the firm should take or give up cash discounts; you also need to understand the

, Ch. 16 the following case study: Integrative Case Casa Diseno p. 681 .( Chapter 16) Only complete the YELLOW  HIGHLIGHTED AREA. ONLY DO the probelm highlighted in question D I have copied and paste and highlighted my part of the assignment. remember it’s a team assignment. You need to understand how to analyze supplier credit terms to decide whether the firm should take or give up cash discounts; you also need to understand the various types of short-term loans, both unsecured and secured, that you will be required to record and report. You need to understand what data the firm will need to process accounts payable, track accruals, and meet bank loans and other short-term debt obligations in a timely manner. You need to know the sources of short-term loans so that, if short-term financing is needed, you will understand its availability and cost. You need to understand how accounts receivable and inventory can be used as loan collateral; the procedures used by the firm to secure short-term loans with such collateral could affect customer relationships. You need to understand the use of accounts payable as a form of short-term financing and the effect on one’s suppliers of stretching payables; you also need to understand the process by which a firm uses inventory as collateral. Management of current liabilities is an important part of your financial strategy. It takes discipline to avoid viewing cash and credit purchases equally. You need to borrow for a purpose, not convenience. You need to repay credit purchases in a timely fashion. Excessive use of short-term credit, particularly with credit cards, can create personal liquidity problems and, at the extreme, personal bankruptcy. Digital advertising revenues hit $36.6 billion in 2012, a 15 percent increase over 2011, which was itself a record-breaking year. Online ads are everywhere, from Google search pages to YouTube videos to your Facebook News Feed. A challenge for the publishers of online ads is collecting money for those ads. The industry standard calls for publishers of online ads to send invoices within 30 days after an ad campaign is complete, and the advertiser then has 30 days or more to pay for the ad. Thus, companies that sell online advertising can accumulate large receivables balances, and collecting cash can be a slow process. That’s where the company FastPay comes in. FastPay makes loans to publishers, ad-tech companies, and other digital media businesses based on those firms’ accounts receivable. FastPay lends up to $5 million per borrower, with the terms of the loan based on the quality of the receivable. For example, if Pepsi were to enter into an agreement with YouTube to place online ads in videos, FastPay would grant a loan to YouTube on relatively favorable terms because it views Pepsi as a good credit risk. One area in which FastPay is expanding rapidly is in making loans to Facebook Preferred Marketing Developers, a network of small and mediumsized businesses that builds advertising apps on Facebook, manages ad campaigns, and helps Facebook develop new marketing strategies. Firms rely on a wide array of short-term financing vehicles. In this chapter, you’ll learn about the ways companies can use short-term finance to help maximize the wealth of their shareholders. arise from the normal course of business. For example, when a retailer orders goods for inventory, the manufacturer of those goods usually does not demand immediate payment but instead extends a short-term loan to the retailer that appears on the retailer’s balance sheet under accounts payable. The more goods the retailer orders, the greater will be the accounts payable balance. Also in response to increasing sales, the firm’s accruals increase as wages and taxes rise because of greater labor requirements and the increased taxes on the firm’s increased earnings. There is normally no explicit cost attached to either of these current liabilities, although they do have certain implicit costs. In addition, both are forms of , short-term financing obtained without pledging specific assets as collateral. The firm should take advantage of these “interest-free” sources of unsecured short-term financing whenever possible. Financing that arises from the normal course of business; the two major short-term sources of such liabilities are accounts payable and accruals. Short-term financing obtained without pledging specific assets as collateral. Accounts payable are the major source of unsecured short-term financing for business firms. They result from transactions in which merchandise is purchased but no formal note is signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s invoice. The discussion of accounts payable here is presented from the viewpoint of the purchaser. The average payment period is the final component of the introduced in . The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In , we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is . Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the which is typically either the or the in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period. In 2013, Brown-Forman Corporation (BF), manufacturer of alcoholic beverage brands such as Jack Daniels, had annual revenue of $3.8 billion, cost of revenue of $1.8 billion, and accounts payable of $468 million. BF had an average age of inventory (AAI) of 168 days, an average collection period (ACP) of 55 days, and an average payment period (APP) of 136 days (BF’s purchases were $1.3 billion). Thus, the cash conversion cycle for BF was 87 days (168 + 55 − 136). The resources BF had invested in this cash conversion cycle (assuming a 365-day year) were Based on BF’s APP and average accounts payable, the daily accounts payable generated by BF is about $3.5 million ($0.48 billion ÷ 136). If BF were to increase its average payment period by 5 days, its accounts payable would increase by about $17.5 million (5 × $3.5 million). As a result, BF’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $17.5 million. Clearly, if this action did not damage BF’s credit rating, it would be in the company’s best interest. The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases. Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment. If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date. Lawrence Industries, operator of a small chain of video stores, purchased $1,000 worth of merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000 − (0.02 × $1,000)] by March 10, thereby saving $20. If the firm chooses to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, when a firm gives up a discount, it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a loan, and the length of this loan is the number of additional days that the purchaser can delay payment to the seller. This cost can be illustrated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period). The implied rate of interest paid to delay payment of an account payable for an additional number of days. Payment options for Lawrence Industries In , we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must pay an extra $20, or $1,000 rather than $980. In other words, if the firm pays on March 30, it will pay $980 (what it could have paid on March 10) plus $20. The extra $20 is like interest on a loan, and in this case the $980 is like the loan principal. Lawrence Industries owes $980 to its supplier on March 10, but the supplier is willing to accept $980 plus $20 in interest on March 30. shows the payment options that are open to the company. To calculate the implied interest rate associated with giving up the cash discount, we simply treat $980 as the loan principal, $20 as the interest, and 20 days (the time from March 10 to March 30) as the term of the loan. Again, the tradeoff that Lawrence faces is that it can pay $980 on March 10 or $980 plus $20 in interest 20 days later on March 30. Therefore, the interest rate that Lawrence is paying by giving up the discount is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The general expression for calculating the annual percentage cost of giving up a cash discount can be expressed as where Substituting the values for (2%) and N (20 days) into results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)]. A simple way to the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of : The smaller the cash discount, the closer the approximation to the actual cost of giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% [2% × (365 ÷ 20)]. The financial manager must determine whether it is advisable to take a cash discount. A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other institution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier. Mason Products, a large building-supply company, has four possible suppliers, each offering different credit terms. Otherwise, their products and services are identical. presents the credit terms offered by suppliers A, B, C, and D and the cost of giving up the cash discounts in each transaction. The approximation method of calculating the cost of giving up a cash discount ( ) has been used. The cost of giving up the cash discount from supplier A is 36.5%; from supplier B, 4.9%; from supplier C, 21.9%; and from supplier D, 29.2%. If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 6%, and if each of the suppliers is viewed which (if any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier A, the firm takes the cash discount, because the cost of giving it up is 36.5%, and then borrows the funds it requires from its bank at 6% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of this action is less than the cost of borrowing money from the bank (4.9% versus 6%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the 6% cost of borrowing from the bank. The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain . However, other factors relative to payment strategies may also need to be considered. For example, some firms, particularly small firms and poorly managed firms, routinely give up discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions. A strategy that is often employed by a firm is , that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduce the cost of giving up a cash discount. Paying bills as late as possible without damaging the firm’s credit rating. Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of giving up the cash discount, assuming payment on the last day of the credit period, was approximately 36.5% [2% × (365 ÷ 20)]. If the firm were able to stretch its account payable to 70 days without damaging its credit rating, the cost of giving up the cash discount would be only 12.2% [2% × (365 ÷ 60)]. Stretching accounts payable reduces the implicit cost of giving up a cash discount. Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases. Jack and Mary Nobel, a young married couple, are in the process of purchasing a 50-inch HD TV at a cost of $1,900. The electronics dealer currently has a special financing plan that would allow them to either (1) put $200 down and finance the balance of $1,700 at 3% annual interest over 24 months, resulting in payments of $73 per month; or (2) receive an immediate $150 cash rebate, thereby paying only $1,750 cash. The Nobels, who have saved enough to pay cash for the TV, can currently earn 5% annual interest on their savings. They wish to determine whether to borrow or to pay cash to purchase the TV. The upfront outlay for the financing alternative is the $200 down payment, whereas the Nobels will pay out $1,750 up front under the cash purchase alternative. So, the cash purchase will require an initial outlay that is $1,550 ($1,750 − $200) greater than under the financing alternative. Assuming that they can earn a simple interest rate of 5% on savings, the cash purchase will cause the Nobels to give up an opportunity to earn $155 (2 years × 0.05 × $1,550) over the 2 years. If they choose the financing alternative, the $1,550 would grow to $1,705 ($1,550 + $155) at the end of 2 years. But under the financing alternative, the Nobels will pay out a total of $1,752 (24 months × $73 per month) over the 2-year loan term. The cost of the financing alternative can be viewed as $1,752, and the