditional sales contract, the seller retains title

Medium-Term Notes (MTN) Sold to investors through an investment bank Instrument may be offered continually Issuers typically are large and creditworthy Maturity range is 9 months to 10 years Registered with the SEC under Rule 415 Major advantage to the borrower is flexibility

Protective Covenants and Loan Agreements Remedies under default General provisions Working capital requirement Cash dividend and repurchase of stock restriction Capital expenditures limitation Limitation on other indebtedness Routine provisions found in most loan agreements Special provisions to achieve a desired total protection

Negotiating Restrictions and the Option Pricing Theory Option pricing can be used to model protective-covenant determination Equity holding motivation Lender restraint