Short term financing in MNC context

Why Do Firms Need Short-term Financing?

Cash flow from operations may not be

sufficient to keep up with growth-related financing needs. Firms may prefer to borrow now for their inventory or other short term asset needs rather than wait until they have saved enough. Firms prefer short-term financing instead of long-term sources of financing due to:
easier availability usually has lower cost (remember yield
2

curve)

Key factors
1. Risk of deviation from IFE ( E = i1 i2 / i1 + i2) if forward contracts not available 2. Element of exchange risk risk associated with borrowing in a particular currency is related to the firms degree of exposure in that currency 3. Firms degree of risk aversion more risk averse the higher price WTP for reducing currency exposure

4. Relative borrowing cost calculated on a covered basis i.e. IRP might not hold after tax costs 5. Even if IRP holds before tax, currency denomination of corporate borrowings matter where there is tax asymmetry 6. Final factor is political risk will try to maximize their local borrowings if they believe that exchange controls are possibilities

objectives
Minimize expected cost

Minimize risk w/o regard to cost contrary to

shareholders interest Trade off expected cost and systematic risk evaluate different loans without considering the relnship between loan cash flows and operating cash flows Trade off expected cost and total risk

Short term financing options

Intercompany financing

Local currency (LC) financing

Local bank financing includes overdrafts,

discounting, and term loans Non bank financing include commercial paper and factoring Bank loans short term credits renewed every 90 days clean up clause for a period of atleast 30 days in a year

Forms of bank credit

Term loans repaid in 90 days and in lump sum

provisions in promissory note Line of credit The borrowing limit that a bank sets for a firm after reviewing the cash budget. The firm can borrow up to that amount of money without asking, since it is pre-approved Usually informal agreement and may change over time Usually covers peak demand times, growth spurts, etc.

 Overdrafts line of credit against which drafts

can be drawn. Often a form of medium term financing Discounting

Estimation of Cost of Short-Term Credit

Effective Interest Rate is used to determine

the cost of the credit to be able to compare differing terms.

Effective Interest Rate

Cost (interest + fees) Amount you get to use

Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000 interest at the end of the year. Your effective rate is the same as the stated rate: $1,000/$10,000 = .10 = 10%

Variation in loan terms

A discount loan requires that interest be paid up

front when the loan is given. This changes the effective cost in the previous example since you only get to use: ($10,000 - $1,000) = $9,000. Effective rate (APR) = $1,000/$9,000 = .1111 = 11.11%.

Variation in loan terms

Sometimes lenders require that a minimum

amount, called a compensating balance be kept in your bank account. It is taken from the amount you want to borrow. If your compensating balance requirement is $500, then the amount you can use is reduced by that amount. Effective Rate (APR) for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.

Both Discount Interest and Compensating Balance

Sometimes, lenders will require both

discount interest (paid in advance) and a compensating balance. If the interest is $1,000 and the compensating balance is $500, then the effective rate (APR) becomes: $1,000 / $10,000 - $1,000 - $500 $1,000 / $8,500 = 11.76%
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Commercial paper
short term unsecured promissory note sold to

institutional investors and corporations by large corporations All CP markets are not the same US dwarfs all other national markets In most countries, the instrument is issued at a discount with the full face value of the note redeemed upon maturity. In other markets, interest bearing instruments are also offered

 Commercial paper is quoted on a discount

basis, meaning that the interest is subtracted from the face value to arrive at the price. See 3 steps below for calculation: Step 1: Compute the discount (D) from face value of the commercial paper Discount (D) = (Discount rate x par x DTG)/365 DTG = days to go (to maturity) Step 2: Compute the price = Face value Discount 14 Step 3: Compute Effective Annual Rate (APR):

Cost of Commercial Paper Example

$1 million issue of 90 day commercial paper

quoted at 4% discount rate. Step 1: Calculate D = .04 x $1 mill. x 90 = $10,000 360

Step 2: Calculate price (amount you get) = $1,000,000 - $10,000 = $990,000

Step 3: Calculate effective rate (APR) = $10,000 / $990,000 = 1.010% x 4 = 4.04% 15

Calculating dollar costs of alternative financing options

Formulas to compute effective dollar costs of a

local currency (LC) loan and a dollar loan for both no-tax and tax cases Case I : no tax 1. LC loan