cost of the cash payment (including forgone interest earnings) would be $1,705. Because it is less expensive, . The lower cost of the cash alternative is largely the result of the $150 cash rebate. The second spontaneous source of short-term business financing is accruals. are liabilities for services received for which payment has yet to be made. The most common items accrued by a firm are wages and taxes. Because taxes are payments to the government, their accrual cannot be manipulated by the firm. However, the accrual of wages can be manipulated to some extent by delaying payment of wages, thereby receiving an interest-free loan from employees who are paid sometime after they have performed the work. The pay period for employees who earn an hourly rate is often governed by union regulations or by state or federal law. However, in other cases, the frequency of payment is at the discretion of the company’s management. Liabilities for services received for which payment has yet to be made. On June 2, 2010, Diebold, Inc., agreed to pay a $25 million fine to settle accounting fraud charges brought by the U.S. Securities and Exchange Commission (SEC). According to the SEC, the management of the Ohio-based manufacturer of ATMs, bank security systems, and electronic voting machines regularly received reports comparing the company’s earnings to analyst forecasts. When earnings were below forecasts, management identified opportunities, some of which amounted to accounting fraud, to close the gap. “Diebold’s financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company’s bottom line,” SEC Enforcement Director Robert Khuzami said in a statement. “When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences.” A number of the SEC’s claims focused on premature revenue recognition. For example, Diebold was charged with improper use of “bill and hold” transactions. Under generally accepted accounting principles, revenue is typically recognized after a product is shipped. However, in some cases, sellers can recognize revenue before shipment for certain bill and hold transactions. The SEC claimed that Diebold improperly used bill and hold accounting to record revenue prematurely. The SEC also claimed that Diebold manipulated various accounting accruals. Diebold was accused of understating liabilities tied to its Long Term Incentive Plan, commissions to be paid to sales personnel, and incentives to be paid to service personnel. Diebold temporarily reduced a liability account set up for payment of customer rebates. The company was also accused of overstating the value of inventory and improper inventory write-ups. Each of these activities allowed Diebold to inflate the company’s financial performance. According to the SEC’s complaint, Diebold’s fraudulent activities misstated reported pretax earnings by at least $127 million between 2002 and 2007. Two years prior to the settlement, Diebold restated earnings for the period covered by the charges. The clawback provision of the 2002 Sarbanes-Oxley antifraud law requires executives to repay compensation they receive while their company misled shareholders. Diebold’s former CEO, Walden O’Dell, agreed to return $470,000 in cash, plus stock and options. The SEC is currently pursuing a lawsuit against two other former Diebold executives for their part in the matter. Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 × $400,000). What are the two major sources of spontaneous short-term financing for a firm? How do their balances behave relative to the firm’s sales? Is there a cost associated with ? Is there any cost associated with ? How do short-term borrowing costs affect the cash discount decision? What is “stretching accounts payable”? What effect does this action have on the cost of giving up a cash discount? Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are available to firms of all sizes; commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions. Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is the . These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. In other words, the use to which the borrowed money is put provides the mechanism through which the loan is repaid, hence the term . An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid. Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, through lines of credit, and through revolving credit agreements. Before we look at these types of loans, we consider loan interest rates. The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often based on the prime rate of interest. The is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent. The lowest rate of interest charged by leading banks on business loans to their most important business borrowers. Loans can have either fixed or floating interest rates. On a , the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a , the increment above the prime rate is initially established, and the rate of interest is allowed to “float,” or vary, above prime until maturity. Generally, the increment above the prime rate will be on a floating-rate loan than on a fixed-rate loan of equivalent risk because the lender bears less risk with a floating-rate loan. . A loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity. A loan with a rate of interest initially set at an increment above the prime rate and allowed to “float,” or vary, above prime until maturity. Once the is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid the —the actual rate of interest paid—for an assumed 1-year period is equal to Most bank loans to businesses require the interest payment at maturity. When interest is paid it is deducted from the loan so that the borrower actually receives less money than is requested (and less than they must repay). Loans on which interest is paid in advance are called . The assuming a 1-year period, is calculated as Loan on which interest is paid in advance by being deducted from the amount borrowed. Paying interest in advance raises the effective annual rate above the stated annual rate. Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000 at a stated annual rate of 10% interest for 1 year. If the interest on the loan is paid at maturity, the firm will pay $1,000 (0.10 × $10,000) for the use of the $10,000 for the year. At the end of the year, Wooster will write a check to the lender for $11,000, consisting of the $1,000 interest as well as the return of the $10,000 principal. Substituting into reveals that the effective annual rate is therefore If the money is borrowed at the same annual rate for 1 year but interest is paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000 ($10,000 − $1,000). The effective annual rate in this case is In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%). A can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest. A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period. Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank B. The loans were incurred on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate was set at % above the prime rate on bank A’s . Over the 90-day period, the rate of interest on this note will remain at % (6% prime rate + % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × ( , × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000). Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective interest rate, or by using . Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1: The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%. Bank B set the interest rate at 1% above the prime rate on its . The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000). Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective rate is 7.46%: Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate. Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000. Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a at 2% above the prime rate or (2) a at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows: Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months. Total interest cost over 180 days Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, . By doing so, she will save about $38 ($1,480 − $1,442) in interest cost over the 180 days. A is an agreement between a commercial bank and a business, specifying the amount of unsecured short-term borrowing that the bank will make available to the firm over a given period of time. It is similar to the agreement under which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is rather, it indicates that if the bank has sufficient funds available, it will allow the borrower to owe it a certain amount of money. The amount of a line of credit is the at any point in time. An agreement between a commercial bank and a business specifying the amount of unsecured short-term borrowing the bank will make available to the firm over a given period of time. When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma balance sheet, and recent financial statements. If the bank finds the customer acceptable, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the creditworthiness of a customer each time it borrows money within the year. The interest rate on a line of credit is normally stated as a floating rate: the . If the prime rate changes, the interest rate charged on new borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the premium (interest increment) above prime and vice versa. In a line-of-credit agreement, a bank may impose , which give it the right to revoke the line if any major changes occur in the firm’s financial condition or operations. The firm is usually required to submit up-to-date, and preferably audited, financial statements for periodic review. In addition, the bank typically needs to be informed of shifts in key managerial personnel or in the firm’s operations before changes take place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the proposed changes and the firm makes them anyway, the bank has the right to revoke the line of credit. Contractual restrictions that a bank may impose on a firm’s financial condition or operations as part of a line-of-credit agreement. To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a equal to a certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20 percent. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower. A required checking account balance equal to a certain percentage of the amount borrowed from a bank under a line-of-credit or revolving credit agreement. Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of-credit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus, it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 × $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 ÷ $800,000), which is 2.5% more than the stated rate of 10%. If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 ÷ $900,000). Thus, a compensating balance raises the cost of borrowing it is larger than the firm’s normal cash balance. To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an . In these cases, the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period ensures that short-term loans do not turn into long-term loans. The requirement that for a certain number of days during the year borrowers under a line of credit carry a zero loan balance (that is, owe the bank nothing). All the characteristics of a line-of-credit agreement are negotiable to some extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of maintaining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce a line of credit that is suitable to both borrower and lender. A is nothing more than a . It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of credit. It is not uncommon for a revolving credit agreement to be for a period greater than 1 year. Because the bank guarantees the availability of funds, a is normally charged on a revolving credit agreement. This fee often applies to the average unused balance of the borrower’s credit line. It is normally about 0.5 percent of the of the line. A line of credit to a borrower by a commercial bank regardless of the scarcity of money. The fee that is normally charged on a it often applies to the of the borrower’s credit line. REH Company, a major real estate developer, has a $2 million revolving credit agreement with its bank. Its average borrowing under the