Chapter 8: Short Term Financing

Learning Outcomes
By the end of this chapter, learners should be
able to:
Understand the concept of secured and
unsecured financing.
Determine the cost of financing.
Calculate the effective cost of borrowing or short
term loans.
Calculate the effective cost of factoring and
pledging of receivable.
 Chapter Content
1. Types of Short Term Financing
a) Secured
b) Unsecured
2. Cost of Financing
 Introduction
Short term financing a short term obligation
that is expected to mature in one year or less.
Is usually required to support a large portion
of the firms current assets.
The use is to meet seasonal and temporary
fluctuation in the companys funds.
 Pros and Cons of Short Term Debt
Flexibility If the needs for funds are seasonal or cyclical, the use of short-
term financing is more appropriate as the firm may not want to
commit itself to long-term debt.
Cost of short term Interest will be lower on short-term rates than on long-term
debt is lower rates.
Relative riskiness The use of short-term debt tends to be riskier. This is due to:
Short term interest rates tend to fluctuate widely while a firm
using long-term debt can lock-in a given rate; and
If a firm borrows heavily on a short term basis, it may find itself
unable to repay or rollover this debt.
Internal or Spontaneous Financing
Short-term financing that is internally
generated from normal business activities.
Can be obtained from:
Accrued wages and taxes
Accounts payable or trade credit
 Direct Borrowings from Banks/
Unsecured Financing
Consists of short-term financing from external
sources.

Short Term
Bank loans

Notes Line of Revolving Commercial

Payable Credit Credit Paper
 Short Term Bank Loans
The banks provide non-spontaneous funds; as
the firms financing needs increase, it will
request its bank to provide the additional
funds.
 Notes Payable
A single payment loan obtained from a
commercial bank by a credit-worthy business
borrower.
This type of loan is made when a borrower
needs additional funds for a short period only.
The instrument resulting from this type of
short term unsecured loan is a note which
must be signed by the borrower.
The note states the term of the loan, the
maturity date and the interest charged.
 Line of Credit
It is an agreement between a commercial
bank and a business firm that states the
amount of unsecured short-term borrowing
the bank will make available to the borrower.
Typically it is made for a period of one year.
It is not a guaranteed loan but it indicates that
if the bank has sufficient funds available, it will
allow the borrower to owe it up to a certain
amount of money.
 Line of Credit
The borrower must apply each time he wants
to obtain a line of credit and submit
documents such as cash budget, proforma
income statement and proforma balance
sheet.
 Revolving Credit
Is a guaranteed line of credit.
The commercial bank guarantees the
borrower that a specified amount of funds will
be made available.
It could be for one, two or three years
depending on the agreement.
A commitment fee is charged to the borrower
on the unused balance of the credit
agreement.
 Consumer Revolving Credit
Credit card companies, department stores,
and banks grant consumers lines of credit up
to specified limits.
Interest is calculated each month on the
outstanding balance and this interest is added
to the previous balance.
Since interest is compounded monthly, the
effective rate will be higher than the stated
rate.
Revolving Credit Agreement (RCA)
It is a formal arrangement between the
borrower and the bank.
Involves commitment fee charged on the
unused portion of the facility granted.
The commitment fee is a penalty for not using
the total amount allocated.
 Overdraft
A short term facility provided by commercial
banks to current account holders.
Is designed to cover the customers short term
financial constraint.
Interest charged is dependant on the
borrowers financial risk.
Interest is calculated on a daily basis and
penalty is charged if the borrower does not
pay the interest at the end of the month.
 Commercial Paper
A form of financing that consists of short-term
unsecured promissory notes issued by firms
with high credit standing.
Generally only large corporations with good
reputation are able to issue commercial paper.
Maturities range from 3 to 270 days.
Generally issued in multiples of RM100,000 or
more.
 Account Receivable Factoring
Involves either pledging of receivables or
selling of receivable (known as factoring) to
secure a loan.
 Pledging
Occurs when account receivable is used as
collateral for loan.
The borrower pledges the account receivables
as collateral for a loan and the finance
company will assess the creditworthiness of
each of the accounts pledged.
 Inventory Financing

Floating Lien Terminal Warehouse Field Warehouse

Trust Receipts
Agreement Receipts Receipts
The firm receives The firm holds the The inventory is Similar to terminal
security interest on inventory for the forwarded as warehouse receipt,
the firms entire lender and any collateral that will but the inventory is
inventory that may proceeds from the be stored in a stored in the firms
include present and inventory must be bonded warehouse. own warehouse.
future inventory. forwarded to the The warehouse will The inventory is
lender. only release the separated from the
inventory when firms other
authorized by the inventories. Only
lender as the the lender has the
borrower repays its authority to release
loan. the goods.
 Cost of Loan

Nominal Interest Effective Annual Compensating

Discounted Loan
Rate Interest Rate Balance
Interest rate The actual cost Interest on Deposit that
unadjusted for of borrowing loans is paid in the firm keeps
inflation or after taking advanced. with the bank
terms of into Reduces loan to compensate
borrowing. consideration proceeds that for bank loans
Is normally the differential can be used by or services.
stated at face in periods of the borrower. Will also
value of the compounding reduce
interest and terms proceeds.
charged on associated with
borrowings. the
borrowings.
 Effective Interest Rate
EIR = Interest x 12
Net Proceeds Maturity in months

