CORPORATE FINANCE

CHAPTER 3 SHORT-TERM FINANCE DECISIONS

Copyright 2011, AZEK/ILPIP

CORPORATE FINANCE Copyright 2011, AZEK/ILPIP All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AZEK/ILPIP.

Table of contents
3.
3.1 3.1.1
3.1.1.1 3.1.1.2

Short-term Finance Decisions*.................................................................................... 1

Short-term Financing* ................................................................................................................... 1 Current Asset Financing* .............................................................................................................. 1
Needs for working capital* .......................................................................................................................2 Components of net working capital* ........................................................................................................2

3.1.2
3.1.2.1 3.1.2.2

Short-term Financing*................................................................................................................... 3
Short-term financing resources* ...............................................................................................................5 Short-term financial planning models* .....................................................................................................6

3.2 3.2.1

Cash Management* ...................................................................................................................... 12 Credit Management* ................................................................................................................... 12

Commercial credit instruments* .............................................................................................................12 Credit decision* ......................................................................................................................................12 3.2.1.1 3.2.1.2

3.2.2
3.2.2.1 3.2.2.2 3.2.2.3

Cash Management* ..................................................................................................................... 16

Target cash balance models* ..................................................................................................................17 Cash conversion cycle*...........................................................................................................................20 Investing idle cash balance* ...................................................................................................................23

3.3 3.3.1

Short-term Lending and Borrowing*.......................................................................................... 24 Short-term Lending* ................................................................................................................... 24

Money markets* .....................................................................................................................................24 Alternatives to money markets* .............................................................................................................25 3.3.1.1 3.3.1.2

3.3.2
3.3.2.1 3.3.2.2

Short-term Borrowing* ............................................................................................................... 26

Credit rationing* .....................................................................................................................................26 Secured and unsecured loan*..................................................................................................................27

* final level

Corporate Finance

3. Short-term Finance Decisions* 3.1 Short-term Financing*

Short-term finance is primarily concerned with decisions that affect current assets and current liabilities as well as the liquidity management of the company. As insufficient liquidity leads to insolvency, the short-term finance or liquidity management is of great importance to every company. Many sources of short-term financing are available to a firm. The choice of the source depends upon a careful consideration of factors such as cost, matching, availability and flexibility. A firm in its infancy may only use a limited number of short-term financing sources. As the firm grows and its operations expand, it must consider many sources of shortterm financing to ensure adequate financing of current assets.

3.1.1 Current Asset Financing*

Typically, a company does not purchase all assets at once, but does so gradually over time. The total cost of a companys assets is called the firms cumulative capital requirement. Most companies cumulative capital requirement grows irregularly, but with a typical seasonal pattern, which is shown in Figure 3-1. The line for a growing firm normally shows an upward trend with seasonal variations. In addition, there are unpredictable week-to-week and month-to-month fluctuations, which are not shown in the figure. CHF seasonal variation of current assets

cumulative capital requirement

capital requirement for fixed and permanent current assets time Figure 3-1: Total capital requirement Short-term or current assets and liabilities form an important part of the balance sheet of a firm. The funds invested in these short-term assets/liabilities are called the working capital of the firm. Thus, working capital management relates to the management of short-term or current assets and liabilities.
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Corporate Finance 3.1.1.1 Needs for working capital* Working capital management deals with various issues affecting day-to-day management of the firm. On the asset side, working capital management handles the following areas: Liquidity management Cash management Credit management (Management of accounts receivable) Inventory management

On the liabilities side, working capital management deals with issues such as: Management of trade credit (accounts payables) Raising short-term financing

Net working capital (NWC) is an important variable in short-term finance decision-making. Net working capital is defined in the following formula:

Net working capital = Current assets - Current liabilities

Alternatively, net working capital is that part of current or short-term assets which is financed with long-term capital. (This definition can be easily understood referring to Figure 3-2) The larger the proportion of short-term finance on the liabilities side of the balance sheet, the lower the NWC will be. Such a firm will be exposed to the fluctuations of short-term interest rates, frequent refinancing and the negative consequences of a deteriorating credit quality. On the other hand, a firm with larger NWC will have financed most of its current assets with long-term financing and thus will not have to face the need for frequent refinancing. If NWC<0, it means that the firms current liabilities are greater than its current assets. This implies that the firm will not be able to raise enough cash from short-term assets to meet the short-term liabilities giving rise to liquidity problems. In such circumstances, the firm has the following options: 1) Control and reduce the investment in inventory. 2) Re-examine and tighten up on credit and thus reduce the firms accounts receivable. 3) Increase long-term debt or issue equity to meet the liquidity crunch. 3.1.1.2 Components of net working capital* Net working capital as defined in the previous section is the difference between the current assets and current liabilities of a firm. Current assets are normally defined as cash and other assets that are expected to be converted into cash within one year. The most important items of the current assets are cash, marketable securities (or cash equivalents), accounts receivable, and inventory. Current liabilities are obligations that are expected to require cash payments within one year (or within the operating period if it is different from one year). The major items found as current liabilities are accounts payable, expenses payable (including accrued wages and taxes), and notes payable. As the cash management is influenced by any change in the balance sheet, it is useful to define cash in terms of the other balance sheet positions.

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Corporate Finance Long-term debt Equity Current liabilities Non-cash current assets Fixed assets Cash

+ + = Figure 3-2 illustrates this definition:

Assets cash

Liabilities + Equity

current liabilities non-cash current assets

net working capital

long-term liabilities

fixed assets equity

Figure 3-2: Main elements of the balance sheet

3.1.2 Short-term Financing*

The short-term financial policy determines: The size of the investment in current assets: It can be measured relative to the firms level of total operating revenues. A flexible or accommodative or conservative shortterm financial policy would maintain a relatively high ratio of current assets to sales. A restrictive or aggressive short-term financial policy would entail a low ratio of current assets to sales. The financing of the short-term assets: It can be measured as the proportion of shortterm debt (or current liabilities) and long-term debt used to finance current assets. A restrictive short-term financial policy means a high proportion of short-term debt relative to long-term financing, and a flexible (conservative) policy means less shortterm financing and more long-term debt.

As a flexible policy means a relatively large investment in current assets financed with relatively little short-term debt, the net effect of a flexible policy is a relatively high level of net working capital. When long-term capital covers more than the total capital requirements, the firm has surplus cash available for investment in marketable securities. The flexible policy in Figure 3-3 implies a short-term cash surplus and a large investment in net working capital.
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Corporate Finance

CHF investment in marketable securities and cash

long-term funds

total capital requirement

time Figure 3-3: Flexible short-term financial policy When the long-term financing does not cover the total capital requirement, the firm must borrow on a short-term basis to make up the deficit. In Figure 3-4 the restrictive policy implies a persistent need for short-term borrowing. Whenever current assets rise because of seasonal variations, the firm borrows on a short-term basis to finance the growth. As these assets are converted into cash, the firm repays the short-term debt out of the proceeds. Thus, the amount of long-term financing raised, given the cumulative capital requirement, determines whether the company is a short-term borrower or lender.

