©2012 McGraw-Hill Ryerson Limited 1 of 23 Learning Objectives 1.Characterize trade credit as an important form of short-term financing and calculate its cost to the firm if a discount is forgone (LO1) 2.Describe bank loans as self-liquidating, as short-term, and as having their interest cost tied to the prime rate. Also, calculate interest rates under differing conditions. (LO2)

©2012 McGraw-Hill Ryerson Limited 2 of 23 Bank Credit A self-liquidating loan generates cash flows that form a built-in or automatic repayment scheme. Short-term loans take on the nature of longer-term financing through renewing arrangements. Demand loans are payable (or can be advanced) as desired and the interest rate fluctuates with prime. Prime Rate: – the interest rate charged to a bank’s best customers – acts as a benchmark for calculating other interest rates LO2

©2012 McGraw-Hill Ryerson Limited 3 of 23 Figure 8-2 Prime interest rate movements LO2

©2012 McGraw-Hill Ryerson Limited 4 of 23 Bank Credit Administration Fees and Compensating Balances: in addition to interest, banks often charge set-up fees and administration or review fees often banks require that business customers maintain a minimum average account balance in chequing accounts; a compensating balance “c” (expressed as a decimal). The compensating balance increases the amount to be borrowed, which in turn increases the interest cost. With compensating balances, where: LO2 Amount needed Amount to be borrowed = (1 – c)

©2012 McGraw-Hill Ryerson Limited 5 of 23 Types of Bank Loans Discounted Loan: – when a bank deducts the interest on the loan in advance and lends the balance Instalment Loan: – calls for a series of equal payments over the life of the loan – e.g. most car loans and home mortgages Compensating Balance Loan: – when a compensating balance is required as part of the loan LO2

©2012 McGraw-Hill Ryerson Limited 6 of 23 Cost of Bank Financing In general, the annual interest rate on a bank loan is: Annual interest rate on discounted loan: Interest Costs with Administration Fees or Compensating Balances: Rate on Installment Loans: LO2