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Exam: June 2015 Level 1 > Study Session 11. Corporate Finance > Reading 39. Working Capital Management

Learning Outcome Statements

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

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Subject 5. Managing short-term financing

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 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.
  • Bankers' acceptance.
    • They 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."
    • Factor is often a subsidiary of a bank holding company.
    • Factor maintains a credit department and performs credit checks on accounts.
    • Allows firm to eliminate their credit department and the associated costs.
    • Contracts are usually for 1 year, but are renewable.

  • Inventory-backed loans. Loan evaluations are made on 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 computer 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 is on the unused portions of credit.


$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%.

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  1. Shaan23: Screw this section. If it gets me it gets me. Those questions were information overload....

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