CHF short term financing total capital requirement

long-term funds

time
Figure 3-4: Restrictive short-term financial policy When current assets are financed only by short-term debt and fixed assets only by long-term debt and equity, the net working capital is always zero. But normally companies do not match maturities strictly. The optimal financing mix depends mainly on the specific characteristics of the company and the industry.

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Corporate Finance 3.1.2.1 Short-term financing resources* The main source of short-term finance for a firm is the trade credit. Trade credit represents the credit extended to the firm by its suppliers. This is a spontaneous source of financing. The firm does not actively seek this sort of financing, but it arises out of normal business activities of the firm. As the business activity expands, the financing provided by trade credit also increases. Trade credit will be available to any firm which is deemed creditworthy by its suppliers. Thus, to obtain trade credit, the firm must possess: a) b) c) d) a good earnings record over time; liquidity; past record of prompt payments; a good relationship with suppliers.

A well-established firm with the above characteristics will have no difficulties in securing trade credit. The best part of financing provided by trade credit is that it is cost-free to the firm. For example, if the firm is offered terms of Net 30, it implies that suppliers are lending the firm the funds owed to them for 30 days without any interest. The main decision so far as the trade credit is concerned arises when the suppliers offer discount if payment is made early. In such cases, the firm must carefully consider the cost of not taking cash discounts. The cost of not taking cash discount can be calculated as follows, assuming that the firm enjoys the terms of 2/10N30:
CHF 100 CHF 98 CHF 100

Day 0

Day 10

Day 30

The purchase of goods worth CHF 100 occurs on day 0. The firm has two options for payment: pay CHF 98 on day 10 or pay CHF 100 on day 30. If the firm decides not to take cash discount (CHF 100 CHF 98 = CHF 2), then it effectively borrows CHF 98 on day 10 against the commitment to repay CHF 100 on day 30. Thus, the firm takes out a loan of CHF 98 and pays interest of CHF 2 on the loan for a period of 20 days. The annualised cost of this loan can be calculated as:

r=

2 360 100% = 36.73% 98 20

Using similar calculations, we can determine the implicit cost of not taking cash discount for several credit terms:

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Corporate Finance
Credit terms 1/10 Net 20 2/10 Net 45 3/10 Net 60 2/15 Net 45 2/10 Net 30 Cost of not taking cash discount (%) 73.40 21.00 22.30 24.50 36.70

Table 3-1: Credit terms and Cash discount From the above table, it is clear that the cost of not taking cash discount always exceeds the borrowing costs of the firm. Thus, when suppliers offer cash discounts to a firm: a firm with no financial constraints must always take cash discount. Accepting the option of cash discount will allow the firm to reduce its costs. a firm which cannot raise funds to take cash discounts must pay only at the end of the credit period or a little bit later.

Trade credit has many advantages to a firm. First, as mentioned above, it is available as a normal part of business and no restrictive conditions are imposed on the firm. Second, it is a flexible form of financing which automatically expands or contracts depending on the business activity of the firm. Finally, it is free and can even allow the firm to reduce its cost or purchases by taking cash discounts. Firms can also raise short-term funds from commercial banks as well as money markets. The various types of financing methods available to a firm from these sources are described in section 3.3.2. 3.1.2.2 Short-term financial planning models* 3.1.2.2.1 Cash Budgeting* Cash budgeting is an important tool in the arsenal of the short-term financial planner. It allows the short-term financial planner to identify his needs (and opportunities). It will show how much the financial planner needs to borrow in the short-run. It is simply the cash flow gap on the cash-flow time line. The cash budget records the estimates of the cash receipts (inflows) and disbursements (outflows). Cash budget allows the financial planner to be alert to the firms future cash needs or surpluses. It also provides a standard against which subsequent performance can be judged. In preparing a cash budget, it is necessary to include all inflows and outflows expected by the firm. To do this, a detailed analysis of past cash flows is needed. Although the future cannot be expected to be exactly like the past, a thorough examination of the past cash flow trends is the first step in effective cash flow forecasting by means of a cash budget. The major items to be considered when estimating a cash budget are the following:

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Corporate Finance Cash Inflows * * * * * * * * Cash sales * Collection of accounts receivable * Income from investments * Income from subsidiaries * Dividends from international ventures * Sale of assets * Sale of securities * Loans * * Cash Outflows Cash Purchases Payment of accounts payable Wages and salaries Rent,insurance and utilities Advertising,selling,and other related cash expenses Taxes(local,state,federal, and international) Capital investments Interest and dividends Repayment of loans

Table 3-2: Items in cash budgeting Let us take an example to see how a cash budget can be prepared.
Example:1 This is Cadbury Schweppess quarterly forecast for next years cash inflows from the sale of confectionery:
Q1 1'000 Q2 2'000 Q3 1'500 Q4 1'000

Sales (GBP million)

Cadbury Schweppess sales are seasonal and are usually very high in the second quarter, due to Christmas sales. But the company sells to superstores on credit, so sales do not generate immediate cash. Cash comes later on collection of accounts receivable. Cadbury Schweppes has a 90-day collection period, and hundred percent sales are collected the following quarter. Symbolically:
Collections = Last quarters sales this means that, Accounts receivable at the end of last quarter = Last quarters sales For our calculation purpose, we assume the sales in the fourth quarter of the previous year were GBP 1000 million. From the equation above: Accounts receivable at the end of Q4 of previous year = GBP 1000 million and thus the collections for the Q1 = GBP 1000 million. Thus the equation:
Ending accounts receivable = starting accounts receivable + sales collections = 1'000 + 1000 1000 = GBP 1000 million The table below shows the cash collections for the next four quarters. In our simplified example the only source of cash is collections, which need not always be the case. Other sources are listed under column cash inflows.
Sources of cash (GBP million) Q1 Q2 Q3 1'000 2'000 1'500 Sales 1'000 1'000 2'000 Cash collections 1'000 1'000 2'000 Starting receivables 1'000 2'000 1'500 Ending receivables

Q4 1'000 1'500 1'500 1'000

The example is partly adapted from Ross/Westerfield/Jaffe (1999), pp. 703-706.