Example:
If the borrower receives RM10,000 now at 12%
interest for a one year period, what is the EIR?
 Effective Interest Rate
Interest = RM10,000 x 12% = RM1,200

EIR = RM1,200 x 12
RM10,000 12
= 12%

Example:
If the borrower receives RM10,000 now at 12%
interest for a period of 6 months, what is the EIR?
 Effective Interest Rate
Interest = RM10,000 x (0.12/ 2) = RM600

EIR = RM600 x 12
RM10,000 6
= 12%
 Discounted Interest Rate
Occurs when the bank deducts the interest in
advance.
Example: If the borrower borrows RM10,000
at 12% interest for a one year period at
discounted interest, what is the EIR?
 Discounted Interest Rate
Interest = RM10,000 (0.12) = RM1,200
Net Proceeds = RM10,000 RM1,200 = RM8,800

EIR = RM 1,200 x 12
RM8,800 12
= 13.64%

Example:
If the borrower borrows RM10,000 at 12% interest at
discounted basis for a six months period, what is the
EIR?
 Discounted Interest Rate
Interest
EIR == RM
RM10,000
10,000 (0.12/2)
(0.12/2) =x RM600
12
Net Proceeds = RM10,000
RM9,400
RM600 = RM9,400
6
= 12.77%
EIR = RM 600 x 12
RM9,400 6
= 12.77%
 Compensating Balance
Compensating balance will increase the
effective interest rate.
Example: If the borrower borrows RM10,000
at 12% interest for a one year period and is
required to have a compensating balance of
10%, what is the EIR?
 Compensating Balance
Interest = RM10,000 (0.12) = RM1,200
Compensating = RM10,000 (0.10) = RM1,000
Balance
Net Proceeds = RM10,000 RM1,000 = RM9,000

EIR = RM 1,200 x 12
RM9,000 12
= 13.33%
Example: If the borrower borrows RM10,000 at 12% interest
at discounted basis for a six months period and is required to
have a compensating balance of 10%, what is the EIR?
 Compensating Balance
Interest = RM10,000 (0.12/2) = RM600
Compensating = RM10,000 (0.10) = RM1,000
Balance
Net Proceeds = RM10,000 RM1,000 = RM9,000

EIR = RM 600 x 12
RM9,000 6
= 13.33%
 Discounted Interest and
Compensating Balance
Example: If a firm borrows RM10,000 for a
one year period and is charged a
compensating balance of 8% and discounted
interest of 10%. What is the firms effective
interest rate?
 Discounted Interest and
Compensating Balance
Interest = RM10,000 (0.10) = RM1,000
Compensating = RM10,000 (0.08) = RM800
Balance
Net Proceeds = RM10,000 RM1,000 = RM8,200
RM800

EIR = RM 1,000 x 12
RM8,200 12
= 12.20%
 Illustration 1
Assume that a firm has been granted a
revolving credit amounting RM100,000 at 14%
annual interest and 0.50% of commitment fee.
It only uses RM80,000 and RM20,000 left
unused. What is the EIR of the firm?
 Solution
Interest = RM80,000 (0.14) = RM11,200
Commitment = RM20,000(0.005) = RM100
Fee
Compensating = None
Balance

EIR = Interest + Commitment Fee x 12

Amount Borrowed Time
Compensating Balance
= RM11,200 + RM100 X 12
RM80,000 0 12
= 14.13%
 Illustration 2
Assume that a firm plans to issue RM100,000
commercial paper that is sold at 94% of its
face value. If the maturity is 6 months and the
issuing cost is 5%, calculate the EIR.
 Solution
Interest = RM100,000 RM100,000 (0.94) = RM6,000
Cost = RM100,000 (0.05) = RM5,000

EIR = Interest x 12
(Face Value Interest Cost) Time
= RM6,000 X 12
RM100,000 RM6,000 RM5,000 6
= 13.48%
 Illustration 3
Renong Corporation has just issued RM1
million worth of commercial paper that has a
90-day maturity and sells for RM980,000. At
the end of 90 days, the purchaser of this
paper will receive RM 1 million for their
investment. Calculate the effective rate of
interest if the interest charged is 2%.
 Solution
Interest = RM1 million (0.02) = RM20,000
Proceeds = RM980,000

EIR = Interest x 12
Proceeds Time
= RM20,000 X 360
RM980,000 90
= 8.16%
 Exercise 1
Mustika Bhd has a revolving credit agreement with
AGS Bank under which it can borrow up to RM15
million. The company must maintain a 10%
compensating balance on outstanding loans. Interest
on the borrowed funds is 15% and the commitment
fee is 1.5% on the unused portion of the credit line.
Find the effective interest rate for Mustika Bhd if the
amount borrowed is:
RM3 million
RM15 million
 Exercise 2
Ratu Bhd determined that it needs an
additional capital of RM100 million. The
financial manager of the company has decided
to issue a commercial paper to fund the
capital. The interest rate is 9.5% and the
placement fee is RM150,000. The commercial
paper has a 270-day maturity. Calculate the
effective rate for this paper.
 References
1. Financial Management by Rohani A. Ghani
and Mohd Sabri Hj Mohd Amin, InED, UiTM
Shah Alam.
End of Chapter 8

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