FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER CHAPTER TWENTY-FOUR TWENTY-FOUR Short-Term Financing Options

Learning Objectives 1. Discuss the different sources of short-term and intermediate-term loans. 2. Identify five common features of term loans. 3. Discuss the reason for hedging through forward or futures contracts or options. 4. Compare the informal and formal types of trade credit. 5. Explain the role of the venture capital firm.

Introduction In this chapter we discuss short and intermediate-term financing In this chapter we discuss short and intermediate-term financing Short-term funds are appropriate for the financing of receivables and inventories Short-term funds are appropriate for the financing of receivables and inventories Intermediate-term financing is useful when funding must be committed for extended periods Intermediate-term financing is useful when funding must be committed for extended periods The most common intermediate term financing is term loans The most common intermediate term financing is term loans Term loan – a loan that has a specified maturity and cannot be called as long as the borrower complies with the conditions of the loan Term loan – a loan that has a specified maturity and cannot be called as long as the borrower complies with the conditions of the loan

Bank Loans Canadian Banks Canadian Banks operate a national system of branch banking operate a national system of branch banking maintain a balanced portfolio of loans maintain a balanced portfolio of loans most short-term loans for business are in the form of lines of credit secured by inventories and receivables most short-term loans for business are in the form of lines of credit secured by inventories and receivables Line of credit – an open lending arrangement with a stated maximum that a bank may be willing to lend a customer for a set period of time Line of credit – an open lending arrangement with a stated maximum that a bank may be willing to lend a customer for a set period of time

Bank Loans Advantages of line of credit include: Advantages of line of credit include: firms know how much bank credit can be expected firms know how much bank credit can be expected borrowing is limited to amounts actually needed borrowing is limited to amounts actually needed the bank’s credit manager can make instant advances up to the maximum amount approved without additional applications the bank’s credit manager can make instant advances up to the maximum amount approved without additional applications Rate of interest on bank loans is expressed as a percentage above prime Rate of interest on bank loans is expressed as a percentage above prime prime loan rate – the interest rate banks charge their most credit-worthy borrowers prime loan rate – the interest rate banks charge their most credit-worthy borrowers

Bank Loans A large portion of business loans are secured by pledged assets (equipment, property) A large portion of business loans are secured by pledged assets (equipment, property) Term loans Term loans are secured by collateral are secured by collateral collateral exceeds the amount of a loan by a margin collateral exceeds the amount of a loan by a margin interest rates are often variable and tied to the prime rate interest rates are often variable and tied to the prime rate

Other Private Financial Institutions Trust Companies Trust Companies most operate as subsidiaries of the major charter banks most operate as subsidiaries of the major charter banks offer many of the same services as banks plus estate management, pension plans, and other trust funds offer many of the same services as banks plus estate management, pension plans, and other trust funds Caisse Populaires and Credit Unions Caisse Populaires and Credit Unions are savings and credit co-operatives are savings and credit co-operatives have different policies regarding asset management have different policies regarding asset management

The Money Markets Money markets – consist of the places and institutions in which debt instruments with relatively short maturities (under 3 years) are traded Money markets – consist of the places and institutions in which debt instruments with relatively short maturities (under 3 years) are traded Since 1954 governments and corporations have used money markets to obtain short-term financing Since 1954 governments and corporations have used money markets to obtain short-term financing Money markets instruments sell at a discount from face value and investors realize a return at maturity when the borrower redeems at face value Money markets instruments sell at a discount from face value and investors realize a return at maturity when the borrower redeems at face value

Money Markets

Commercial Paper Commercial paper Commercial paper Commercial paper – consists of short-term promissory notes issued by major corporations that are well known to investors and have excellent credit history Commercial paper – consists of short-term promissory notes issued by major corporations that are well known to investors and have excellent credit history Issued in denominations > $100,000 Issued in denominations > $100,000 Unsecured with maturities of 60, 90, and 120 days Unsecured with maturities of 60, 90, and 120 days Not subject to scrutiny of the provincial securities commission the way long-term debt and equity issues are Not subject to scrutiny of the provincial securities commission the way long-term debt and equity issues are Rating agencies publish reports on the quality of commercial paper Rating agencies publish reports on the quality of commercial paper