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Corporate Finance
Next, we consider the cash outflows. They can be classified into four basic categories: 1. Payments of Accounts Payable: These are payments for goods and services, such as raw materials. These payments will generally be made after purchases. Purchases will depend on the sales forecast. In the case of Cadbury Schweppes we assume that
Payments = Last quarters purchases Purchases = next quarters sales forecast 2. Wages, Taxes and Other Expenses: This category includes all other normal costs of doing business that require actual expenditures. Depreciation, for example, is often thought of as a normal cost of business, but it requires no cash outflow. 3. Capital Expenditures: These are payments of cash for long-lived assets. Cadbury Schweppes plans a major capital expenditure in the fourth quarter. 4. Long-term Financing: This category includes interest and principal payments on long-term outstanding debt and dividend payments to shareholders. The table below gives the total forecasted outflow.
Cash outflows (GBP million) Q1 Q2 1'000 2'000 1'000 750

Sales Purchases

Q3 1'500 500

Q4 1'000 500*

Uses of cash Payments of accounts payable Wages, taxes and other expenses Capital expenditures Long-term financing expenses Total uses of cash

500 200 0 100 800

1'000 400 0 100 1'500

750 300 0 100 1'150

500 200 1'000 100 1'800

* The projected sales in Q1 of the next year are GBP 1'000 million

Finally, we prepare the cash balance. Cadbury Schweppes wants to keep a minimum cash balance of GBP 25 million to facilitate transactions, protect against unexpected contingencies, and maintain compensating balances at its commercial banks. From the cash balance table below, we can see there is a large net cash outflow in Q2. This large outflow is not caused by the companys inability to earn profits; rather it is a result of delayed collections on sales. This leads to a cumulative cash shortfall of GBP 300 million in Q2, and in a finance deficit requirement of GBP 325 million (due to the minimum cash balance of GBP 25 million).
Total cash receipts ./.Total cash disbursements Net cash flow from operations ./. Minimum cash balance Cash required for operations Cumulative excess cash balance Minimum cash balance Cumulative finance surplus (deficit) requirement 1000 800 200 25 175 200 25 175 1000 1500 -500 25 -525 -300 25 -325 2000 1150 850 25 825 550 25 525 1500 1800 -300 25 -325 250 25 225

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Corporate Finance 3.1.2.2.2 The Short-Term Financial Plan* The above table shows that Cadbury Schweppes cannot meet the forecasted cash outflows in the second quarter from internal sources. Its financing options include (1) unsecured bank borrowing, (2) secured borrowing, and (3) stretching payables. 1) Unsecured Loans: The most common way to finance a temporary cash deficit is to arrange a short-term unsecured bank loan. Cadbury Schweppes can do this by asking its bank for an uncommitted or a committed line of credit. A non-committed line is an informal arrangement that allows the company to borrow up to a previously specified limit without going through the normal paperwork. The interest rate charged by the bank is the banks prime lending rate plus an additional percentage (in our case, it is 15 percent). The bank also requires Cadbury Schweppes to maintain a compensating balance equal to 10 percent on the line of credit. In effect it means that Cadbury Schweppes will have to borrow GBP 361.1 million to cover the finance deficit of GBP 325 million in Q2 (325/0.9). Also, the stated interest rate of 15 percent per annum comes to GBP 54.2 million (0.15 361.1). The effective interest rate is equal to 16.67 percent (54.2/325). Committed lines of credit are formal legal arrangements and usually involve a commitment fee paid by the firm to the bank. For larger firms, the interest rate is often tied to the London Interbank Offered Rate (LIBOR) or to the banks cost of funds, rather than the prime rate. For Cadbury Schweppes it is a non-committed line of credit. 2) Secured Loans: The other option with Cadbury Schweppes is to take a secured loan. The security for the loan usually consists of accounts receivable financing or inventories. Under accounts receivable financing, receivables are either assigned or factored. Under assignment, the lender not only has a lien on the receivables but also has recourse to the borrower. Factoring involves the sale of accounts receivable. The purchaser, who is called a factor, must then collect on the receivables. The factor assumes the full risk of default on bad accounts. As the name implies, an inventory loan uses inventory as collateral. Some common types of inventory loans are: Blanket Inventory Lien: The blanket inventory lien gives the lender a lien against all the borrowers inventories. Trust Receipt: Under this arrangement, the borrower holds the inventory in trust for the lender. The document acknowledging the loan is called the trust receipt. Proceeds from the sale of inventory are remitted immediately to the lender. Cadbury Schweppes can get up to 90 percent against its accounts receivable from a nonbank finance company at an interest rate of 15 percent. In turn it has to pledge its accounts receivable as security. 3) Stretching Payables: In this plan Cadbury Schweppes can defer its accounts payable to have more cash for the quarter when the financing is required. But even if no goodwill is lost, stretching payables is costly as most of the suppliers offer discounts for quick payment. Thus if Cadbury Schweppes defers the payments it loses this discount which is 5 percent of the deferred amount.

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Corporate Finance Below is the model prepared if Cadbury Schweppes goes for the unsecured loan and stretching of accounts payable. We assume that the company can borrow only up to an amount of GBP 300 million by credit line. To cover the cumulative finance deficit requirement of GBP 325 million in Q2, Cadbury Schweppes must stretch therefore the payables.
Q1 1 2 3 4 5 6 7 New borrowing Line of credit Stretching payables Total (1 + 2) Repayments Line of credit Stretched payables Total (4 + 5) Total cash raised (3 - 6) Cash required Interest on line of credit (15% p.a. = 0.15/4 p.q.) Interest on stretched payables (5% of the stretched amount) Less interest on marketable securities (given) Net interest paid (8 + 9 - 10) Additional funds for compensating balance* Cash required for operations (above table) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Q2 300.0 52.4 # 352.4 0.0 0.0 0.0 352.4 Q3 0.0 0.0 0.0 300.0 52.4 352.4 -352.4 Q4 0.0 0.0 0.0 0.0 0.0 0.0 0.0

8 9 10 11 12 13

0.0 0.0 1.3 -1.3 0.0 -175.0 -176.3 -176.3 0.0 176.3

0.0 0.0 1.3 -1.3 5.0 525.0 528.7 528.7 352.4 176.3 0.0

11.3 2.6 1.3 12.6 -5.0 -825.0 -817.4 -817.4 -352.4 0.0 465.0

0.0 0.0 1.3 -1.3 0.0 325.0 323.7 323.7 0.0 465.0 141.3

14 Total cash required (11 + 12 + 13) 15 Total cash required (14) 16 Total cash raised (7) 17 Total cash balance previous quarter 18 Total cash balance (-15 + 16 + 17)

# GBP 52.4 million = total cash required in Q2 (GBP 528.7 million) - credit line in Q2 (GBP 300 million) - total cash balance in Q1 (GBP 176.3 million). *Amount required to maintain the compensating cash balance of 10% of the credit line in excess to GBP 250 million. Cadbury Schweppes' GBP 25 million minimum cash balance serves as compensating balance for the credit line up to GBP 250 million (25/0.1).