agreement for the past year was $1.5 million. The bank charges a commitment fee of 0.5% on the average unused balance. Because the average unused portion of the committed funds was $500,000 ($2 million − $1.5 million), the commitment fee for the year was $2,500 (0.005 × $500,000). Of course, REH also had to pay interest on the actual $1.5 million borrowed under the agreement. Assuming that $112,500 interest was paid on the $1.5 million borrowed, the effective cost of the agreement was 7.67% [($112,500 + $2,500) ÷ $1,500,000]. Although more expensive than a line of credit, a revolving credit agreement can be less risky from the borrower’s viewpoint because the availability of funds is guaranteed. is a form of financing that consists of short-term, unsecured promissory notes issued by firms with a high credit standing. Generally, only large firms of unquestionable financial soundness are able to issue commercial paper. Most commercial paper issues have maturities ranging from 3 to 270 days. Although there is no set denomination, such financing is generally issued in multiples of $100,000 or more. A large portion of the commercial paper today is issued by finance companies; manufacturing firms account for a smaller portion of this type of financing. Businesses often purchase commercial paper, which they hold as marketable securities, to provide an interest-earning reserve of liquidity. For further information on recent use of commercial paper, see the box. A form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing. The difficult economic and credit environment in the post–September 11 era, combined with historically low interest rates and a deep desire by corporate issuers to reduce exposure to refinancing risk, had a depressing effect on commercial paper volumes from 2001 through 2003. According to the Federal Reserve, U.S. nonfinancial commercial paper, for example, declined 68 percent over the 3-year period, from $315.8 billion outstanding at the beginning of 2001 to $101.4 billion by December 2003. In addition to lower volume, credit quality of commercial paper declined over the same period, with the ratio of downgrades outpacing upgrades 17 to 1 in 2002. In 2004, signs emerged that the volume and rating contraction in commercial paper was finally coming to an end. The most encouraging of them was the pickup in economic growth, which spurs the need for short-term debt to finance corporate working capital. Although commercial paper is typically used to fund working capital, it is often boosted by a sudden surge of borrowing activity for other strategic activities, such as mergers and acquisitions and long-term capital investments. According to Federal Reserve Board data, at the end of July 2004, total U.S. commercial paper outstanding was $1.33 trillion. By 2006, commercial paper surged to $1.98 trillion, an increase of 21.5 percent over 2005 levels. However, after peaking at $2.22 trillion, the tide changed in response to the credit crisis that began in August 2007. According to Federal Reserve data, as of October 1, 2008, the commercial paper market had contracted to $1.6 trillion, a reduction of nearly 28 percent, and new issues virtually dried up for several weeks. With much of the commercial paper outstanding at the start of the credit crisis coming up for renewal, the Federal Reserve began operating the Commercial Paper Funding Facility (CPFF) on October 27, 2008. The CPFF was intended to provide a liquidity backstop to U.S. issuers of commercial paper and, thereby, increase the availability of credit in short-term capital markets. CPFF allowed for the Federal Reserve Bank of New York to finance the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers. Even with the CPFF up and running, companies that were worried about their ability to roll over their outstanding commercial paper every few weeks turned to long-term debt to meet their liquidity needs. Merrill Lynch & Co. and Bloomberg data showed that to manage short-tem liability risk, companies were paying as much as $75 million in additional annual interest to swap long-term debt for $1 billion of 30-day commercial paper. With the recession in the rearview mirror and short-term credit markets working again, the CPFF was closed on February 1, 2010. But three years later, the commercial paper market was still far smaller than it had been before the financial crisis. In March 2013, the Federal Reserve reported that the total amount of commercial paper outstanding was a little more than $1 trillion, about half the size of the market in 2007 before the crisis. Commercial paper is sold at a discount from its or . The size of the discount and the length of time to maturity determine the interest paid by the issuer of commercial paper. The actual interest earned by the purchaser is determined by certain calculations, illustrated by the following example. Bertram Corporation, a large shipbuilder, has just issued $1 million worth of commercial paper that has a 90-day maturity and sells for $990,000. At the end of 90 days, the purchaser of this paper will receive $1 million for its $990,000 investment. The interest paid on the financing is therefore $10,000 on a principal of $990,000. The effective 90-day rate on the paper is 1.01% ($10,000 ÷ $990,000). Assuming that the paper is rolled over each 90 days throughout the year (that is, 365 ÷ 90 = 4.06 times per year), the effective annual rate for Bertram’s commercial paper, found by using , is 4.16% [(1 + 0.0101) − 1]. An interesting characteristic of commercial paper is that its interest cost is 2 percent to 4 percent below the prime rate. In other words, firms are able to raise funds more cheaply by selling commercial paper than by borrowing from a commercial bank. The reason is that many suppliers of short-term funds do not have the option, as banks do, of making low-risk business loans at the prime rate. They can invest safely only in marketable securities such as Treasury bills and commercial paper. Although the stated interest cost of borrowing through the sale of commercial paper is normally lower than the prime rate, the of commercial paper may not be