1. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-1 Chapter 9 Short-term debt

2. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-2 Learning objectives Overview of the characteristics of various forms of short-term debt –Main types  Trade credit, bank overdraft, commercial and bank-accepted bills, promissory notes, negotiable certificates of deposit, inventory accounts receivable and factoring –Sources –Reasons and patterns of use –Advantages and disadvantages for borrowers and lenders –Calculations relevant to discount securities

3. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-3 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

4. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-4 9.1 Trade credit Short-term debt is a financing arrangement for a period of less than one year with various characteristics to suit borrowers’ particular needs –Timing of repayment, risk, interest rate structures (variable or fixed) and the source of funds Matching principle –Short-term assets should be funded with short-term liabilities –The importance of this principle was highlighted by the GFC (cont.)

5. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-5 9.1 Trade credit (cont.) A supplier provides goods or services to a purchaser with an arrangement for payment at a later date Often includes a discount for early payment (e.g. 2/10, n/30, i.e. 2% discount if paid within 10 days, otherwise the full amount is due within 30 days) From provider’s perspective –Advantages include increased sales –Disadvantages include costs of discount and increased discount period, increased total credit period and accounts receivable, increased collection and bad debt costs (cont.)

6. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-6 9.1 Trade credit (cont.) The opportunity cost of the purchaser forgoing the discount on an invoice (1/7, n/30) is:

7. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-7 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

8. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-8 9.2 Bank overdrafts Major source of short-term finance Allows a firm to place its cheque (operating) account into deficit, to an agreed limit Generally operated on a fully fluctuating basis Lender also imposes an establishment fee, monthly account service fee and a fee on the unused overdraft limit (cont.)

9. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-9 9.2 Bank overdrafts (cont.) Interest rates negotiated with bank at a margin above an indicator rate, reflecting the borrower’s credit risk  Financial performance and future cash flows  Length of mismatch between cash inflows and outflows  Adequacy of collateral Indicator rate typically a floating rate based on a published market rate, e.g. BBSW In some countries overdraft borrower may be required to hold a credit average balance or compensating credit balance

10. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-10 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

11. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-11 9.3 Commercial bills A bill of exchange is a discount security issued with a face value payable at a future date A commercial bill is a bill of exchange issued to raise funds for general business purposes A bank-accepted bill is a bill that is issued by a corporation and incorporates the name of a bank as acceptor (cont.)

12. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-12 9.3 Commercial Bills (cont.) (cont.)

13. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-13 9.3 Commercial Bills (cont.) Features of commercial bills—parties involved (bank- accepted bill) (cont.)

14. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-14 9.3 Commercial Bills (cont.) Features of commercial bills—parties involved (bank- accepted bill) (cont.) –Drawer  Issuer of the bill  Secondary liability for repayment of the bill (after the acceptor) –Acceptor  Undertakes to repay the face value to the holder of the bill at maturity  Acceptor is usually a bank or merchant bank (cont.)

15. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-15 9.3 Commercial Bills (cont.) Features of commercial bills—parties involved (bank- accepted bill) (cont.) –Payee  The specified party to whom the bill is to be paid, i.e. the party who receives the funds  Usually the drawer, but the drawer can specify some other party as payee –Discounter  The party that discounts the face value and purchases the bill  The provider or lender of the funds  May also be the acceptor of the bill (cont.)

16. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-16 9.3 Commercial Bills (cont.) Features of commercial bills—parties involved (bank- accepted bill) (cont.) –Endorser  The party that was previously a holder of the bill  Signs the reverse side of the bill when selling, or discounting, the bill  Order of liability for payment of the bill runs from acceptor to drawer and then to endorser (cont.)

17. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-17 9.3 Commercial Bills (cont.) The flow of funds (bank-accepted bills) (cont.)

18. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-18 9.3 Commercial Bills (cont.) The flow of funds (non-bank bills) –Alternatively, a bill can be drawn by the bank and accepted by the borrower –The bank is both drawer and discounter of the bill  If the bank rediscounts a bill (sells to a third party), the bank becomes the endorser, creating a bank-endorsed bill –Funds are lent to borrower as payee –At maturity date the borrower, as acceptor of the bill, is liable to pay face value to the holder of the bill (cont.)

19. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-19 9.3 Commercial Bills (cont.) Establishing a bill financing facility –Borrower approaches bank or merchant bank –Assessment made of borrower’s credit risk –Credit rating of borrower affects size of discount –Maturity usually 30, 60, 90, 120 or 180 days –Minimum face value usually $100 000 (cont.)

20. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-20 9.3 Commercial Bills (cont.) Advantages of commercial bill financing –Lower cost than other short-term borrowing forms, i.e. overdraft, fully-drawn advances –Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest rates) –A bill line  Arrangement with a bank where it agrees to discount bills progressively up to an agreed amount –Term of loan may be extended by ‘rollover’ at maturity

21. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-21 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

22. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-22 9.4 Calculations: discount securities Calculations considered –Calculating price—yield known –Calculating face value—issue price and yield known –Calculating yield –Calculating price—discount rate known –Calculating discount rate (cont.)

23. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-23 Calculating price—yield known (cont.)

24. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-24 Calculating price—yield known (cont.) Example 3: A company decides to fund its short-term inventory needs by issuing a 30-day bank-accepted bill with a face value of $500 000. Having approached two prospective discounters, the company has been quoted yields of 9.52% per annum and 9.48% per annum. Which quote should the company accept, and what amount will the company raise? (cont.)

25. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-25 Calculating price—yield known (cont.) An alternative formula for calculating price

26. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-26 Calculating face value—issue price and yield known (cont.)

27. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-27 Calculating face value—issue price and yield known (cont.) Example 4: A company needs to raise additional funding of $500 000 to purchase inventory. The company has decided to raise the funds through the issue of a 60-day bank-accepted bill rollover facility. The bank has agreed to discount the bill at a yield of 8.75%. At what face value will the initial bill be drawn?

28. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-28 Calculating yield (cont.)

29. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-29 Calculating yield (cont.) Example 7: In Example 3, a company issued a 30-day bank-accepted bill with a face value of $500 000. The bill was discounted at a yield of 9.48% per annum, representing a price of $496 134.23. After seven days the discounter sells the bill in the short-term money market for $497 057.36. The bill is not traded again in the market. Calculate the yield to the original discounter and to the holder at maturity. (cont.)

30. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-30 Calculating yield (cont.) Yield to original discounter: Yield to holder at maturity:

31. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-31 Calculating price—discount rate known (cont.)

32. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-32 Calculating price—discount rate known (cont.) Example 8: The price of a 180-day bill, with a face value of $100 000, selling at a discount of 14.75%, would be: –The discount in this formula is effectively the rate of return to the buyer of the bill (or the cost of funds to the drawer of the bill), expressed as a percentage per annum, in relation to the face value of the bill.

33. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-33 Calculating discount rate (cont.)

34. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-34 Calculating discount rate (cont.) Example 9: A 180-day bill with a face value of $100 000 and selling currently at $92 000, with a full 180 days to run to maturity, has a discount rate of:

35. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-35 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

36. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-36 9.5 Promissory notes Also called P-notes or commercial paper, they are discount securities, issued in the money market with a face value payable at maturity but sold today by the issuer for less than face value Typically available to companies with an excellent credit reputation because: –there is no acceptor or endorser –they are unsecured instruments (cont.)

37. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-37 9.5 Promissory notes (cont.) Calculations—use discount securities formulae Issue programs –Usually arranged by major commercial banks and money market corporations –Standardised documentation –Revolving facility –Most P-notes are issued for 90 days  By tender, tap issuance or dealer bids (cont.)

38. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-38 9.5 Promissory notes (cont.) Underwritten issues –Underwriting guarantees the full issue of notes is purchased and typical fee is 0.1% per annum –Underwriter is usually a commercial bank, investment bank or merchant bank –The underwritten issue can incorporate a rollover facility, effectively extending the borrower’s line of credit beyond the short-term life of the P-note issue Issues may also be non-underwritten –Issuer may approach money market directly –Commercial bank, investment bank or merchant bank may be retained as lead manager and receive fees

39. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-39 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

40. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-40 9.6 Negotiable certificates of deposit Short-term discount security issued by banks to manage their liabilities and liquidity Maturities range up to 180 days Issued to institutional investors in the wholesale money market The short-term money market has an active secondary market in CDs Calculations—use discount securities formulae

41. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-41 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

42. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-42 9.7 Inventory finance, accounts receivable financing and factoring Inventory finance –Most common form is ‘floor plan finance’ –Particularly designed for the needs of motor vehicle dealers to finance their inventory of vehicles  Bailment common—finance company holds title to dealership’s stock –Dealer is expected to promote financier’s financial products (cont.)

43. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-43 9.7 Inventory finance, accounts receivable financing and factoring (cont.) Accounts receivable financing –A loan to a business secured against its accounts receivable (debtors) –Mainly supplied by finance companies –Lending company takes charge of a company’s accounts receivable; however, the borrowing company is still responsible for the debtor book and bad debts (cont.)

44. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-44 9.7 Inventory finance, accounts receivable financing and factoring (cont.) Factoring –Company sells its accounts receivable to a factoring company  Converting a future cash flow (receivables) into a current cash flow –Factoring provides immediate cash to the vendor; plus it removes administration costs of accounts receivable –Main providers of factor finance are the finance companies –Factor is responsible for collection of receivables (cont.)

45. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-45 9.7 Inventory finance, accounts receivable financing and factoring (cont.) Factoring (cont.) –Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be made to the factor –Recourse arrangement  Factor has a claim against the vendor if a receivable is not paid –Non-recourse arrangement  Factor has no claim against vendor company

46. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-46 Chapter organisation 9.1Trade credit 9.2Bank overdrafts 9.3Commercial bills 9.4Calculations: discount securities 9.5Promissory notes 9.6Negotiable certificates of deposit 9.7Inventory finance, accounts receivable, financing and factoring 9.8Summary

47. Copyright  2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips Slides prepared by Peter Phillips 9-47 9.8 Summary Short-term debt is appropriate for funding short-term assets (matching principle) Trade credit—simple and common Bank overdraft—common Discount securities –Bill financing—important source of funds –Promissory notes (P-notes)—good credit rating required –Certificates of deposit (CDs)—issued by banks to manage liabilities and liquidity Inventory loans, accounts receivable finance and factoring—alternative sources of finance for small and medium-sized businesses (SMEs)