Commercial Paper

Bankers Acceptances Bankers acceptances Bankers acceptances Bankers acceptances – drafts or orders to pay, drawn on a chartered bank by the firm seeking funds Bankers acceptances – drafts or orders to pay, drawn on a chartered bank by the firm seeking funds are short-term debt instruments similar to commercial paper guaranteed by the bank are short-term debt instruments similar to commercial paper guaranteed by the bank virtually default-free virtually default-free issued in multiples of $500,000 issued in multiples of $500,000 issued for periods between 30 and 90 days issued for periods between 30 and 90 days banks charge an acceptance fee between 1/2 to 1 percent of face value to the firm seeking funds banks charge an acceptance fee between 1/2 to 1 percent of face value to the firm seeking funds

Securities Issued by Banks and Trust Companies Securities Issued by Banks and Trust Companies Certificates of deposit (CDs) – are non- redeemable, registered, transferable, interest- bearing notes with maturities between one and six years Certificates of deposit (CDs) – are non- redeemable, registered, transferable, interest- bearing notes with maturities between one and six years Deposit receipts – are transferable term deposits with maturities of between 30 and 364 days that can be cashed in at any time subject to an interest penalty Deposit receipts – are transferable term deposits with maturities of between 30 and 364 days that can be cashed in at any time subject to an interest penalty Bearer deposit – are issues exceeding $100,000 for fixed maturities of up to seven years Bearer deposit – are issues exceeding $100,000 for fixed maturities of up to seven years

Factoring Factors are firms that provide financing to businesses by purchasing their accounts receivable Factors are firms that provide financing to businesses by purchasing their accounts receivable Factors can provide three services: Factors can provide three services: 1. taking over credit screening and collections 2. assuming the risk of bad debt 3. financing by advancing funds that would otherwise be collected later

Trade Credit Trade credit – is the financing suppliers extend by allowing customers to pay for goods or services sometime after delivery Trade credit – is the financing suppliers extend by allowing customers to pay for goods or services sometime after delivery Reasons for the wide use of trade credit include: Reasons for the wide use of trade credit include: convenience to both suppliers and purchasers convenience to both suppliers and purchasers there are no negotiations to be entered into or detailed forms to be filled out there are no negotiations to be entered into or detailed forms to be filled out

Trade Credit Major types of trade credit include: Major types of trade credit include: Open account – where the seller accepts the account and fills the buyer’s order and sends out an invoice Open account – where the seller accepts the account and fills the buyer’s order and sends out an invoice Open accounts also extended under selling terms classified by the timing of called-for payments which include: Open accounts also extended under selling terms classified by the timing of called-for payments which include: Ý cash before delivery (CBD) Ý cash on delivery (COD) Cash discounts are offered to induce customers to make prompt payments which include: Cash discounts are offered to induce customers to make prompt payments which include: Ý 2/10 net 30 Ý 2/10 EOM net 30

Federal Government Programs and Agencies Federally guaranteed loan plans Federally guaranteed loan plans The federal government guarantees reimbursement in case of default up to an annual maximum The federal government guarantees reimbursement in case of default up to an annual maximum Business Development Bank of Canada (BDC) Business Development Bank of Canada (BDC) Provides credit to any industrial enterprise in Canada provided that such credit would not otherwise be available on reasonable terms and conditions Provides credit to any industrial enterprise in Canada provided that such credit would not otherwise be available on reasonable terms and conditions For a fee the BDC will act as a guarantor for a client dealing with private financial institutions For a fee the BDC will act as a guarantor for a client dealing with private financial institutions

