Current Liabilities Management

Week 7

Spontaneous Liabilities

Sources

1. Accounts Payable

2. Accruals (wages and taxes)

Spontaneous Liabilities: Accounts Payable Management• Accounts payable

– Average payment period– Payment float time– Credit terms – Cash discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.)• Cost of Giving Up the Cash Discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.)• Cost of Giving Up the Cash Discount

Spontaneous Liabilities: Analyzing Credit Terms (cont.)

Calculation

Supplier Credit TermsX 1/10 net 55 EOMY 2/10 net 30 EOMZ 2/20 net 60 EOM

a. Calculate the cost of giving up cash discount from each supplier.

b. Assuming that the firm needs short term financing, indicate whether it would be better to give up the cash discount or take it and borrow from bank at 15% annual interest.

Spontaneous Liabilities: Effects of Stretching Accounts Payable

Supplier Credit TermsY 2/10 net 30 EOM

• Postpone the credit period to 50 days from 30.

Unsecured Sources of Short-Term Loans:

1. Bank Loans2. Commercial Paper

Bank LoansSelf-liquidating Types:• single-payment notes• lines of credit• revolving credit agreements.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)• Loan Interest Rates

– Prime rate of interest – Premium

Types of Loans:1. Fixed Rate Loans2. Floating Rate Loans

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)• Method of Computing Interest

– Nominal rate – Effective rate of interest

If interest rate is paid at maturity:

Calculation• If interest rate is paid at maturity:

$10,000, 90 day loan at an interest rate of 15% p.a. payable at maturity.a) How much interest will be paid on 90 day loan?b) Find effective 90 day rate on the loanc) Find the effective annual rate if the loan is

rolled over every 90 days throughout the year.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)

If the interest is paid in advance (discount loans)

ExpenseInterest Annual - BorrowedAmount

ExpenseInterest Annual Interest Effective

Effective Rate• Calculation

A financial institution made a $10,000, 1 year discount loan at 10% interest. Determine the effective annual rate associated with this loan.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)• Single Payment Notes

– A single-payment note is a short-term, one-time loan payable as a single amount at its maturity.

CalculationBank A

Bank BLoan Amount $100,000

$100,000Premium Rate 1.5%

1%Interest type Fixed

FloatingLoan Period 90 days

90 daysPrime Rate 9%

9%

9.5%

9.25%

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)

• Line of Credit (LOC)

– Loan Amount is not guaranteed

– Floating rate

– Operating- Change restrictions

– Compensating Balance

– Annual Cleanups

• Calculation

A financial institution made a $10,000, 1 year discount loan at 10% interest, requiring compensating balance equal to 20 % of the face value of the loan. Determine the effective annual rate associated with this loan.

Unsecured Sources of Short-Term Loans: Bank Loans (cont.)

Revolving Credit Agreement (RCA)

• Guaranteed line of credit• Commitment fees

Unsecured Sources of Short-Term Loans: Commercial Paper

• Commercial paper - unsecured promissory note

• Sold at a discount form par value.

• 3 to 270 days

• Interest rate < Prime rate

• Other costs (rating cost, line of credit, floatation costs etc)

Unsecured Sources of Short-Term Loans: International Loans

• Exchange Rate Risk

• Letter of Credit

• Transactions between Subsidiaries

Secured Sources of Short-Term Loans: Characteristics

• Collateral does not reduce the riskiness of default on a loan.

• Life of the loan and maturity of collateral.• Loan amount is 30 and 100 percent of the book value

of the collateral.• rate of interest on secured loans > interest on

unsecured debt.

Secured Sources of Short-Term Loans

• The Use of Accounts Receivable as Collateral

– Pledging accounts receivable

– Value adjustment of acceptable A/R accounts

– lend between 50 and 90 percent of the face value of acceptable receivables.

– Lien on the collateral

– Notification Vs Non-Notification

– Cost of pledge > Prime Rate

Secured Sources of Short-Term Loans (cont.)• The Use of Accounts Receivable as Collateral

Factoring accounts receivable

– Factors (credit collection agencies)

– Loss absorbance

– Notification basis

Secured Sources of Short-Term Loans (cont.)• The Use of Inventory as Collateral

– Marketability of Inventory

Types:

1. Floating Liens – stable inexpensive inventory, <50% of BV,

3% to 5 % above Prime Rate

2. Trust Receipt – Expensive inventory, Lein, 80-100% of BV, 2% or more above Prime Rate

3. Warehouse Receipt – Inventory under lender’s control, 75-90% of BV, 3% to 5 % above Prime Rate, Other costs