less than that of a bank loan. Additional costs include various fees and flotation costs. Also, even if it is slightly more expensive to borrow from a commercial bank, it may at times be advisable to do so to establish a good working relationship with a bank. This strategy ensures that when money is tight, funds can be obtained promptly and at a reasonable interest rate. Commercial banks are legally prohibited from lending amounts in excess of 15 percent (plus an additional 10 percent for loans secured by readily marketable collateral) of the bank’s unim-paired capital and surplus to any one borrower. This restriction is intended to protect depositors by forcing the commercial bank to spread its risk across a number of borrowers. In addition, smaller commercial banks do not have many opportunities to lend to large, high-quality business borrowers. In some ways, arranging short-term financing for international trade is no different from financing purely domestic operations. In both cases, producers must finance production and inventory and then continue to finance accounts receivable before collecting any cash payments from sales. In other ways, however, the short-term financing of international sales and purchases is fundamentally different from that of strictly domestic trade. The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to . A U.S.-based company that exports goods and has accounts receivable denominated in a foreign currency faces the risk that the U.S. dollar will appreciate in value relative to the foreign currency. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar will depreciate. Although can often be by using currency forward, futures, or options markets, doing so is costly and is not possible for all foreign currencies. Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms. Several specialized techniques have evolved for financing international trade. Perhaps the most important financing vehicle is the , a letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country. A letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. Firms that do business in foreign countries on an ongoing basis often finance their operations, at least in part, in the local market. A company that has an assembly plant in Mexico, for example, might choose to finance its purchases of Mexican goods and services with peso funds borrowed from a Mexican bank. This practice not only minimizes exchange rate risk but also improves the company’s business ties to the host community. Multinational companies, however, sometimes finance their international transactions through dollar-denominated loans from international banks. The allow creditworthy borrowers to obtain financing on attractive terms. Much international trade involves transactions between corporate subsidiaries. A U.S. company might, for example, manufacture one part in an Asian plant and another part in the United States, assemble the product in Brazil, and sell it in Europe. The shipment of goods back and forth between subsidiaries creates accounts receivable and accounts payable, but the parent company has considerable discretion about how and when payments are made. In particular, the parent can minimize foreign exchange fees and other transaction costs by “netting” what affiliates owe each other and paying only the net amount due rather than having both subsidiaries pay each other the gross amounts due. How is the relevant to the cost of short-term bank borrowing? What is a ? How does the differ between a loan requiring interest payments and another, similar loan requiring interest ? What are the basic terms and characteristics of a How is the on such a note found? What is a ? Describe each of the following features that are often included in these agreements: operating-change restrictions, compensating balance, and annual cleanup. What is a ? How does this arrangement differ from the line-of-credit agreement? What is a ? How do firms use to raise short-term funds? Who can issue commercial paper? Who buys commercial paper? What is the important difference between international and domestic transactions? How is a used in financing international trade transactions? How is “netting” used in transactions between subsidiaries? When a firm has exhausted its sources of unsecured short-term financing, it may be able to obtain additional short-term loans on a secured basis. has specific assets pledged as collateral. The commonly takes the form of an asset, such as accounts receivable or inventory. The lender obtains a security interest in the collateral through the execution of a with the borrower that specifies the collateral held against the loan. In addition, the terms of the loan against which the security is held form part of the security agreement. A copy of the security agreement is filed in a public office within the state, usually a county or state court. Filing provides subsequent lenders with information about which assets of a prospective borrower are unavailable for use as collateral. The filing requirement protects the lender by legally establishing the lender’s security interest. Short-term financing (loan) that has specific assets pledged as collateral. The agreement between the borrower and the lender that specifies the collateral held against a secured loan. Although many people believe that holding collateral as security reduces the risk that a loan will default, lenders do not usually view loans in this way. Lenders recognize that holding collateral can reduce losses if the borrower defaults, but . A lender requires collateral to ensure recovery of some portion of the loan in the event of default. What the lender wants above all, however, is to be repaid as scheduled. In general, lenders prefer to make less risky loans at lower rates of interest than to be in a position in which they must liquidate collateral. Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral. Typically, the lender determines the desirable to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral. The percentage of the book value of the collateral that constitutes the principal of a secured loan. The interest rate that is charged on secured short-term loans is typically than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both. The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. are lending institutions that make secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits. Lending institutions that make secured loans—both short-term and long-term—to businesses. Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services. Two commonly used means of obtaining short-term financing with accounts receivable are and . Actually, only a pledge of accounts receivable creates a secured short-term loan; factoring really entails the of accounts receivable at a discount. Although factoring is not actually a form of secured short-term borrowing, it does involve the use of accounts receivable to obtain needed short-term funds. A is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral. The use of a firm’s accounts receivable as security, or collateral, to obtain a short-term loan. When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral. After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage. Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a , which is a publicly disclosed legal claim on the collateral. A publicly disclosed legal claim on loan collateral. Pledges of accounts receivable are normally made on a , meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a , the customer is notified to remit payment directly to the lender. The basis on which a borrower, having pledged an account receivable, continues to collect the account payments without notifying the account customer. The basis on which an account customer whose account has been pledged (or factored) is notified to remit payment directly to the lender (or factor). Founded in 2007, the Receivables Exchange is an online marketplace where organizations such as hedge funds and commercial banks looking for short-term investments can bid on receivables pledged by small, medium-sized, and large companies from a wide range of industries. Companies that need cash put their receivables up for auction on the Receivables Exchange, and investors bid on them. In its first few years of operation, the Receivables Exchange provided funding of more than $1 billion to companies selling their receivables. The Receivables Exchange attracted the attention of the NYSE Euronext, which purchased a minority stake in the company in 2011. The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing. involves selling them outright, at a discount, to a financial institution. A is a financial institution that specializes in purchasing accounts receivable from businesses. Although it is not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with accounts receivable as collateral. The outright sale of accounts receivable at a discount to a or other financial institution. A financial institution that specializes in purchasing accounts receivable from businesses. A factoring agreement normally states the exact conditions and procedures for the purchase of an account. The factor, like a lender against a pledge of accounts receivable, chooses accounts for purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to be on a continuing basis, the factor will actually make the firm’s credit decisions because this will guarantee the acceptability of accounts. Factoring is normally done on a and the factor receives payment of the account directly from the customer. In addition, most sales of accounts receivable to a factor are made on a , meaning that the factor agrees to accept all credit risks. Thus, if a purchased account turns out to be uncollectible, the factor must absorb the loss. The basis on which accounts receivable are sold to a factor with the understanding that the factor accepts all credit risks on the purchased accounts. The use of credit cards such as MasterCard, Visa, and Discover by consumers has some similarity to factoring because the vendor that accepts the card is reimbursed at a discount for purchases made with the card. The difference between factoring and credit cards is that cards are nothing more than a line of credit extended by the issuer, which charges the vendors a fee for accepting the cards. In factoring, the factor does not analyze credit until after the sale has been made; in many cases (except when factoring is done on a continuing basis), the initial credit decision is the responsibility of the vendor, not the factor that purchases the account. Typically, the factor is not required to pay the firm until the account is collected or until the last day of the credit period, whichever occurs first. The factor sets up an account similar to a bank deposit account for each customer. As payment is received or as due dates arrive, the factor deposits money into the seller’s account, from which the seller is free to make withdrawals as needed. In many cases, if the firm leaves the money in the account, a will exist on which the factor will pay interest. In other instances, the factor may make to the firm against uncollected accounts that are not yet due. These advances represent a negative balance in the firm’s account, on which interest is charged. Factoring costs include commissions, interest levied on advances, and interest earned on surpluses. The factor deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the commissions. The commissions are typically stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The is generally 2 to 4 percent above the prime rate. It is levied on the actual amount advanced. The is generally between 0.2 and 0.5 percent per month. Although its costs may seem high, factoring has certain advantages that make it attractive to many firms. One is the ability it gives the firm to without having to worry about repayment. Another advantage is that it ensures a . In addition, if factoring is undertaken on a continuing basis, the firm . Inventory is generally second to accounts receivable in desirability as short-term loan collateral. Inventory normally has a market value that is greater than its book value, which is used to establish its value as collateral. A lender whose loan is