FM- Financing Options Flashcards
Short-term (Working Capital) Financing
obligations that will become due within one year. Therefore, items which are considered current liabilities also are considered forms of short-term financing. In addition, current assets which can be used to secure financing would be forms of short-term financing.
include:
-Trade accounts payable
-Accrued accounts payable (e.g., wages, taxes, etc.)
-Short-term notes payable:is least likely to be restricted as to use of proceeds
-Line of credit, revolving credit and letter of credit
-Commercial paper
-Pledging accounts receivable
-Factoring accounts receivable
-Inventory secured loans
APR
APR = Discount Lost / Principal × 1 / Time Fraction of Year
Accrued Accounts Payable
Accrued accounts payable result from benefits or cash received for the related unpaid obligation. Thus, they are very much like trade accounts payable in their financing implications. Common examples are:
Salaries and wages payable
Taxes payable
Unearned revenue (collected in advance)
Short-Term Notes Payable
result from borrowing, usually from a commercial bank, with repayment due in one year or less. These borrowings are typically for a designated purpose, require a promissory note be given, and carry a rate of interest determined by the credit rating of the borrower. Although a promissory note (a legally enforceable promise to pay) is required, short-term notes generally are unsecured, unless the borrower’s credit rating dictates the lender require security. The interest rate usually will be expressed as a rate (or points) above the prime rate (or a similar benchmark). For example, the rate may be expressed as “1.00% over prime.”
Compensating balances are amounts that must be maintained on deposit with a bank as a condition of a bank loan or other service. A required compensating balance increases the cost of borrowing.
effective rate of interest
computed as the net proceeds from the loan divided into the cost of the loan.
Commercial Paper
Commercial paper:Short-term unsecured promissory notes sold by large, highly creditworthy firms as a form of short-term financing.
- maturity of 60–270 days.
- sold with interest discounted (deducted up front) or to pay interest over the (short) life of the note or at its maturity, and may be sold directly to investors or through a dealer.
- The effective interest rate is typically less than the cost of borrowing through a commercial bank.
- Firms that can issue commercial paper can borrow large sums at relatively low rates.
letter of credit
A letter of credit is a bank’s commitment on behalf of a firm to pay a third party under certain conditions.
-used to assure a foreign supplier of payment. A letter of credit is a conditional commitment to pay a third party in accordance with specified terms.
line of credit
provides a firm reasonable assurance that an amount of funds is available for borrowing.
Revolving credit agreement
A revolving credit agreement is a formal legal commitment, usually by a bank, to extend credit up to some maximum amount to a borrower over a stated period.
Pledging Accounts Receivable
commonly used form of obtaining short‐term financing.
-Financing through pledging accounts receivable uses a current asset—trade accounts receivable—as security for short-term borrowings. Specifically, the firm pledges some or all of its accounts receivable as collateral for a short-term loan from a commercial bank or finance company. If the terms of agreement between the firm and the lender provide that all accounts receivable are pledged without regard to or an analysis of the collectibility of individual accounts, the lender will lend a smaller portion of the face value of receivables than if only specific accounts with known risk are pledged
Factoring Accounts Receivable
Factoring accounts receivable is the sale of accounts receivable to a commercial bank or other financial institution (called a “factor”). Actual payment to the firm for its accounts receivable may occur at various times between the date of sale and collection of the receivables. The funds received can then be used for financing of other assets or used for other purposes. The terms of the sale may be:
Without Recourse—the factor bears the risk associated with collectibility (unless fraud is involved). transfers risk of uncollectibility to the buyer.
With Recourse—the factor has recourse against the firm for some or all of the risk associated with uncollectibility.
Inventory Secured Loans
inventory secured loan a firm pledges all or part of its inventory as collateral for a short-term loan. The amount that can be borrowed depends on the value and marketability of the inventory. Different arrangements for inventory secured loans provide different treatment of the inventory and different levels of security for the lender:
Floating lien agreement
The borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces.
Chattel mortgage agreement
The borrower gives a lien against specifically identified inventory and retains control of the inventory, but cannot sell it without the lender’s approval.