Federal Government Programs and Agencies The Export Development Corporation (EDC) The Export Development Corporation (EDC) provides insurance to Canadian firms against commercial and political risks when dealing in foreign markets provides insurance to Canadian firms against commercial and political risks when dealing in foreign markets offers financing services to assist exporters and to stimulate foreign interest in Canadian technology and products in the form of direct loans offers financing services to assist exporters and to stimulate foreign interest in Canadian technology and products in the form of direct loans Provincial Crown Corporations Provincial Crown Corporations provide financial assistance designed to complement the lending of private institutions and the federal government to firms who otherwise would be unable to obtain funding under reasonable terms provide financial assistance designed to complement the lending of private institutions and the federal government to firms who otherwise would be unable to obtain funding under reasonable terms

Project Financing Project financing Project financing obtained from private institutions and/or government agencies to fund projects involving large capital expenditures obtained from private institutions and/or government agencies to fund projects involving large capital expenditures different from traditional debt financing because they are supported by assets and future income stream of the project different from traditional debt financing because they are supported by assets and future income stream of the project most of the projects are financed through debt most of the projects are financed through debt the risks of the venture are carefully assessed between equity sponsors and the lenders the risks of the venture are carefully assessed between equity sponsors and the lenders

Venture Capital Venture capital – unsecured term funds provided to a non-public firm by an outsider Venture capital – unsecured term funds provided to a non-public firm by an outsider Private venture capital firms and government agencies provide risk capital by buying common or preferred shares, debt, or warrants of firms seeking start-up capital Private venture capital firms and government agencies provide risk capital by buying common or preferred shares, debt, or warrants of firms seeking start-up capital A venture normally terminates in one of three ways: A venture normally terminates in one of three ways: 1. a successful public offering of shares 2. the private sale of the investment to another party 3. bankruptcy

Summary 1. Short-term credits covers loans with maturities of one year or less. Primary sources of funds are banks and other financial institutions, money markets (both domestic and international), factoring, and trade credit. 2. Intermediate-term loans mature within one to 10 years. Sources of intermediate-term debt may be divided into two broad categories: private institutions including banks, and government agencies.

Summary 3. Most short-term bank loans are granted under lines of credit. They may be secured or unsecured, and the interest rate is normally quoted as a given percentage above the prime loan rate. Although provisions in term loans vary and are negotiable, the following features are common: Most term loans are secured Most term loans are secured Lenders often require personal guarantees from smaller companies Lenders often require personal guarantees from smaller companies Borrowers have to provide the lender with periodic information about the operations of the firm Borrowers have to provide the lender with periodic information about the operations of the firm

Summary Various restrictions may be imposed on the operations of the borrowing firm in order to strengthen the position of the lender Various restrictions may be imposed on the operations of the borrowing firm in order to strengthen the position of the lender Interest rates charged are typically variable and tied to fluctuations in the prime rate. Interest rates charged are typically variable and tied to fluctuations in the prime rate. 4. Money market instruments such as treasury bills, commercial and finance company paper, and banker acceptance, are short-term promissory notes issued by major corporations and governments. Most money market securities provide returns by selling at a discount from face value.

Summary 5. A country with lower interest rates will sell at a forward premium relative to the currency of a country with higher interest rates. 6. Factoring entails the sale of accounts receivable. 7. Trade credit is an important source of short- term funds for Canadian business. It arises spontaneously with the purchase of goods if payment is called for sometime after delivery.

Summary 8. Credit terms vary, and can be classified by the timing of called-for payments and the cash discounts provided. Datings, commonly used in seasonal industries, allow delayed payments to stimulate sales during the off-season. 9. Federal programs and agencies that provide term financing include the Business Development Bank of Canada, the Export Development Corporation, and federally guaranteed loan plans such as those extended under the Canada Small Business Financing Act.

Summary 10. Venture capital firms provide money for riskier equity investments that typically entail promising start-up or development situations.