Short- and medium-term finance

Question 1

Mrs Grass is buying a lawnmower. She uses a hire purchase agreement with the local garden
centre to take the lawnmower home and cut her lawn today. However, she subsequently fails to
make the payments under the hire purchase agreement. State the action that the garden centre
would take.

Answer 1

Solution
The garden centre would reclaim the lawnmower and have a second-hand lawn mower for sale.
Companies will often use hire purchase agreements to buy machines and computer equipment. It is
important from the seller’s point of view that the term of the hire purchase agreement is a lot less
than the useful life of the good. If this is not the case, the buyer might decide not to make the final
payments when the good is worthless.

Question 2

Question
Mrs Grass wants to buy another lawnmower. The garden centre has a hardly used second-hand
lawn mower on sale available under a credit sale agreement. Mrs Grass uses the credit sale
agreement, but once again Mrs Grass fails to keep up the repayments. State the action that the
garden centre would take.
Sol

Answer 2

Solution
The garden centre would most likely first send Mrs Grass letters threatening to take her to court.
If she fails to pay, she would be taken to court and ordered to pay the money owing.
If she still fails to pay, bailiffs would likely be sent to Mrs Grass’ home to seize possessions equal in
value to the amount owed.

Question 3

Question
Compare the features of a credit sale agreement with a hire purchase agreement

Answer 3

Solution
Ownership of asset – Under a hire purchase agreement, ownership of the asset does not pass to
the buyer until the last payment is made. Under a credit sale agreement the ownership passes
immediately.
Structure of payments – Both involve a series of (usually fixed) payments over a period of years.
Event of default – Under a hire purchase agreement the owner can reclaim the asset. Under a
credit sale, the recipient of the payments must sue to reclaim the outstanding amounts.

Question 4

Medium-term finance usually has a term of over ______ but less than ______. Short-term finance, on the other hand, has a term of ______ one year.

Answer 4

Medium-term finance usually has a term of over one year but less than five years. Short-term finance, on the other hand, has a term of less than one year.

Question 5

There are four forms of medium-term finance:

Answer 5

There are four forms of medium-term finance: hire purchase, credit sale, leasing, and bank loans.

Question 6

Explain Hire purchase

Answer 6

Hire purchase agreements are used by both consumers and commercial transactions. The agreement requires regular rental payments and ownership only passes to the buyer when the final payment is made. The seller can take back the goods if the buyer fails to make the payments due under the hire purchase agreement.

Question 7

Credit sales are similar to hire purchase agreements, but ……

Answer 7

Credit sales are similar to hire purchase agreements, but legal ownership passes from the seller to the buyer at the start of the agreement. The seller cannot reclaim the goods even if the buyer defaults. The seller has no more legal right over the good sold than over any of the defaulting customer’s other possessions.

Question 8

Leasing is used by companies to _________

Answer 8

Leasing is used by companies to obtain the use of machines, property, and vehicles. Legal ownership does not change hands. Instead, the lessee has the right to use the asset over a period of time in return for a regular series of payments. Lease agreements may or may not give the lessee the option to buy the asset at the end of the lease period.

Question 9

what are the two types of leases explain them.

Answer 9

Operating leases and finance leases are the two types of leases. Operating leases are for a period substantially shorter than the likely life of the asset, while finance leases are for the expected economic life of the asset.

Question 10

Bank loans are another form of medium-term finance. They may be secured or .

Answer 10

Bank loans are another form of medium-term finance. They may be secured or unsecured and usually involve regular repayments of principal and interest. The repayment period is typically between one and five years.

Question 11

The loan facilities you mentioned, where borrowers can take out the loan in instalments, are known as

Answer 11

The loan facilities you mentioned, where borrowers can take out the loan in instalments, are known as flexible loans or revolving credit facilities. They can be a useful option for borrowers who have irregular income or expenses, as they allow for greater flexibility in repayment schedules.

Question 12

Multi-currency loans and syndicated loans are

Answer 12

Multi-currency loans and syndicated loans are more complex options that are typically used for larger-scale borrowing. Multi-currency loans can be beneficial for borrowers who need to borrow in a foreign currency, as the bank can help them navigate the foreign exchange market and obtain the best exchange rates.

Question 13

Syndicated loans,

Answer 13

Syndicated loans, on the other hand, are used when the amount needed to borrow is too large for a single bank to provide, and a group of banks work together to provide the necessary funds.