secured with inventory will probably be able to sell that inventory for at least book value if the borrower defaults on its obligations. The most important characteristic of inventory being evaluated as loan collateral is . A warehouse of items, such as fresh peaches, may be quite marketable, but if the cost of storing and selling the peaches is high, they may not be desirable collateral. such as moon-roving vehicles, are also not desirable collateral because finding a buyer for them could be difficult. When evaluating inventory as possible loan collateral, the lender looks for items with very stable market prices that have ready markets and that lack undesirable physical properties. A lender may be willing to secure a loan under a , which is a claim on inventory in general. This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. Inventories of items such as auto tires, screws and bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. The interest charge on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often require floating liens as extra security on what would otherwise be an unsecured loan. Floating-lien inventory loans may also be available from commercial finance companies. A secured short-term loan against inventory under which the lender’s claim is on the borrower’s inventory in general. A often can be made against relatively expensive automotive, consumer durable, and industrial goods that can be identified by serial number. Under this agreement, the borrower keeps the inventory, and the lender may advance 80 to 100 percent of its cost. The lender files a on all the items financed. The borrower is free to sell the merchandise but is to remit the amount lent, along with accrued interest, to the lender immediately after the sale. The lender then releases the lien on the item. The lender makes periodic checks of the borrower’s inventory to make sure that the required collateral remains in the hands of the borrower. The interest charge to the borrower is normally 2 percent or more above the prime rate. A secured short-term loan against inventory under which the lender advances 80 to 100 percent of the cost of the borrower’s relatively expensive inventory items in exchange for the borrower’s promise to repay the lender, with accrued interest, immediately after the sale of each item of collateral. Trust receipt loans are often made by manufacturers’ wholly owned financing subsidiaries, known as to their customers. Captive finance companies are especially popular in industries that manufacture consumer durable goods because they provide the manufacturer with a useful sales tool. For example, General Motors Acceptance Corporation, the financing subsidiary of General Motors, grants these types of loans to its dealers. Trust receipt loans are also available through commercial banks and commercial finance companies. A is an arrangement whereby the lender, which may be a commercial bank or finance company, receives control of the pledged inventory collateral, which is stored by a designated agent on the lender’s behalf. After selecting acceptable collateral, the lender hires a warehousing company to act as its agent and take possession of the inventory. A secured short-term loan against inventory under which the lender receives control of the pledged inventory collateral, which is stored by a designated warehousing company on the lender’s behalf. Two types of warehousing arrangements are possible. A is a central warehouse that is used to store the merchandise of various customers. The lender normally uses such a warehouse when the inventory is easily transported and can be delivered to the warehouse relatively inexpensively. Under a arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged collateral. Regardless of the type of warehouse, the warehousing company places a guard over the inventory. Only on written approval of the lender can any portion of the secured inventory be released by the warehousing company. The actual lending agreement specifically states the requirements for the release of inventory. As with other secured loans, the lender accepts only collateral that it believes to be readily marketable and advances only a portion—generally 75 to 90 percent—of the collateral’s value. The specific costs of warehouse receipt loans are generally higher than those of any other secured lending arrangements because of the need to hire and pay a warehousing company to guard and supervise the collateral. The basic interest charged on warehouse receipt loans is higher than that charged on unsecured loans, generally ranging from 3 to 5 percent above the prime rate. In addition to the interest charge, the borrower must absorb the costs of warehousing by paying the warehouse fee, which is generally between 1 and 3 percent of the amount of the loan. The borrower is normally also required to pay the insurance costs on the warehoused merchandise. Are secured short-term loans viewed as more risky or less risky than unsecured short-term loans? Why? In general, what interest rates and fees are levied on secured short-term loans? Why are these rates generally than the rates on unsecured short-term loans? Describe and compare the basic features of the following methods of using to obtain short-term financing: pledging accounts receivable and factoring accounts receivable. Be sure to mention the institutions that offer each of them. For the following methods of using as short-term loan collateral, describe the basic features of each, and compare their use: floating lien, trust receipt loan, and warehouse receipt loan. Current liabilities represent an important and generally inexpensive source of financing for a firm. The level of short-term (current liabilities) financing employed by a firm affects its profitability and risk. Accounts payable and accruals are spontaneous liabilities that should be carefully managed because they represent free financing. Notes payable, which represent negotiated short-term financing, should be obtained at the lowest cost under the best possible terms. Large, well-known firms can obtain unsecured short-term financing through the sale of