Chapter 9 sources of short term debt
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Chapter 9 Sources of Short-Term Debt. Learning Objectives. Identify the main forms of short-term borrowing by Australian companies. Understand the characteristics of trade credit and calculate the implied interest rate.

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Chapter 9 Sources of Short-Term Debt

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Chapter 9Sources of Short-Term Debt


Learning Objectives

  • Identify the main forms of short-term borrowing by Australian companies.

  • Understand the characteristics of trade credit and calculate the implied interest rate.

  • Understand the main forms of bank lending and appreciate when each may be suitable to a borrower’s needs.


Learning Objectives (cont.)

  • Understand debtor finance, inventory loans and bridging finance, and be able to distinguish between them.

  • Understand the basic features of the interbank cash market.

  • Understand the process of using promissory notes and bills of exchange to raise funds.

  • Calculate prices and yields for promissory notes and bills of exchange.


Introduction

  • ‘Short-term debt’ is defined as debt due for repayment within a period of 12 months.

  • The major short-term borrowing choices available to Australian companies are:

    • Trade credit.

    • Borrowing from banks and other financial institutions.

    • Issuing short-term marketable debt securities such as promissory notes and bills of exchange.


Trade Credit

  • When companies sell goods or services to other businesses ‘on credit’.

  • Usually, the seller allows the purchaser several weeks to pay.

  • Thus, trade credit is, in effect, a form of short-term debt in which the seller lends the purchase price to the purchaser.


Borrowing from Banks and Other Financial Institutions

  • Bank overdraft

    • An overdraft permits a company to run its current (cheque) account into deficit up to an agreed limit.

    • The cost of a bank overdraft includes the interest cost and fees.

    • The interest rate charged is usually at a margin above an indicator rate, published regularly by the bank, and only on the amount by which the account is overdrawn.


Borrowing From Banks and Other Financial Institutions (cont.)

  • Debtor financing

    • Debtor finance allows a company to raise funds by selling its accounts receivable on a continuing basis to a financier (called a discounter), who is then responsible for managing the sales ledger and collecting the debts.

    • The discounter earns a return by discounting the value of the receivable and charging a fee.


Borrowing From Banks and Other Financial Institutions (cont.)

  • Debtor finance with recourse

    • Agreement in which the discounter is reimbursed by the selling company if the debtor defaults.

  • Debtor finance without recourse

    • Agreement in which the discounter is not reimbursed by the selling company if the debtor defaults.

  • Invoice discounting

    • A discounting agreement in which the debtors of the company seeking finance are unaware of the existence of the discounting agreement.


Borrowing From Banks and Other Financial Institutions (cont.)

  • Inventory loans

    • Known as floor-plan or wholesale finance.

    • A loan, usually made by a wholesaler to a retailer, that finances an inventory of durable goods, such as motor vehicles.

  • Bridging finance

    • A short-term loan, usually in the form of a mortgage, to cover a need normally arising from timing differences between two or more transactions.


Interbank Deposits

  • Interbank market is a loan market that operates between banks that lend to each other overnight.

  • Facilitated by exchange settlement accounts that all banks hold with RBA.

  • These funds can be lent to (borrowed from) another bank at the interbank cash rate.

    • ‘Interbank cash rate’ is the rate changed on overnight interbank loans which is closely tied to the RBA’s cash rate.


Short-Term Marketable Debt

  • Companies can obtain short-term debt funding by issuing (selling) securities such as promissory notes and bills of exchange.

  • The securities are a promise to pay a sum of money on a future date.

  • These are generally discount securities.

  • A secondary market exists for the exchange of such securities.


Promissory Notes

  • A promise to pay a stated sum of money on a stated future date.

  • Also known as ‘one-name paper’ and ‘commercial paper’.

  • Face value

    • Sum promised to be paid in the future on the debt security.

  • Discounter

    • Purchaser of a short-term debt security such as a promissory note or a bill of exchange.


Promissory Notes (cont.)

  • To calculate the price P of a promissory note:


Promissory Notes (cont.)

Example 9.2:

  • 90-day promissory note, $500k face value, and a yield of 4.926% p.a. What is the price?


Promissory Notes (cont.)

  • A promissory note can be underwritten, banks and other financial institutions are usually involved.

  • To facilitate trading it is usual for promissory note issues to have a credit rating from a ratings agency.

  • For example, Moody’s Investors Service assigned a long- and short-term rating to a WMC Resources $500m promissory note program.


Bills of Exchange

  • A marketable short-term debt security in which one party (the drawer) directs another party ( the acceptor) to pay a stated sum on a stated future date.

Figure 9.1


Bills of Exchange (cont.)

  • A company will struggle to issue and sell a promissory note if it does not have a credit rating from a ratings agency.

  • This is one of the reasons that bills of exchange have been developed — in order to enable an unrated entity to borrow by issuing marketable securities.

  • In addition to the issuer of the bill, there is an acceptor who promises to redeem the bill in the event that the issuer defaults.


Bills of Exchange (cont.)

  • The face value is paid to whoever holds the bill on the maturity date.

  • The discounter has the choice of either holding the bill until maturity, when payment will be received from the acceptor, or selling (rediscounting) the bill.

  • However, if the bill is sold, the seller normally endorses the bill at the time of sale, creating a chain of protection for the bill holder.


Bills of Exchange (cont.)

  • Endorsement:

    • Acceptance by the seller of a bill in the secondary market, of responsibility to pay the face value if there is default by the acceptor, drawer and earlier endorsers.


Bills of Exchange (cont.)

  • Normal process of repayment

Figure 9.2


Bills of Exchange (cont.)

  • Bank accepted bills

    • Bills of exchange that have been accepted or endorsed by a bank.

  • Non-bank bills

    • Any bill of exchange that has been neither accepted nor endorsed by a bank.


Bills of Exchange (cont.)

  • Bill facilities

    • Bill discount facility

      • Agreement in which one entity (normally a bank) undertakes to discount (buy) bills of exchange drawn by another entity (the borrower).

    • Bill acceptance facility

      • Agreement in which one entity (normally a bank) undertakes to accept bills of exchange drawn by another entity (the borrower).


Bills of Exchange (cont.)

  • Fully drawn bill facility

    • Bill facility in which the borrower must issue bills so that the full agreed amount is borrowed for the period of the facility.

  • Revolving credit bill facility

    • Bill facility in which the borrower can issue bills as required, up to the agreed limit.


Summary

  • Various sources of short-term finance are available to companies.

  • The simplest is trade credit; however, cash discounts are forgone.

  • Banks and other financial institutions offer a range of short-term finance:

    • Banks offer overdrafts, which are a common and flexible form of short-term finance.

    • More specialised forms of finance include debtor finance, inventory loans and bridging finance.


Summary (cont.)

  • A company can issue short-term marketable debt such as promissory notes and bills of exchange.

    • Promise to pay face value at a future date and sold at a discount to face value.

  • Promissory note, promise/guarantee made only by issuer of note.

  • Bill of exchange, there is an acceptor who guarantees the loan.

  • Secondary market for these debt instruments exists.


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