Question 14

It is important for borrowers to carefully consider the terms and conditions of any loan facility they are considering,

Answer 14

including interest rates, fees, and repayment schedules, in order to make an informed decision about whether it is the right option for their needs.

Question 15

types of short-term finance:

Answer 15

bank overdrafts
 trade credit
 factoring
 bills of exchange
 commercial paper.

Question 16

Bank overdrafts

Answer 16

A form of short-term borrowing where the borrower is granted a facility to draw money out of a current account.
The borrower can go down to an agreed limit, and pay interest only on the amount they are actually overdrawn.

Question 17

Overdrafts made to companies are usually secured by a floating charge.
Interest rates are almost always

Answer 17

variable, often on a daily basis, and will usually be higher than on a loan of an equivalent amount.

Question 18

Overdrafts are more flexible, and the borrower pays interest only on

Answer 18

the amount of the facility that is actually used.

Question 19

Banks prefer overdrafts to be used for

Answer 19

short-term working capital needs.

Question 20

Overdraft facilities usually need to be re-negotiated annually, and a bank can demand

Answer 20

immediate repayment with no notice.

Question 21

Borrowing on overdraft for long-term purposes makes a company vulnerable to

Answer 21

a bank’s continuing support.

Question 22

Lack of _______ with an overdraft being called in causes business bankruptcy, not a fundamental lack of profitability.

Answer 22

Lack of liquidity with

Question 23

Trade credit ?

Answer 23

An agreement between a company and one of its suppliers to pay for goods or services after they have been supplied.

Question 24

Benefits of trade credit

Answer 24

Available from almost all suppliers of goods and services to their business customers.
Late payment is common, and no explicit interest is charged.

Question 25

Businesses often try to pay ______________________

Answer 25

later than the date stated on the invoice.

Question 26

Using trade credit is a way for businesses to obtain ‘free’ finance, but it can

Answer 26

damage a company’s relationship with its suppliers.

Question 27

Trade credit can cause problems for the suppliers of goods, who can use factoring to finance it.
There are two types of factoring:

Answer 27

non-recourse factoring and recourse factoring.

Question 28

Non-recourse factoring is

Answer 28

where the supplier sells on its trade debts to a factor in order to obtain cash payment of the accounts before their actual due date.

Question 29

Non-recourse factoring characteristics

Answer 29

The factor takes over all responsibility for credit analysis of new accounts, payment collection, and credit losses.
The factor gives the supplying company money earlier than if it had to wait to be paid, protection against bad debts, and an administrative service.

Question 30

Recourse factoring is

Answer 30

where the supplying company is still responsible for collecting its debts.The factor has no control over the debt collection process, and excessive pressure on the supplying company’s customers could have a negative effect on the supplier’s future business with these customers.

Question 31

State with reasons whether a bank loan or a bank overdraft is likely to be more expensive.

Answer 31

Solution
A bank overdraft is likely to be more expensive. The reasons include:
 Overdrafts are more flexible for the borrower, so are less predictable for the lender.
 Loans are normally secured on assets of the company. Overdrafts are usually unsecured
and therefore more risky for the lender.

Question 32

Bills of exchange:

Answer 32

A bill of exchange is a formal document drawn up by a supplier (drawer) of goods or services, asking the customer (drawee) to sign it, guaranteeing to pay a certain sum of money to the supplier or their order at a future date.

Question 33

benefit of a bill of exchange

Answer 33

is that the supplier can sell the bill to a discount house or bank for cash, with the bill acting as collateral for the loan.

Question 34

Before a bill of exchange is bought, it has to be guaranteed by

Answer 34

an investment bank, which will endorse the bill, making it known as a ‘bank bill’ or a ‘bill of exchange.’

Question 35

Bills of exchange are considered ‘two-name’ papers since

Answer 35

they carry the name of the company which owes the money and the name of the accepting bank.

Question 36

Bills of exchange can be sold on to a ______ or a ______, which will pay a price ________-the face value of the bill.

Answer 36

Bills of exchange can be sold on to a discount house or a bank, which will pay a price below the face value of the bill.

Question 37

Eligible bills of exchange are those that are guaranteed by

Answer 37

an investment bank, which is approved by the Bank of England, making them secure investments.

Question 38

Commercial paper:

Answer 38

Commercial paper is a type of short-term borrowing by large companies, which is an alternative to overdrafts or short-term bank loans.

Question 39

Commercial paper is issued at a discount and later redeemed at its

Answer 39

face value.