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Corporate Finance Now, if Cadbury Schweppes goes for secured loan against its receivables:
Q1 New borrowing 1 Secured loan Repayments 2 Secured loan 3 Total cash raised (1 - 2) Cash required Interest on secured loan (15% p.a. = 0.15/4 p.q.) Less interest on marketable securities (given) Cash required for operations 0.0 0.0 0.0 Q2 347.4 0.0 347.4 Q3 0.0 347.4 -347.4 Q4 0.0 0.0 0.0

4 5 6

0.0 1.3 -175.0 -176.3 -176.3 0.0 176.3

0.0 1.3 525.0 523.7 523.7 347.4 176.3 0.0

13.0 1.3 -825.0 -813.3 -813.3 -347.4 0.0 465.9

0.0 1.3 325.0 323.7 323.7 0.0 465.9 142.2

7 Total cash required (4 - 5 + 6) 8 Total cash required (7) 9 Total cash raised (3) 10 Total cash balance previous quarter 11 Total cash balance (-8 + 9 + 10)

Q1 Interest payments 1st plan (GBP million) Interest payments 2nd plan (GBP million) -1.3 -1.3

Q2 -1.3 -1.3

Q3 12.6 11.7

Q4 -1.3 -1.3 Difference

Total 8.7 7.8 0.9

From the above tables, we can see that if Cadbury Schweppes goes for the line of credit method and stretching payables it will be raising more capital and paying more interest than when it opts for secured loans. The savings in interest payments it is able to achieve is GBP 900000. Analysis of the above models will show that in the case of secured loans, no compensating balance has to be kept and every GBP borrowed can be spent. Further, in the case of stretching payables, the cost is higher at 20 percent per annum. If there is a cash shortfall for many periods, this policy of stretching payables will become very costly. Fortunately, the task of creating such models has been delegated to the computer. Small companies use spreadsheet models while larger firms use stand-alone software or Enterprisewide solutions to create such models. The whole emphasis is to minimize costs, keeping in mind the other constraints like goodwill lost, various sources of finances available etc.

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Corporate Finance

3.2 Cash Management* 3.2.1 Credit Management*

Credit management activity relates to the management of a firms accounts receivable. Accounts receivable form a significant part of a firms current assets and thus, the credit management can have a great impact on the firms cash flows and thus, shareholders wealth. 3.2.1.1 Commercial credit instruments* The following are some commonly used commercial credit instruments, in order to ensure recovery of receivables. Promissory note Commercial draft Trade acceptance / Bank acceptances Letter of credit

Promissory note: This is a straightforward IOU (I Owe You), that is, a written promise to pay the borrowed amount with interest on a specified date, signed by the customer. It prevents any arguments about the existence of the debt.
Example: Zurich April1, 1999
Sixty days after date I promise to pay to the order of the XYZ Company one thousand Swiss Francs (CHF 1000.00) for the value received. Signature

Commercial draft: The seller draws a draft ordering payment by the customer and sends this draft to the customers bank together with the shipping documents. If immediate payment is required, the draft is termed as a sight draft; otherwise it is known as a time draft. Trade acceptance /Bank acceptance: In the case of a time draft, the customer acknowledges the debt by adding the word accepted and signs the draft. This is a trade acceptance which is forwarded by the bank to the seller. In the case of the seller suspecting the buyer, the seller may ask the customer to arrange for the bank to accept the time draft. Thus, when the bank guarantees the customers debt, it is known as bank acceptance. Letter of credit: In case of exports, the exporter generally requires the importer to arrange for a letter of credit to assure the payment. 3.2.1.2 Credit decision* Credit management activity involves the following decisions: a) The decision to grant credit b) The terms and conditions of credit sales c) Monitoring of accounts receivable

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Corporate Finance 3.2.1.2.1 The decision to grant credit: When a customer approaches a firm with a request to be granted credit, the firm will undertake a credit analysis for the particular customer. Credit analysis will allow a firm to identify the customers creditworthiness and paying potential. Credit analysis requires financial information regarding the customer and also the payment history of the customer. The financial information can be obtained by requesting the customer to furnish financial statements for the recent past, or through the customers bank. The customers payment history can be ascertained through credit reports by credit rating agencies such as Dun and Bradstreet or TRW (in the U.S.) Once all the information has been collected, the firm will classify the customer as either high risk, moderate risk, or low risk customer. The decision whether to extend credit to this class of customers is made using the Net Present Value (NPV) technique. Due to the extension of credit, the firm has to make a one-time investment of NINV, which is calculated as:

NINV = VCR S
where:

ACP 365

VCR variable cost ratio, i.e., ratio of variable costs to sales S annual sales to the new customer group ACP average collection period in days for the new group The investment made by the firm in granting credit is based on the assumption of 365 days in a year. The annual net cash flows received by the firm will depend upon the contribution from the incremental sales to new customers, bad debt losses expected, and the incremental expenses incurred by the firm to monitor and manage the new customers. The net cash flows after taxes will be:
NCF = [S (1 VCR) BDL S ADEXP ] (1 T) where: NCF BDL ADEXP T net cash flows after taxes bad debt losses as percentage of sales additional annual expenses incurred by the firm tax rate

Thus, the relevant cash flows related to the credit decision can be graphed as follows:
-NINV

NCF

NCF

NCF

NCF

NCF .

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Corporate Finance Finally, the credit extension decision will be based on the NPV of the above perpetual cash flow stream.

NPV =

NCF NINV k

In the above formula, k is the discount rate determined by the risk of the customer class. If the NPV happens to be positive, the new class of customers will be extended credit, otherwise not. The use of the above techniques is illustrated in the following example:
Example: Aventis, the large European pharmaceutical company, is considering extension of credit to a new group of customers. It is expected that the annual sales to this new customer group will be EUR 750000. This group will, on average, pay their bills after 60 days. The bad debt losses are expected to be 9% of the sales. The credit and collection department expenses will increase by EUR 45000 if credit is extended to this group. If the company pays taxes at the rate of 40% and its variable costs are 80% of sales, should it extend credit to this group? The risk of the customer group requires a discount rate of 16%. Solution: The net investment made by the firm in extending credit is
NINV = VCR S ACP 60 = 0.80 750000 = EUR 98630.14 365 365

The recurring annual cash flows, NCF, are

NCF = 750000 (1 0.80 ) 0.09 750000 45000 (1 0.40 ) = EUR 22500 Thus, the NPV is NPV = NCF 22'500 - NINV = 98'630.14 = EUR 41'994.86 k 0.16

Since the net present value of the decision to extend credit is positive, the new group of customers should be extended credit.

