Short-term Funding Choices

Regular assessment of short-term funding aims to ensure that a company has the ability to handle peak cash needs and maintain sufficient sources of credit to fund ongoing cash needs.

Short-term Funding

The short-term funding alternatives that are available to a company may be divided into bank sources and non-bank sources.

Bank sources of funding include:

• uncommitted lines of credit – this is the weakest form of bank borrowing since it involves no formal commitment from the bank;
• regular lines of credit – these are stronger than uncommitted lines due to the presence of a formal bank commitment;
• overdraft lines;
• revolving credit agreements – these are the strongest form of short-term bank borrowing facilities. They have formal legal agreements;
• collateralized loans – these loans require a borrower to list a collateral in the form of an asset;
• discounted receivables;
• banker’s acceptances; and
• factoring

Non-bank sources of funding include:

• non-bank finance companies; and
• commercial paper

Recommending a Financing Method

Given a range of short-term funding options, a company has to select the most cost-effective one. To determine the cost of borrowing for comparison, the total cost of borrowing for each option is divided by the total loan proceeds, adjusting for any discounting or compensating balances.

For a line of credit which requires payment of a commitment fee:

$$ \text{Cost}=\cfrac {\text{Interest}+\text{Commitment Fee}}{\text{Loan amount}} $$

However, if the interest rate is stated as “all-inclusive” and the loan amount includes the amount of interest, for example, in the case of banker’s acceptances, then the formula is adjusted as follows:

$$ \text{Cost}=\cfrac {\text{Interest}}{\text{Net proceeds}}=\cfrac {\text{Interest}}{\text{Loan amount}-\text{Interest}} $$

If the borrowing arrangement is all-inclusive and involves a dealer’s commission and backup costs, for example, in the case of commercial paper, the formula is again adjusted as follows:

$$ \text{Cost}=\cfrac {\text{Interest}+\text{Dealer’s commission}+\text{Backup costs} }{\text{Loan amount}-\text{Interest}} $$

It is important to keep the periods for the loan proceeds and interest payments consistent during the computation.

Question

A company is considering three options for borrowing $5 million for one month:

• a line of credit at 8% with a 0.5% commitment fee on the full amount and no compensating balances;
• a banker’s acceptance at an all-inclusive rate of 7.8%; and
• commercial paper at 7.4% with dealer’s commission of ¼% and backup costs of 1/3%.

Which of these forms of borrowing has the lowest cost of credit?

A. Commercial paper

B. Line of credit

C. Banker’s acceptance

Solution

The correct answer is C.

For the line of credit:

$$ \text{Cost}=\cfrac {\text{Interest}+\text{Commitment Fee}}{\text{Loan amount}} $$

$$ \text{Cost}=\frac { \left( 0.08\times $5,000,000\times { 1 }/{ 12 } \right) \left( 0.005\times $5,000,000\times { 1 }/{ 12 } \right) }{ $5,000,000 } \times 12=8.5\% $$

For the banker’s acceptance:

$$ \text{Cost}=\cfrac {\text{Interest}}{\text{Net proceed}} \times 12 $$

$$ \text{Cost}=\frac { \left( 0.078\times $5,000,000\times { 1 }/{ 12 } \right) }{ $5,000,000-\left( 0.078\times $5,000,000\times { 1 }/{ 12 } \right) } \times 12=7.85\% $$

For the commercial paper:

$$ \text{Cost}=\cfrac {\text{Interest}+\text{Dealer’s commission}+\text{Backup costs} }{\text{Loan amount}-\text{Interest}} \ast 12 $$

$$ \begin{align*} \text{Cost} & \\ & =\frac { \$30 833.33 + \$1 041.66 + \$1 388.75}{ $5,000,000-\left( 0.074\times $5,000,000\times { 1 }/{ 12 } \right) } \times 12 \\ & =8.03\% \\ \end{align*} $$

In each of the calculations, we multiply by 12 in order to get an annual rate. Since the 7.85% cost for the banker’s acceptance is the lowest of the three options, the banker’s acceptance has the lowest cost of credit.

Reading 35 LOS 35g:

Evaluate the choices of short-term funding available to a company and recommend a financing method