Question 40

The effective rate of interest paid by the borrowing company for the commercial paper will be slightly

Answer 40

higher than the equivalent rate on a risk-free investment

Question 41

The size of the ‘margin’ over the risk-free rate of interest will depend on the company’s

Answer 41

credit rating.

Question 42

Commercial paper is not listed on the Stock Exchange but can be

Answer 42

bought and sold quite easily.

Question 43

Commercial paper is a type of bearer document, meaning

Answer 43

there is no register of holders, and payment is made to whoever presents the piece of paper at the end of the term.

Question 44

why is Commercial paper is described as a ‘single-name’ security

Answer 44

as the security is provided only by the company issuing the paper, unlike bank bills.

Question 45

Question
(i) State the advantages and disadvantages of hire purchase agreements and credit sale
agreements from the point of view of the supplier.
(ii) State the main distinction between an operating lease and a finance lease.
(iii) State the main distinction between a bank loan and a loan facility.
(iv) State the main distinction between a loan facility and an overdraft.
(v) State the main distinction between a credit sale agreement and trade credit.

Answer 45

Solution
(i) Hire purchase and credit sale agreements
Hire purchase
 Advantage to supplier: the supplier retains ownership of the goods until the end of the
term of the agreement and can reclaim them if the buyer does not keep up the
repayments. Seller receives interest on top of the price of the goods.
 Disadvantage to supplier: not as good as getting the cash up-front.
Credit sale agreement
 Advantage to supplier: seller receives interest in addition to the price of the goods.
 Disadvantage to supplier: legal ownership of the goods passes to the buyer at the start of
the agreement. If the buyer defaults on the repayments, the seller has to sue the buyer
through the courts.
(ii) Operating and finance leases
Operating lease
The owner of the asset retains most of the risks associated with ownership of the asset. The term of
the lease will be substantially shorter than the expected useful life of the asset.
Finance lease
The lessee takes on most of the risks and rewards of ownership. The term of the lease will be close
to the expected useful life of the asset.CB1-06: Short- and medium-term finance Page 15
The Actuarial Education Company © IFE: 2019 Examinations
(iii) Bank loan and loan facility
Bank loan
Here, a fixed sum is lent to the borrower on a fixed date for a specified term.
Loan facility
A sum is made available to the borrower. The borrower may draw the sum in instalments, giving
the bank a few days’ notice of each instalment. In addition, there may be flexible repayment
arrangements. Interest is only charged on the amount outstanding.
(iv) Loan facility and overdraft
Loan facility
A sum of money is available for borrowing. This sum can be drawn in instalments and added to the
borrower’s bank account. The bank will need a few days’ notice before each instalment is made.
There may be flexible repayment terms.
Overdraft
The borrower is granted a facility to draw money out of a current account so that its balance
becomes negative, subject to an agreed maximum limit. The borrower does not have to give any
notice to be able to use the overdraft. There are no set repayment terms. However, the bank has
the option to demand immediate repayment of the overdraft at any time with no notice.
(v) Credit sale and trade credit
Credit sale
This will be repaid by regular instalments over a period of time. The instalments will include an
element of interest.
Trade credit
This means that a company can pay its supplier for goods and services after they have been
received. Typically, business customers will settle their bills 30 to 60 days after they have been
invoiced. The bills are then settled in full, in one payment. No explicit interest is charged, although
suppliers may give discounts for ‘cash on delivery’.
The Examiners may ask for descriptions of the main forms of finance and comparisons between
them. They may also ask which form of finance may be most appropriate in a particular situation.Page 16 CB1-06:

Question 46

Which of the following is most often used by companies that are suffering from cashflow
problems arising from late-paying customers?
A hire purchase
B bills of exchange
C invoice discounting
D trade credit

Answer 46

Answer = C
Invoice discounting is another name for recourse factoring. This provides early payment of a
percentage of the value of the invoices by a factor. The supplier retains contact with the
customers and when the customers eventually pay their bills, the loan is repaid to the factor, with
interest.

Question 47

List the features of commercial paper. Explain how it differs from a bill of exchange

Answer 47

Commercial paper is
 a short-term bearer document issued at a discount and redeemed at par [1]
 issued by large companies who have to meet certain minimum requirements, for
example, be listed on the London Stock Exchange [1]
 a single-name paper, ie the name of the company that owes the money. [1]
A bills of exchange is also issued at a discount and redeemed at par … [1]
… but differs in that it is:
 potentially much smaller in size, as issues of commercial paper require to be at least £50m
in size. [1]
 two-name paper, ie the name of the company that owes the money and the name of the
bank or issuing house that is guaranteeing payment. [1