3.2.1.2.2 The terms and conditions of sale: The credit policy is an important tool that a firm possesses in a competitive market. Usually, all the firms in an industry follow similar credit policy. In slack time, generous credit policies are followed to generate demand for the firms product. When the demand for the firms product is brisk, tight credit policies may be followed. A good example of this behaviour can be found in the consumer credit offered by the U.S. automobile firms. To generate demand during slack times, these firms offer credit to the buyers at ridiculously low interest rates.
If the sales are deemed to be risky, the firm usually demands cash on delivery or COD. Ordinary trade credit is granted on terms of payment after 30 or 60 days. During a recessionary period, a firm may offer cash discounts to encourage early payments. The usual terms are described as 2/10 N/30: these terms state that the customer can avail of a 2% discount if the payment is made within ten days of purchase, otherwise the payment is due within 30 days.
Example: Suppose U.S. powerhouse General Electric usually does not grant credit to its customers, meaning that it demands cash on delivery. Because of the request of an important client, GE calculates the impact of granting a 2/10 N/30. Assume that GEs cost of debt capital is 10% and the clients payment amounts to USD 10 million. Would a 2/10 N/30 policy hurt GE?
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Solution: The present value under the current terms (N/30) and the proposed terms (2/10 N/30), respectively, look as follows:
USD 10 million = USD 9'918'478 1 + (0.1 30/365) USD 10 million (1 - 0.02 ) Proposed Policy: PV = = USD 9'773'224 1 + (0.1 10/365)

Current Policy: PV =

Granting a discount of 2% would, thus, cost GE 9918478 9773224 = USD 145254. GEs calculations, however, dont stop here. Granting credit may very well have side effects one has to take into account. Lets assume that the client will increase his order size by 10% and GEs operating costs are USD 0.50 per USD 1 of sales. Whats the impact of the credit policy now?

Solution:
Current Policy: NPV = 5'000'000 + USD 10 million = USD 4'918'478 1 + (0.1 30/365) USD 11 million (1 - 0.02 ) = USD 5'250'546 Proposed Policy: NPV = 5'500'000 + 1 + (0.1 10 /365)

As one can see, GE would be better off by USD 332068 if it adopted the new policy.

An industry may have unique credit arrangements due to the nature of its business. A large chunk of sales in the toys industry, for example, is during the month preceding Christmas. Though toys companies may produce toys and ship them to toy outlets, the system of seasonal dating is used in extending credit. This allows the buyer to pay for the goods after the peak season. Monitoring receivables: The decision to extend credit to customers brings along with it the added burden of making sure that all outstanding bills are collected in a timely fashion. To guarantee that bills are collected on time without significant bad debts, collection departments are established. The collection department is responsible monitoring and following up on accounts receivable. Two techniques are often used in monitoring accounts receivable. The simplest technique is to monitor on a continuous basis the average collection period (ACP) and take steps to ensure that the ACP does not increase beyond a desired level. ACP is defined as

ACP =

Average Receivables 365 Credit sales

While this technique is easy to use, it has certain drawbacks. It is an aggregate measure and thus does not indicate individual differences among customers. ACP is susceptible to changes in the sales pattern. If the sales decrease, ACP will show an increase. Similarly, if the payments are delayed, ACP will increase. Thus, an increase in ACP may be one of the two factors. Obviously, ACP is not an ideal measure for internal monitoring of receivables. A preferred alternative is the receivables pattern approach. Receivables pattern is the percentage of credit sales that remain outstanding in the month of the sales and subsequent months. Each months credit sales are monitored separately. Thus, if the sales from January are still uncollected by the end of March, the firm knows that the collection effort has to be increased to collect January sales. The receivables pattern is unaffected by changes in sales and therefore preferable to the ACP monitoring approach.
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3.2.2 Cash Management*

Cash is defined as the balance in a firms demand deposits and currency on hand. The balances in demand deposits and cash on hand are unproductive assets of the firm, as these assets do not earn any interest. According to John Maynard Keynes, a firm has to maintain an adequate amount of cash for the following reasons: The speculation motive is the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases that might arise, attractive interest rates and favourable exchange rate fluctuations. The precautionary motive is the need to hold cash as a safety margin to act as a financial reserve. The transaction motive is the need to hold cash to satisfy normal disbursement and collection activities with a firms ongoing operations. As cash inflows and outflows are not perfectly synchronised, some level of cash holdings is necessary to serve as a buffer. Perfect liquidity is the characteristic of cash that allows it to satisfy the transaction motive. The interest lost to the firm because of the need to maintain a certain level of cash can be viewed as the opportunity cost of keeping cash. Because of the opportunity cost, the basic objective of cash management is to keep the level of cash as low as possible while ensuring that the firm does not suffer from liquidity problems. This goal usually translates to Collect early and pay late. Ways of accelerating collections and managing disbursements can be seen as an integral part of cash management. The cash management function in a business firm is concerned with the following areas:

Cash collection procedures: The importance of the cash collection process for a business firm varies in direct proportion to its size. Small, local firms may be able to survive with simple cash collection procedures. But large, national firms must be able to design an efficient system to collect cash from all their customers and make timely payments to their suppliers while maintaining adequate liquidity at all times. To speed up collections and to reduce the float (delay in collection), firms use a variety of techniques, some of which are listed below:
Decentralised collection system Pre-authorised cheques Special handling Payments by wire transfer

Determination of optimal cash balance: A firm has to maintain a cash balance for a variety of reasons described previously. The cash balances are maintained either in the form of demand deposits or checking accounts which receive no interest or as currency on hand. Thus, large cash balances will ensure that the firm is liquid at all times, but the cost of holding large cash balances in the form of foregone interest will be correspondingly high. On the other hand, low cash balances will reduce the foregone interest, but will increase the risk that the firm may not have adequate cash to meet its obligations. Models used for the determination of optimal cash balance are discussed in the next section.

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Corporate Finance

Cash disbursement techniques: While cash collection techniques are designed to speed up the collection of cash by reducing float, the cash disbursement procedures are structured so that the firm can delay payments as far as possible without incurring the displeasure of its suppliers. The payment must always be just before the due date. Paying earlier only incurs the opportunity cost in the form of foregone interest earnings. Management of marketable securities portfolio: The Management of marketable securities portfolio involves intelligently investing the idle funds or surplus cash available with the firm. 3.2.2.1 Target cash balance models* Target cash balance models are used to calculate the optimal cash balance a firm needs. The Baumol model and the Miller-Orr model discussed below. 3.2.2.1.1 Baumol Model* The firm will have to strike the right balance between minimising the opportunity cost of foregone interest and the low risk of large cash balances. The Baumol model allows the firm to determine the optimal cash balances by making certain assumptions about the firms cash inflows and outflows.
The model is based on the assumption that firms have a choice of maintaining the available cash as either a non-interest earning demand deposit or as an investment in marketable securities portfolio. The larger the cash balance in the demand deposit, the larger the foregone interest earnings (opportunity cost). These are shown in the above figure as the upward sloping straight line. On the other hand, smaller cash balances will lead to frequent transfers from the marketable securities portfolio. Every time funds are to be transferred from marketable securities to cash, the firm incurs a fixed expense (such as brokerage commissions and costs of placing an order with the broker), called the conversion cost. The more frequent such transfers, the larger the total conversion cost. The conversion costs will thus decline as the cash balance increases. These are shown in the figure below as the down-sloping curve. The U-shaped curve is the sum of the two costs.

chapter 3 / page 17

Corporate Finance
Costs of holding Cash Total costs of holding cash Opportunity cost

Conversion cost OCB Optimal cash balance Size of cash balance (CB)

