Viney 8e IRM ch09 - ujjjjjjj PDF

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Financial Institutions, Instruments and Markets 8th edition Instructor's Resource Manual

Christopher Viney and Peter Phillips

Chapter 9 Short-term debt Learning objective 1: Und e r s t a ndwhyt hefina nc i a lma r k e t so ffe rs ho r t t e r md e b ta ndfina nc i ng f ac i l i t i e s 

Firms seek short-term financing arrangements that incorporate different features, such as the source of funds, the amount borrowed, the timing of cash flows (repayments), fixed or variable interest rate structures, terms to maturities, liquidity and risk.

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Short-term finance may be intermediated finance provided by a financial institution such as a commercial bank, or direct finance obtained from the sale of securities into the money markets.

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Short-term finance allows borrowers to apply an important part of the matching principle; that is, to fund short-term assets with short-term liabilities.

Learning objective 2: Consider the concept and reasons for the provision of trade credit 

Trade credit is a situation where a supplier of goods, such as an electrical parts wholesaler, provides those goods to tradespersons today, with payment due in, say, 30 days.

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When invoicing the tradesperson the supplier will often offer an early payment discount, for example if payment in made within seven days.

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Both the provider of trade credit and the receiver of trade credit should consider the opportunity cost associated with the facility. The opportunity cost of a discount is:

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Learning objective 3: Explain the purpose and operation of a bank overdraft facility 

An overdraft is a financing arrangement whereby a business is authorised to place its bank operating account into deficit up to an agreed limit.

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Terms of the overdraft facility are negotiated with the bank, including the overdraft amount, the interest rate, an unused-limit fee and other fees.

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The interest rate will typically be a variable rate based on a published reference rate such as the bank’s prime rate or BBSW.

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An overdraft is used by a business to manage the timing of cash flows; therefore an overdraft is fully fluctuating. It is placed in deficit when expenses are paid and brought back into credit when revenues are received.

Learning objective 4: Describe the structure of a commercial bill, including the parties, the flow of funds, the establishment and the advantages of issuing a bank-accepted bill 

A bill of exchange issued by a company to raise short-term finance is called a commercial bill; maturities range up to 180 days.

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A bill does not pay interest; it is a discount security. That is, the bill is issued today with a face value that is payable at the maturity date; the bill is sold today for less than the face value (discounted); the difference between the purchase price and the face value is the return to the investor.

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The drawer is the issuer of the bill. The credit status of the bill is enhanced if a bank puts its name on the bill as acceptor (and thus takes primary liability to repay the bill at maturity). The payee is the party who receives the funds when the bill is sold, the discounter is the buyer of the bill (investor) and the endorser signs the bill on the reverse when it is sold.

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A bank may act as both the acceptor and the discounter of a bill for a customer. The bank may also provide a rollover facility whereby it agrees to discount bills for a period of a few years.

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A bill provides fixed rate funding for the period of the bill, but is re-priced at each rollover 2

date. 

Banks often discount bills for a customer and then sell the bills into the money markets.

Learning objective 5: Complete a range of calculations relevant to discount securities, in particular the: o price where yield is known o face value where the issue price and yield are known o yield o price where the discount rate is known o discount rate

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The price of a discount security (bill of exchange, promissory note, certificate of deposit, Treasury note) is:

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The formula used to calculate the face value of a discount security, where the issue price and yield are known, is:

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The formula used to calculate the yield on a discount security is:

The formula to calculate the price where the discount rate and face

value are given:

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The formula for calculating the discount rate, when the face value and the current price

are known, is: 3

9.7

Le ar ni ngo b j e c t i v e6:De s c r i b et hes t r uc t ur e , a dv a nt a g e s , e s t a b l i s hme nt , unde r wr i t i ngand c a l c ul a t i o no fp r o mi s s o r yno t e s( c o mme r c i a lp ap e r ) 

A P-note is a discount security issued with a face value payable at maturity, but sold today for less than the face value; the face value is discounted by the current market yield; maturities range up to 180 days.

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The market convention is to refer to P-notes as commercial paper.

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A P-note does not have an acceptor, so only corporations with a high credit rating are able to issue.

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A company may appoint a commercial bank or an investment bank as the lead manager of a large commercial paper issue. The lead manager will prepare all related documentation and depending on the size and structure of the issue establish a dealer panel.

 The dealer panel will comprise a syndicate of domestic and international banks who will promote and distribute the paper in the markets. The dealer panel members will create an active secondary market in the P-note issue. 

The issuer may also use a syndicate of underwriters to assist with the distribution of the paper. They guarantee, subject to the terms of the underwriting agreement, to purchase any paper not taken up by dealer panel or institutional investors.

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The discount security formulae are used to make P-note calculations.

Learning objective 7: Explain the structure, issue and calculation of negotiable certificates of deposit 

A negotiable certificate of deposit (CD) is a discount security issued into the money markets by a bank.