Field warehouse agreement
The inventory used as collateral remains at the firm’s warehouse, placed under the control of an independent third-party and held as security.
Terminal warehouse agreement
The inventory used as collateral is moved to a public warehouse where it is held as security.
Long-Term (Capital) Financing
Long-term financing comprises the sources of funds used by a firm that do not mature within one year.
a. intermediate-term financing-mature in more than one year but less than ten years
b. long-term financing- beyond ten years, including shareholders’ equity.
Since the different sources may overlap those two time periods, the discussion here treats both categories as long term and makes note of the likely term of each source. Furthermore, treating all sources of funding that are not short term as a group is consistent with distinguishing those sources which constitute capital structure (as contrasted with financial structure) of a firm.
Because long-term financing provides the major source of funding for most firms and because the length of commitment associated with these sources is by definition for a long period of time, a firm should carefully consider the alternative sources of long-term financing and the relative proportion of each it will employ. The cost associated with each source and the relative dollar amount of each source used will determine the firm's weighted average cost of capital that, as we discussed earlier, will determine which undertakings are economically feasible for the firm to pursue. The primary forms of long-term financing include: Long-term notes Financial (Capital) leases Bonds Preferred stock Common stock
Capital Markets
Markets in which long-term financial securities are traded.
Major markets exist for equity securities (stock markets) and bonds (bond markets).
1. Primary markets
Where new securities are issued, either directly by the issuer or from underwriters of the securities.
2. Secondary markets
Where previously issued securities are bought and sold, including:
a. Organized exchanges
Physical locations or electronic platforms for the orderly and fair matching of sellers and buyers of securities. Primary examples in the U.S. include New York Stock Exchange (NYSE), (Nasdaq).
b. Over-the-counter (OTC)
Where dealers interact directly with each other in the selling and buying of securities not listed on an organized exchange.
Outstanding stocks of publicly owned companies are traded among investors in the secondary market.
structured note
A structured note (or other structured security) is one whose cash flows (borrower’s/issuer’s payment obligation and lender’s/investor’s return) are contingent on changes in the value of an underlying interest rate, stock index, commodity price or other factor. As an example: A transportation company borrows using a five-year note with the interest rate on the borrowing tied to a transportation stock index. Because the cash flows are dependent on the value of an underlying, structured notes and other structured securities are derivatives.
leasing
A disadvantage of leasing is that the length of the lease may turn out to be longer than the usefulness of the asset to the firm.
net‐net lease
Other things being equal, a net‐net lease is likely to cost the lessee more than a net lease.
the lessee assumes responsibility for the executory costs during the life of the lease, as well as for a residual value at the end of the lease.
long‐term note
If the interest charged on a long‐term note is a function of the prime rate of interest, the interest rate on the note may change over the life of the note.
A violation of a restrictive covenant on a long‐term note can trigger default.
-may require collateral as security.
Financial leverage
Financial leverage derives from the use of debt with a fixed or determinable cost (rate of interest) for capital financing. Therefore, financial leverage would be possible with either fixed rate or variable rate debt (notes); however, fixed rate debt would better facilitate financial leverage because the cost of the use of debt‐financed capital would not change over the life of the financing. The cost of variable rate debt can change, thereby making the degree of leverage more uncertain over the life of the debt.
Debt covenants
place contractual limitations on activities of the borrower to help protect the lender, but they are not imposed “retroactively.” Agreeing to a debt covenant would reduce the risk and related interest rate associated with new debt, not existing debt.
net lease
the lessee assumes the executory costs associated with the asset during the lease, including such elements as maintenance, taxes and insurance.
Bonds
Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
- Indenture
the bond contract - Par value or face value
the “principal” that will be returned at maturity, most commonly $1,000 per bond - Coupon rate of interest
the annual interest rate printed on the bond and paid on par value - Maturity
the time at which the issuer repays the par value to the bondholders
Debenture bonds
Unsecured;
- no specific asset is designated as collateral.
- Carry more risk and, therefore, must provide a greater return than secured bonds.
- Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.
Secured bonds
Have specific assets (e.g., machinery and equipment) designated as collateral for the bonds.