Figure 3-5: Trade-off between increasing and falling cash balance holding costs
The above model determines the optimal cash balance by minimising the sum of the conversion cost and the opportunity costs. Let the annual interest earned on the marketable securities portfolio be I; let the annual cash disbursement by the firm be C; and let F be the fixed cost incurred by the firm every time the marketable securities are sold to raise cash. Then the optimal cash balance, OCB, can be determined using the following formula:

OCB =

2FC I

Example: Assume Austrian Pro Med GmbH, the developer of and manufacturer of Smartdose, a new generation of drug delivery systems, has annual disbursements of EUR 580 million. It can invest surplus cash in marketable securities yielding 4%. The fixed cost incurred every time marketable securities are sold to raise cash is EUR 750. What is the optimal cash balance for Ageon? Solution: C = EUR 580 million I = 4% F = EUR 750 Using these data, we can determine the OCB as,
OCB = 2 750 580'000'000 = EUR 4'663'690 0.04

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Corporate Finance

3.2.2.1.2 Miller-Orr Model* When cash flows of a firm are more volatile in nature than Baumols model, the Miller-Orr target cash balance model is a much more appropriate model for determining the optimal cash level. This model establishes two levels of cash, the upper limit and the return point or the target cash balance. When the cash balance reaches the upper limit, a predetermined amount is transferred to marketable securities. Subsequently, if the cash balance falls to the lower limit, a fixed amount of marketable securities are sold to raise cash. The model calculates the return point as:
1

3 F 2 3 Target Cash Balance = Z = +L 4 I daily

and F 2 L Idaily fixed cost of buying and selling securities variance of the net daily cash flows lower control limit, determined by the firm opportunity cost of holding cash

Upper limit = H = 3 Z 2 L
When the cash balance reaches the upper limit,
Cash converted to marketable securities = H Z When the cash balance falls to the lower limit,
Cash transferred from marketable securities = Z L

Textbooks for the introductory financial management courses simplify the above formula by assuming that the lower level of cash is equal to zero. Let us take an example to understand the above model.
Example: Find the target cash balance, and the upper control limit for Baxter International, a global medical products and services company with a mission of delivering critical therapies for people with lifethreatening conditions. We assume the following figures for its target cash balance model:
F = USD 1000 per transaction I = 10% p.a. (effective annual rate) = USD 2 million (daily) L=0

Solution: The daily compounding opportunity cost is (1+Idaily)365 1 = 0.10 (1+Idaily)365 = 1.10 1+Idaily = (1.10)1/365 Idaily = 1.000261 1 Idaily = 0.000261 Variance (2) of the net daily cash flows is (USD 2m)2 = USD 4000b 1 3 1'000 4'000b 3 Then the target cash balance (Z) = + 0 = CHF 2'256'803 4 0.000261
H = 3 2256803 2 0 = USD 6770409. What happens if the firm sets a lower control limit (L) of USD 5 million?

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Corporate Finance
Solution: Target cash balance = Z = 2256803 + 5000000 = USD 7256803 Upper control limit = H = 3 7256803 2 5000000 = USD 11770409
Thus, increasing or decreasing the lower control limit simply increases or decreases all the levels by the amount of change in the lower control limit.

When examining the target cash balance model, note that the target cash balance is closer to the lower control limit than to the upper control limit. Therefore, the cash balance on average will hit the lower control limit more often than the upper control limit. The Baumol model is based on a rather simplistic assumption that the firms daily cash outflows remain constant. The Miller-Orr model, on the other hand, is based on a more realistic scenario with regard to a firms daily cash inflows and outflows. It assumes that the daily net cash flows of the firm fluctuate randomly and are normally distributed. Thus, the Miller-Orr model is much more applicable in practice.

3.2.2.2 Cash conversion cycle* The activities of a company create patterns of cash inflows and outflows. These cash flows are both unsynchronised and uncertain. They are unsynchronised because, for example, cash payment for raw material supplies need not be made at the same time as the receipt of cash from selling the product. The cash flows are uncertain also because future sales and costs cannot be precisely predicted.
Let us take an example of a firm producing a product by processing raw material. The firm start by purchasing the raw material from its supplier on credit. It starts processing the raw material immediately. It will take 55 days in our example to produce the finished good. It will immediately sell the finished good on credit. The collection of the credit sale will take another 35 days. The timing of events is shown in the following table:
Day 0 30 55 90 Event Purchase raw material Pay the supplier Sell finished good on credit Collect credit sales Cash effect None 10000 CHF None +18000 CHF

The same information is shown below in a graphical format:

t=0 t = 30 Operating c ycle t = 55 Sale of goods Cash cycle Inventory period Receivables period t = 90 Collection of receivables

Payment for inventory

Figure 3-6: The operating and the cash conversion cycle

The inventory period is the period taken by the firm to sell the finished good (after the purchase of raw material). In the example above, it amounts to 55 days.
chapter 3 / page 20

Corporate Finance The accounts receivable period is the time between the sale on credit of the finished good and the collection of the receivables. In our example, it amounts to 35 days.

The accounts payable period is the time between the date of purchase of raw material and the date of payment for it. In the above example, it is 30 days.
The operating cycle is the number of days it takes for raw material to be converted into cash. In the above example, it amounts to 90 days. The operating cycle can be divided into two components: the days until the raw material is processed into the finished good and the days until the receivables generated by the credit sale of finished good are converted into cash. The formula for the operating cycle, from the above diagram, is:

Operating cycle = Inventory period + Accounts receivable period

A firms operating cycle is affected by its ability to process raw material quickly into finished goods and then collect its accounts receivable within the shortest possible time. Shorter operating cycle will imply better current assets management because of lower level of funds tied up in inventory and accounts receivable.

Cash conversion cycle is the period between the date on which the supplier has been paid for supply of raw material and the date on which the firm collects cash from its credit sales after processing the raw material. During this period, the firm does not receive any cash and will have to provide cash from long-term sources of funds to meet the operating expenses. The longer the cash conversion cycle, the greater will be the need for such funds. The net working capital of the firm will be proportional to its cash conversion cycle. Thus, the firms liquidity is affected by its cash conversion cycle. The cash conversion cycle can be calculated as:

Cash conversion cycle = Operating cycle - Accounts payable period

3.2.2.2.1 Calculating the operating and cash conversion cycles* It is possible to calculate the average operating and cash conversion cycles on the basis of the financial statements of a company.
Example (all figures in USD million):
Item Inventory Accounts receivable Accounts payable The income statement shows: Net sales: USD 24681 Cost of goods sold USD 10120 We need the inventory period for the calculation of the operating cycle. Inventory turnover = Cost of goods sold 10'120 = = 2.58 times Average inventory 3'918.5 365 days 365 = = 141 days Inventory turnover 2.58 Beginning 3'393 4'360 3'218 End 4'444 6'173 5'225 Average 3'918.5 5'266.5 4'221.5