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As with other money-market discount securities, CDs typically have maturities ranging up to 180 days.

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Banks may use CDs to manage their liability needs (short-term funding requirements) and their liquidity needs (managing day-to-day cash flows).

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The discount security formulae are used for calculations.

Learning objective 8: Discuss the nature and operation of inventory finance, accounts receivable financing and factoring 

Inventory finance is provided to a retail outlet to fund the purchase of stock (inventory); for example, floor plan finance is used to fund vehicles in a motor vehicle dealership.

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The finance provider may use a system of bailment, whereby the finance company buys the inventory, allows the dealership to hold and sell the vehicles, but retains actual ownership of the vehicles until they are sold.

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Accounts receivable financing is the provision of loans to companies by finance companies, using the accounts receivable debtors of the company as security for the loans.

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Factoring is an arrangement whereby a company sells its accounts receivable at a discount to a factor company in order to raise additional funds.

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Factoring may be with-recourse, where the factor company can claim against the company if a defined percentage of the accounts receivable is not recovered from debtors, or it may be non-recourse.

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The factoring agreement is often on a notification basis, whereby the factoring company advises the accounts receivable debtors that repayment is to be made directly to the factor company.

Essay questions Th ef o l l o wi n gs u g g e s t e da n s we r si n c o r p o r a t et h ema i np oi n t st h a ts h o u l db er e c o g n i s e db yas t ud e nt .An i n s t r u c t o rs h o u l da dv i s es t u d e n t so ft h ed e p t hofa na l y s i sa n dd i s c u s s i o nt h a ti sr e q u i r e df o rap a r t i c u l a r q ue s t i on .Fo re x a mp l e ,a nun d e r gr a d u a t es t u de n tma yo n l yb er e q u i r e dt ob r i e flyi n t r o d u c ep o i nt s , e x p l a i ni nt h e i ro wnwo r dsa n dp r o v i d ea ne x a mp l e .Ont h eo t h e rha n d ,ap os t g r a d u a t es t u d e n tma yb e r e q u i r e dt op r o v i d emu c hg r e a t e rd e p t ho fa n a l y s i sa n dd i s c u s s i o n .

1. As the finance manager for a growing mining services company, you approach BankWest Limited to discuss their range of business loan facilities. Identify the fundamental principle of finance that relates to the use of both short-term and medium- to longer-term finance by a 5

business. Explain the principle and discuss why it is important. (LO 9.1) 

The question relates to the matching principle.

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The matching principle contends that short-term assets should be funded with short-term liabilities, while longer-term assets should be funded with longer-term liabilities and equity.

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Short-term debt is the term used for those types of loans and instruments through which a company can raise debt finance for a period as short as a day, and up to one year.

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Short-term debt is appropriate for financing short-term working capital requirements and investments that are self-financing within the short period of time.

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The use of short-term debt is also appropriate for firms that experience seasonal peaks and troughs in their net cash flows.

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Sources of short-term debt include trade credit, overdrafts, commercial bills, promissory notes, inventory loans, accounts receivable finance and factoring.

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Medium- to longer-term debt is generally in the form of instruments issued with an initial maturity greater than one year.

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Types of medium- to longer-term debt instruments include term loans, mortgage finance, debentures, unsecured notes and leasing.

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The money markets (short-term) and capital markets (medium- to longer-term) facilitate the matching principle in relation to funding, whereby the cash flows associated with a source of funds (liabilities) are able to be matched over the life of the cash flows of the use of funds (assets). This occurs because the markets provide a whole range of products with varying maturities and repayment structures

2.

A fencing contractor purchases a range of fencing materials from the local hardware store in order to build a number of paling fences for a housing project. The hardware store provides its standard trade finance facility to the fencing contractor. (LO 9.2) (a) Explain the operation of trade credit and why the hardware store would provide this type of facility.

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Trade credit is often provided by suppliers of goods and allows the purchaser a specified period before the account has to be paid.

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As in the example above, a firm that is a hardware supplier to the trade may grant trade credit to fencing contractors. The fencing contractor is able to obtain the timber, nails and concrete required to carry out a job for a client, and receive payment for that job before payment is due to the supplier.

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The firm supplying the hardware will often include a discount for early payment.

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In this example, the fencing contractor has a choice; either pay early and receive the discount, or pay by the later specified date and obtain a longer period of credit.

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The fencing contractor should consider the opportunity cost attached to the discount versus the benefit of the extended credit period.

(b) What are the advantages to the fencing contractor in using trade credit? 

the hardware store uses trade credit as a marketing tool; that is, to attract trades people to buy their hardware, tools and equipment from the store. The provision is an important strategy used to increase sales turnover

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the majority of small business trade people do not have excess liquidity available such that they can pay for their supplies before a job is completed and payment is received, therefore the availability of this form of short-term finance is attractive

(c) Calculate the opportunity cost of an invoice that specifies the following conditions: 1.25/10, n/30. % discount 365  Opportunit y cost  100 - % discount days difference between early and late settlement 1.25 365   98.75 20 0.2310 or 23.10% p.a.

