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Subject 5. Managing Short-Term Financing PDF Download
There are two sources of short-term financing:

Bank Sources

Unsecured Loans: A form of debt for money borrowed that is not backed by the pledge of specific assets.

  • Line of credit (L/C).

    • A bank provides a letter of credit, for a fee, guaranteeing the investor that the company's obligation will be paid. It is a promise from a bank for payment in the event that certain conditions are met.
    • It is frequently used to guarantee payment of an obligation.
    • Committed lines of credit are stronger than those that are uncommitted because of the bank's formal commitment.

  • Revolving credit agreement: A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
  • Banker's acceptance.

    • These are short-term promissory trade notes for which a bank (by having "accepted them") promises to pay the holder the face amount at maturity.
    • They are used to facilitate foreign trade or the shipment of certain marketable goods.

Secured Loans: A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.

  • Factoring accounts receivable. Factoring is the selling of receivables to a financial institution, the factor, usually "without recourse."

    • A factor is often a subsidiary of a bank holding company.
    • A factor maintains a credit department and performs credit checks on accounts.
    • This type of loans allows a firm to eliminate its credit department and the associated costs.
    • Contracts are usually for 1 year, but are renewable.

  • Inventory-backed loans. Loan evaluations are made on the basis of marketability, price stability, perishability, and difficulty and expense of selling for loan satisfaction.
  • Floating Lien: A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.
  • Trust Receipt: A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.
  • Terminal Warehouse Receipt: A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.

Nonbank Sources

  • Commercial paper.

    • Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).
    • Cheaper than a short-term business loan from a commercial bank.
    • Dealers often require a line of credit to ensure that the commercial paper is paid off.

  • Nonbank finance companies.

The best mix of short-term financing depends on:

  • Cost of the financing method;
  • Availability of funds;
  • Timing;
  • Flexibility;
  • Degree to which the assets are encumbered.

Cost of Borrowing

The fundamental rule is to compute the total cost of borrowing and divide that by the net proceeds.

  • Collect basis: interest is paid at maturity of the note.

    • Example: $100,000 loan at 10% stated interest rate for 1 year.
    • $10,000 in interest / $100,000 in usable funds = 10.00%.

  • Discount basis: interest is deducted from the initial loan.

    • Example: $100,000 loan at 10% stated interest rate for 1 year.
    • $10,000 in interest / $90,000 in usable funds = 11.11%.

  • Compensating balances: demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans.

    • Example: $1,000,000 loan at 10% stated interest rate for 1 year with a required $150,000 compensating balance.
    • $100,000 in interest / $850,000 in usable funds = 11.76%.

  • Commitment fees: The fee charged by the lender for agreeing to hold credit available on the unused portions of credit.

Example

$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?

Interest: ($600,000) x (10%) = $60,000
Commitment Fee: ($400,000) x (0.5%) = $2,000
Compensating Balance: ($600,000) x (5%) = $30,000
Usable Funds: $600,000 - $30,000 = $570,000

Cost = ($60,000 in interest + $2,000 in commitment fees) / $570,000 in usable funds = 10.88%

Learning Outcome Statements

g. evaluate the choices of short-term funding available to a company and recommend a financing method.

CFA® Level I Curriculum, 2020, Volume 4, Reading 35

User Contributed Comments 3

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Shaan23 Screw this section. If it gets me it gets me. Those questions were information overload....
chris297 Do we really need to know all these? Can someone who has read the curriculum advise me?
applelee I have this in the Mock exam ....
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