Inventory period =

The inventory turnover of 2.58 means that an average item of inventory turns over 2.58 times a year or that the inventory stays on average 141 days in the company before it is sold. The receivables period can be calculated in the same way:

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Corporate Finance
Receivables turnover = Sales 24'681 = = 4.69 times Average accounts receivable 5'266.5 365 days 365 = = 78 days Receivables turnover 4.69

Receivables period =

The receivables period is also called the days sales in receivables or the average collection period. It gives the average time the customers take to pay. The operating cycle is the time from receiving the inventory to receiving cash, i.e. the sum of the inventory and receivables periods:
Example (continued): Operating cycle = Inventory period + Accounts receivable period = 141 days + 78 days = 219 days In the same way, the cash conversion cycle can be calculated: Payables turnover = Purchases 10'120 = = 2.4 times Average payables 4'221.5

Payables period =

365 days 365 days = = 152 days Payable turnover 2.4

This means that, on average, the bills are paid after 152 days. As the cash conversion cycle is the period between paying for the inventory and collecting cash, it is the difference between the operating cycle and the accounts payable period: Cash conversion cycle = Operating cycle Accounts payable period = 219 days 152 days = 67 days There is on average a delay of 67 days between paying for the merchandise and collecting the sales proceeds2.

3.2.2.2.2 Analysis of the cash conversion cycle* The above example illustrates that the cash conversion cycle depends on the inventory, the receivables and the payables periods. The cash conversion cycle increases with the inventory and receivables periods, and decreases when lengthening the payables period.
Most companies have a positive cash conversion cycle. Thus, they need capital for inventory and receivables. The longer the cash conversion cycle, the more financing is required. In addition, changes in the cash conversion cycle must often be considered as early warning signs. A lengthening cash conversion cycle can indicate that a company has trouble selling its finished products or collecting its receivables.

Instead of using the average of the beginning and end values, it is also possible to use the end values only. chapter 3 / page 22

Corporate Finance The cash conversion cycle is also directly linked to the profitability of a firm, since efficient asset management is one of the basic determinants of profitability and growth of a company. An increase in the sales produced by a given investment in assets (all other things being equal) also increases the return on assets (ROA) and the return on equity (ROE). Therefore, the shorter the cash conversion cycle, the lower the investment in inventory and receivables and the higher the profitability of the company.

3.2.2.3 Investing idle cash balance* The surplus cash available to a firm must be invested in marketable securities so as to minimise the opportunity cost of foregone interest. The selection of securities making up the portfolio will vary from country to country. Marketable securities selection is usually based on the following criteria: Risk
Since the investments are made so that the surplus cash can earn a reasonable rate of return, the first and the foremost consideration is the risk of the security in question. Low risk securities such as the Government debt (e.g., Treasury securities in the U.S.), commercial paper issued by AAA rated firms or Certificates of deposit (CDs) are good candidates as investments.

Liquidity
The funds invested in marketable securities need to be available as cash at a very short notice. Thus, a major requirement in the choice of marketable securities is the liquidity of the securities chosen as investments. Preferably, the selected securities should have a liquid secondary market (such as for T-bills, Commercial paper or CDs); or the issuing institution should be ready to redeem the securities before the due date. The so-called repurchase agreements (Repos) achieve this objective.

Maturity
The maturity of the selected securities is also of great importance. Longer maturity securities are more volatile while shorter securities are less volatile. Thus, in selecting marketable securities, a firm will tend to favour short-term securities. Alternatively, it may follow a cash matching strategy so that the maturity of liabilities is matched with that of investments.

Yield
The final selection criterion is the yield of the security in question. Obviously, less risky securities will yield lower returns, while more securities will experience higher yields. Thus, the selection of the securities based on their yield will be made only after satisfying the first three objectives (risk, liquidity and maturity).

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3.3 Short-term Lending and Borrowing*

If a company has a temporary cash surplus, it can invest in short-term securities. If it has a temporary deficiency, it can replenish cash by selling securities or by borrowing on a shortterm basis.

3.3.1 Short-term Lending*

3.3.1.1 Money markets* The market for short-term investments is generally known as the money market. It consists of a loose agglomeration of banks and dealers linked together by telex, telephones and computers. The volume of trading in the money market is very high and competition is vigorous.
In general, the danger of default is less for money market securities issued by corporations, than for corporate bonds. There are two reasons for this. First, the range of possible outcomes is smaller for short-term investments. Even though the distant future may be clouded, you can usually be confident that a particular company will survive for at least the next month. Second, mostly only well-established companies can borrow in the money market. If you are going to lend only for one day, you cant afford to spend too much time in evaluating the loan. Thus you will consider only blue chip borrowers. Many money market instruments are pure discount securities. This means that they do not pay interest. The return consists of the difference between the amount you pay and the amount you receive at maturity. We will discuss some of the money market investments.

Treasury bills:
Treasury bills have maturities of 3 months, 6 months or 1 year. A sale of treasury bills is done by auction. You can enter a competitive bid and take your chance of receiving an allotment at your bid price. Alternatively, if you want to be sure of getting your bills, you can enter a noncompetitive bid. Non-competitive bids are filled at the average price of the successful competitive bids. There is also an excellent secondary market for treasury bills.

Short-term tax-exempts:
Municipalities, states and agencies such as universities and school districts issue short-term notes. They are slightly more risky than treasury bills and not as easy to buy or sell. However, they have the attraction of tax exemptions.

Bank time deposits and Certificates of deposit:

When you make a time deposit with a bank, you are lending money to the bank for a fixed period. If you need the money before maturity, the bank usually allows you to withdraw the money, but it will levy a penalty, in the form of a fixed charge or reduced rate of interest. In certain cases, the borrowing bank may issue a negotiable certificate of deposit (CD). A CD being proof of a time deposit can also be sold to a third party before maturity. The new owner can claim the amount from the bank at maturity.
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Commercial paper:
Commercial paper is issued by large, safe and well known companies in the form of shortterm unsecured notes. Financial institutions, such as bank holding companies and finance companies also issue commercial paper. There is no intermediary involved, thus reducing the cost to the issuer.

Bankers acceptances:
Bankers acceptances have been discussed earlier. These are IOUs by a bank and are negotiable securities which can be bought and sold through money market dealers. These have a low credit risk.

Repurchase agreements:
Repurchase agreements or repos, are loans given to a Government securities dealer. These are secured instruments, since the investor purchases part of the dealers holding in treasury securities and simultaneously arranges to sell them back again at a later date at a specified higher price. Repos are the most liquid instruments and can be bought and sold overnight.