3.

Most businesses organisations establish an overdraft facility with their bank. Explain the

purpose and operation of overdraft finance. Why is this form of debt facility so popular? (LO 9.3) 

An overdraft is a credit facility where prior approval is given by a bank to a business to allow that business to obtain credit on a fluctuating basis.

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That is, the business may draw cheques from time to time at its own discretion on its current account in excess of the account balance.

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A business will negotiate a maximum overdraft credit limit with their bank (e.g. $50 000).

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The amount of the limit will be dependent on the characteristics of the cash-flows which normally pass through the business, but in particular the bank will consider the reputation, credit worthiness, future prospects and management of the business.

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The interest rate charged on a debit balance in the overdraft facility is generally a variable rate based on a published reference rate such as BBSW or the bank’s prime rate, plus a margin determined by the bank.

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Interest is calculated on the daily debit balance, monthly in arrears. A range of fees will also be charged, including an establishment fee and a commitment or an unused limit fee.

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Overdrafts are a flexible funding arrangement in that once an overdraft credit limit is established with a bank, the business can write cheques to meet its day-to-day operating needs without further reference to the bank.

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The bank expects the facility to be fully fluctuating; that is, as future cash flows into the business the overdraft facility should be reduced or brought back into credit.

4.

The National Bank has approved an overdraft facility that allows a small business to

manage its day-to-day liquidity position. In providing the overdraft to the business, identify and briefly discuss some of the liquidity-related issues that the National Bank would have analysed before granting an overdraft. (LO 9.3) 

The cash flows within a business will rarely be matched; that is, at times a business will incur cash outflows to meet operating expenses and at other times will receive cash inflows from the sale of goods and services.

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The primary purpose of an overdraft facility is to allow the management of liquidity and working capital needs.

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The fluctuating nature of credit available through an overdraft facility enables the mismatch in cash-flows to be managed; that is, when expenses need to be paid the business can draw-down on the overdraft facility and when income is received the business can reduce or place the facility back into credit.

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Prior to granting an overdraft to a customer, and also with periodic reviews, the bank will look at a number of liquidity-related issues, including: o its overall banking relationship with the customer

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o the historic and forecast performance of the business (bottom-up approach) and any impacts forecast changes might have on cash flows and liquidity requirements o forecasts for the industry in which the business operates (top-down approach) and the impact of changes in economic activity might have on the business o how the business has managed its cash flow and liquidity positions, in particular, its accounts receivables and accounts payable.

5.

As a lending manager with Mega Bank, you have been asked by a corporate client to

explain commercial bill financing. Describe the structure of a bank-accepted bill facility. Include in your answer definitions and explanations of the roles of the parties associated with the bill issue. (LO 9.4) 

Bills of exchange are categorised as short-term debt instruments with maturities usually ranging from 30 to 180 days.

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Arrangements can be put in place with a lender to roll-over the facility, thus extending the term of the finance.

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Commercial bills are discount securities, that is, before maturity they are sold at a price less then their face value.

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The face value is repayable to the holder of the bill at maturity.

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The difference between the issue price and the face value is the cost of borrowing.

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The yield, if the bill is sold before maturity, is the discounted sale price minus the discounted buy price divided by the original buy price, adjusted for the number of days the security is held.

We use as an example a hypothetical technology company—Axis Limited—to introduce the various parties to a bill 

Axis needs to obtain short-term debt funding and decides to issue commercial bills. A bill is drawn by Axis with a face value of $100 000 and a maturity date in 90 days. In issuing the bill, Axis is the drawer of the bill; that is, the drawer is the party that issues the bill.

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The drawer is usually also the payee, the party requiring the funds. Bills may be issued where the drawer instructs the funds to be paid to a third party payee; for example, a subsidiary company.

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Axis discovers that investors are reluctant to purchase the bill because Axis has not established a sound credit reputation in the financial markets. The company would have to pay a much higher 9

yield on the bill to attract a discounter (lender). Therefore, Axis decides to approach its bank and request that the bank act as the acceptor of the bill. 

The acceptor is the party to whom the bill is addressed and who undertakes to pay the face value of the bill to the person presenting the bill at the maturity date.

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The accepting function is usually performed by a bank and this gives the bill added credit status, and thus makes it easier to sell (discount) the bill.

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A bank will agree to take on the role of acceptor, for a fee.

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At the maturity date the acceptor will pay the face value to the bill holder and then recover its funds from the drawer.

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So far Axis still has not raised any funds, it has issued a bill and has improved the quality of the bill by obtaining a bank as acceptor. Axis must now find a discounter that is willing to purchase the bill.

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The discounter is the party that lends the drawer an amount of money in...