Current Liabilities Management Week 7

Spontaneous Liabilities Sources Accounts Payable Accruals (wages and taxes)

Spontaneous Liabilities: Accounts Payable Management Average payment period Payment float time Credit terms Cash discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.) Cost of Giving Up the Cash Discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.) Cost of Giving Up the Cash Discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.) Calculation Supplier Credit Terms X 1/10 net 55 EOM Y 2/10 net 30 EOM Z 2/20 net 60 EOM Calculate the cost of giving up cash discount from each supplier. Assuming that the firm needs short term financing, indicate whether it would be better to give up the cash discount or take it and borrow from bank at 15% annual interest.

Spontaneous Liabilities: Effects of Stretching Accounts Payable Supplier Credit Terms Y 2/10 net 30 EOM Postpone the credit period to 50 days from 30.

Unsecured Sources of Short-Term Loans: Bank Loans Commercial Paper Self-liquidating Types: single-payment notes lines of credit revolving credit agreements.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Loan Interest Rates Prime rate of interest Premium Types of Loans: Fixed Rate Loans Floating Rate Loans

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Method of Computing Interest Nominal rate Effective rate of interest If interest rate is paid at maturity:

Calculation If interest rate is paid at maturity: $10,000, 90 day loan at an interest rate of 15% p.a. payable at maturity. How much interest will be paid on 90 day loan? Find effective 90 day rate on the loan Find the effective annual rate if the loan is rolled over every 90 days throughout the year.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) If the interest is paid in advance (discount loans)

Effective Rate Calculation A financial institution made a $10,000, 1 year discount loan at 10% interest. Determine the effective annual rate associated with this loan.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Single Payment Notes A single-payment note is a short-term, one-time loan payable as a single amount at its maturity.

Calculation Bank A Bank B Loan Amount $100,000 $100,000 Premium Rate 1.5% 1% Interest type Fixed Floating Loan Period 90 days 90 days Prime Rate 9% 9% 9.5% 9.25%

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Line of Credit (LOC) Loan Amount is not guaranteed Floating rate Operating- Change restrictions Compensating Balance Annual Cleanups

Calculation A financial institution made a $10,000, 1 year discount loan at 10% interest, requiring compensating balance equal to 20 % of the face value of the loan. Determine the effective annual rate associated with this loan.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.) Revolving Credit Agreement (RCA) Guaranteed line of credit Commitment fees

Unsecured Sources of Short-Term Loans: Commercial Paper Commercial paper - unsecured promissory note Sold at a discount form par value. 3 to 270 days Interest rate < Prime rate Other costs (rating cost, line of credit, floatation costs etc)

Unsecured Sources of Short-Term Loans: International Loans Exchange Rate Risk Letter of Credit Transactions between Subsidiaries

Secured Sources of Short-Term Loans: Characteristics Collateral does not reduce the riskiness of default on a loan. Life of the loan and maturity of collateral. Loan amount is 30 and 100 percent of the book value of the collateral. rate of interest on secured loans > interest on unsecured debt.

Secured Sources of Short-Term Loans The Use of Accounts Receivable as Collateral Pledging accounts receivable Value adjustment of acceptable A/R accounts lend between 50 and 90 percent of the face value of acceptable receivables. Lien on the collateral Notification Vs Non-Notification Cost of pledge > Prime Rate

Secured Sources of Short-Term Loans (cont.) The Use of Accounts Receivable as Collateral Factoring accounts receivable Factors (credit collection agencies) Loss absorbance Notification basis

Secured Sources of Short-Term Loans (cont.) The Use of Inventory as Collateral Marketability of Inventory Types: Floating Liens – stable inexpensive inventory, <50% of BV, 3% to 5 % above Prime Rate 2. Trust Receipt – Expensive inventory, Lein, 80-100% of BV, 2% or more above Prime Rate 3. Warehouse Receipt – Inventory under lender’s control, 75-90% of BV, 3% to 5 % above Prime Rate, Other costs