3.3.1.2 Alternatives to money markets* An alternative to money market investments is investing in making short-term investments in long-term instruments. But, these instruments bear a higher risk for the short term. There are also advantages of such investments such as the investment in municipal bonds are taxexempt. Dividend received on common stock and preferred stock from other companies is also usually taxed at a lower rate than other interest incomes. Floating-rate preferred stock:
Investments in preferred stock are attractive as the dividends carry a low tax rate. However, the preferred dividends are fixed, thus subjecting the price of preferred shares to vary based on the changes in interest rates. Floating rate preferred stocks are issued by companies in the US and Canada as alternative. The dividend payment on the preferred stock goes up and down with the general level of interest rates. Hence prices of floating rate preferred stock are less volatile than those of fixed dividend preferred. There still lies a problem, as the investors become more concerned about the risk of preferred stock, they would demand higher relative return. So investment bankers added another feature to the floating rate preferred. Instead of being rigidly tied to interest rates, the dividend can be reset periodically by a bidding process among the investors. The firms that would be interested in issuing floating rate preferred stock are firms that are not paying taxes and hence do not get the benefit of the tax shield on interest payments. Such firms find that they can raise funds at a lower cost using floating rate preferred stock rather than floating rate bonds.

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3.3.2 Short-term Borrowing*

We have seen how to invest surplus cash that the firm may be having. Now let us examine the other problem cash deficit. How does the firm raise short-term funds? As can be revealed by simple thought, someone must issue the money market instruments that we discussed in the section 3.3.1. Hence a company planning to raise short-term funds can employ the methods discussed above.

Borrowing from money markets: Large firms with excellent credit ratings can approach money market participants directly for their need of short-term funds. These firms can sell promissory notes in the money market at relatively low interest rates. These promissory notes are called commercial paper. The commercial paper market has shown rapid growth over the last few years. The commercial paper is usually issued with maturity of 270 days and in denominations of USD 100000 (in the U.S.).
There are also other methods that a firm can use to raise short-term funds, such as credit rationing and loans from banks.

3.3.2.1 Credit rationing* The concept of credit rationing comes into play in the lender-borrower framework. The more the borrower wishes to borrow, the higher the interest rate he will have to pay and a point will come when the lender will refuse to lend, whatever the interest rate is. Consider the following situation:3
Say Mr. Smallbusiness has an option to invest in two projects with the following payoffs:

Project A Project B

Investment -12 -12

Payoff +15 +24 0

Probability of Payoff 1 0.5 0.5

Project A provides certain returns and is very profitable while project B is risky and a rotten project. Mr. Smallbusiness now approaches the bank and asks for a USD 10 loan (he will arrange for the remaining USD 2 from his own pocket). The bank calculates the expected payoff as follows:
Project A Project B Expected Payoff to bank 10 1 (0.5 10) + (0.5 0) = +5 Expected Payoff to Mr. Small 1 (15 - 10) = +5 0.5 (24 - 10) = +7

From the above payoff matrix we can see that Mr. Smallbusiness will be better off if he accepts project B. If there is a gain, he will get most of the profit while if anything goes wrong, the bank will bear most of the loss. By accepting project A the bank is sure to get back its debt. Unless the bank specifies which project Mr. Smallbusiness picks up it will not lend to him the present value of USD 10. Another way is by lending Mr. Smallbusiness only a present value of USD 5. The payoff matrix will be as follows:

Adapted from Brealey & Myers. chapter 3 / page 26

Corporate Finance
Expected Payoff to bank 51 (0.5 5) + (0.5 0) = +2.5 Expected Payoff to Mr. Small 1 (15 - 5) = +10 0.5 (24 - 5) = +9.5

Project A Project B

This is what is known as credit rationing; which is a method of discouraging the borrower to speculate with the lenders money.

3.3.2.2 Secured and unsecured loan* Bank loans are an alternative source of short-term financing. A firm can raise funds in the form of secured or unsecured loans. 3.3.2.2.1 Secured loans* Firms obtain secured loans with its liquid assets such as accounts receivable or inventory as security. As the bank is lending for the short-term these liquid assets are matching the shortterm requirements. 3.3.2.2.2 Financing against accounts receivable: Since most firms carry on their balance sheets substantial investments in accounts receivable, they can use the accounts receivable to obtain short-term financing. Such financing against accounts receivable is available in two forms: a) pledging of accounts receivable and b) factoring of accounts receivable.
The pledging of accounts implies using the receivables as a collateral against a loan. The lender typically lends only a fraction (70-80%) of receivables pledged against the loan to protect him against bad debts. The interest charged is typically 2 to 3% above the primelending rate. In addition, the lender will charge a processing fee. Thus, the cost of funds raised by pledging receivables can be substantially greater than the cost of bank loans. An alternative procedure often employed by firms to raise funds against receivables is factoring the receivables. Factoring of receivables implies selling the receivables to a third party called the factor. The factoring may be carried out with or without recourse. When the factoring is without recourse, the factor bears the risk of non-payment by the firms customers. When the factoring is done with recourse, the non-payment risk is borne by the firm. It will agree to pay the factor funds not paid by its customers.

3.3.2.2.3 Financing with Inventory: A firms inventory also provides the firm with a source for short-term loans. Inventory financing is somewhat similar to receivables financing, but the procedures employed to secure the inventory will vary from country to country.
A typical procedure employed in most countries may be termed warehouse financing. In this, inventory is stored in secure premises owned by a third party. The lender finances the inventory, but the borrower can draw upon the inventory only when authorised by the lender. Another arrangement common in the United States is called the trust receipt. This arrangement is used for financing high value items such as automobiles. When automobiles are shipped to the dealer, the bank finances the shipment, but the shipment is held by the dealer on his premises in trust for the bank. When an automobile is sold, the dealer approaches the bank with requisite amount to secure the release of the automobile. Every now
chapter 3 / page 27

Corporate Finance and then, the bank will inspect the dealers inventory to ensure that the financing is adequately secured.

3.3.2.2.4 Unsecured loans* An alternative source of financing for current assets is provided by loans from commercial banks, which are traditionally unsecured loans. The interest rate charged on these types of loan is variable and is based on what is known as the Prime Lending Rate. The prime rate, as it is most often referred to, is the interest rate a bank charges its most creditworthy customers. Less creditworthy customers will pay a premium over the prime rate (e.g., prime + 1%). The prime rate itself will change from time to time based on the economy-wide cost of funds.
A firm may obtain a bank loan for a specific purpose or for financing its current assets over a period (a line of credit). A bank loan for a specified purpose will require the borrower to sign a promissory note specifying the interest rate, the date of repayment and collateral, if any. A line of credit is usually a revolving credit arrangement which allows the borrower to borrow any amount up to a specified maximum amount (credit limit). But the bank may require the firm to pay off all the borrowings at the end of the year, before the line of credit arrangement is renewed for the next year. Since the bank stands ready to lend the borrower any amount up to the specified limit, it charges the borrower a commitment fee on the maximum amount whether the firm borrows against it or not. Interest is also charged on the amount borrowed by the firm. Finally, the bank may ask the borrowing firm to maintain a minimum balance in its demand deposit with bank. This minimum balance is called the compensating balance.

chapter 3 / page 28