Topic 7– Short-term and Medium-to-Long Term Debt Financing Flashcards
Short Term Debt
A debt financing arrangement for a period of less than one year
Short-term debt is used to finance
- working capital requirements
- liquidity needs or cash-flow mismatches
- inventory/stock
The short-term finance sources of funds used by business studied in this unit are
bank overdrafts
commercial bills
promissory notes
certificates of deposit
Bank overdrafts
- allows a firm to place its operating account into deficit (overdraft);
- limit is negotiated with the bank;
- limit and interest charged will depend on the credit standing and relationship the firm has with its bank
Operating Account
A cheque account through which a firm conducts its day to day financial transactions
Overdrafts interest charge
- interest is charged on the debit balance, at a margin above a ‘reference’ rate.
for example: reference rate may be the bank’s published ‘prime rate’ or BBSW
margin
the interest charge above a specified reference interest rate that reflects the credit risk of the borrower
Prime rate
a reference interest rate set by a financial institution for the purpose of pricing certain variable rate loans
The reference rate a bank might use
is the prime rate or published market rate such as BBSW
Overdraft fees include
establishment, account service, unused limit
Commercial bills
provide funding for non-specific business transactions
Bill of Exchange
is a binding agreement by one party to pay a fixed amount of cash to another party as of a predetermined date or on demand.
Two types of bills of exchange
Commercial Bills
Trade Bills
Trade Bills
A bill of exchange issues to finance a specific international trade transaction
3 types of commercial bills
Bank Accepted bills
Bank Endorsed bills
Non-Bank bills
A bank-accepted bill
bill that is issued by a corporation and incorporates the name of a bank as acceptor
Parties to a Bill of Exchange
Drawer
Acceptor
Payee/Endorser
Discounter
Drawer
- the issuer of the bill.
- has a secondary liability for repayment of the bill at maturity date.
Acceptor
- a bank that puts its name on the face of a bill and takes primary liability to repay the holder at maturity
- the bank acceptor improves the credit status of the bill.
- acceptor charges the drawer a fee.
Payee
The party who receives the the funds when a bill of exchange is initially discounted
-Usually the drawer, but the drawer can specify some other party as payee.
Discounter
The party that purchases a bill of exchange; the provider of funds
- May also be the acceptor of the bill.
- Purchases bill at less than the face value.
- Subsequent discounters may purchase existing bills in the secondary market.
Endorser
The party that signs the reverse of a bill, creates legal chain of ownerships
- The party that was previously a holder of the bill.
- Order of liability for payment of the bill runs from acceptor to drawer and then to endorser.
Steps of a Bank Accepted Bill
- issued today by the drawer, face value only repayable at the maturity date.
- on the issue date, the payee receives the discounted amount.
- the difference between the discounted amount and the face value is the yield.
- at maturity date the holder of the bill will receive the face value of the bill from the acceptor [bank].
- the acceptor will, at the same time, recover its funds from the drawer under a separate related agreement.
Promissory Notes
Discount securities issued by corporations without an acceptor or endorsement
Generally referred to in the markets as commercial paper
Negotiable Certificates of Deposit
Is a short term discount security, issued by a bank, typically with an initial term to maturity of up to 180 days
Types of medium to longer term finance
term loans
mortgage finance
corporate bonds (debentures and unsecured notes)
lease finance
Term Loan
A loan advanced for a specific period, usually for a known purpose; fixed or variable interest rate
Use of Term Loans
typically used to finance capital expenditure (e.g. buildings, equipment)
Time frame for Fixed Term loans
from 3 to 15 years
3 term loan repayment types
Interest Only
Amortised Loan
Deferred repayment loan
Interest Only Loan
periodic interest payments, with principal repaid at maturity.
Amortised Loan
equal periodic instalments, comprising interest and principal reduction.
Deferred Repayment Loans
repayment commences after a specified period , usually when a project becomes cash flow positive
Interest rate charged on a loan will depend on
The credit risk of borrower
the term of loan
the repayment schedule
Term Loan Fees include
establishment, account service, and commitment fees.
Service Fee
Charged by lender to offset ongoing loan account administration costs
Commitment Fee
A charge on any portion of a financing facility that has not been drawn down
Loan Covenants
Restrict the business and financial activities of the borrowing firm
conditions designed to protect the lender
2 types of loan covenants
Positive and Negative
Positive Covenants
Actions specified in loan contract which must be taken by borrower
e.g. maintain a minimum level of working capital, audit accounts
Negative Covenants
Conditions included in a loan contract that restrict the activities and financial structure of borrower
e.g. amount of dividend, maximum debt to equity ratio, limits further borrowing.
Mortgage
- A mortgage is a form of security given by the borrower to the lender for a loan;
- the borrower (mortgagor) conveys an interest in land to the lender (mortgagee);
- the mortgage is registered on the asset
mortgage loans include both
residential and commercial mortgage loans
residential mortgage loans time frame
up to 30 years
commercial mortgage loans time frame
up to 10 years
Which debt securities are issued in the corporate bond market
debentures, unsecured notes, and subordinated debt
Debentures and Unsecured Notes
- borrower company will make periodic interest payments during the term of the bond, and repay the face value to the holder at maturity date.
- generally fixed interest instruments, with equal interest coupons payable half-yearly
Debenture
- corporate bond with a form of security attached
- cost of borrowing usually lower
- listed on stock exchange
- higher claim of assets (on liquidation) than unsecured note holders
Unsecured Notes
- unsecured corporate bond
- higher risk so higher cost of borrwoing
- issued by companies with good credit rating
- limited secondary market
Three ways to issue debentures or unsecured notes
Public issue
Family issue
Private placement
Public Issue
Issued to the public at large, by prospectus
Family issue
Issued to existing shareholders and investors by prospectus
Private placement
Issued to institutional investors, prospectus not required
Subordinated Debt
A long term debt issue; holders claims are subordinated against all other creditors, but before equity holders
‘Tier 2 capital’
Leasing
- leasing is borrowing (renting) of an asset instead of borrowing funds to purchase the asset.
Lease
contract where the owner of an asset (lessor), grants another party (lessee), the right to use the asset for an agreed period of time in return for periodic rental payments.
Providers of Lease Finance
- major providers of lease finance are banks and finance companies
- some manufacturers of capital equipment provide their own lease finance
