Corporate Finance

Chapter 9
Short-term Debt
Copyright 2007 McGraw-Hill Australia Pty Ltd

PPTs t/a McGraths Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
9-1
Learning Objectives
Overview of the characteristics of various forms of
short-term debt
Main types
Sources
Reasons and patterns of use
Advantages and disadvantages for borrowers and
lenders

9-2
Chapter Organisation
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Calculations: Discount Securities
Promissory Notes
Negotiable Certificates of Deposit
Inventory Finance, Accounts Receivable
Financing and Factoring
Summary

9-3
9.1
Trade Credit
Short-term debt is a financing arrangement for a

period of less than one year with various
characteristics to suit borrowers particular needs
Timing of repayment, risk, interest rate structures
(variable or fixed) and the source of funds
Matching principle
Short-term assets should be funded with short-term
liabilities

9-4
9.1
Trade Credit (cont.)
A supplier provides goods or services to a

purchaser with an arrangement for payment at a
later date
Often includes a discount for early payment (e.g.
2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)

9-5
9.1
Trade Credit (cont.)
The opportunity cost of the purchaser foregoing

the discount on an invoice (1/7, n/30) is
Opportunit y cost
% discount
365
100 % discount days difference between

early and late settlement
(9.1)
1.0 365
99.0 23
0.160298 or 16.03% p.a.

9-6
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Calculations; Discount Securities
Promissory Notes
Summary

9-7
9.2
Bank Overdrafts
Major source of short-term finance

Allows a firm to place its cheque (operating)
account into deficit, to an agreed limit
Generally operated on a fully fluctuating basis
Lender also imposes an establishment fee,
monthly account service fee and a fee on the
unused overdraft limit

9-8
9.2
Bank Overdrafts (cont.)
Interest rates negotiated with bank at a margin

above an indicator rate, reflecting the borrowers
credit risk
Financial performance and future cash flows
Length of mismatch between cash inflows and outflows
Adequacy of collateral
Indicator rate typically a floating rate based on a

published market rate, e.g. BBSW
In some countries overdraft borrower may be
required to hold a credit average balance or
compensating credit balance

9-9
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-10
9.3
Commercial Bills
A bill of exchange is a discount security issued with

a face value payable at a future date
A commercial bill is a bill of exchange issued to
raise funds for general business purposes
A bank-accepted bill is a bill that is issued by a
corporation and incorporates the name of a bank
as acceptor

9-11
9.3
Commercial Bills (cont.)

9-12
9.3
Features of commercial billsparties involved (bankaccepted bill)

9-13
9.3
Features of commercial billsparties involved

(bank-accepted bill) (cont.)
Drawer
Issuer of the bill
Secondary liability for repayment of the bill (after the
acceptor)
Acceptor
Undertakes to repay the face value to the holder of the bill
at maturity
Acceptor is usually a bank or merchant bank

9-14
9.3

Payee
The party to whom the bill is specified to be paid, i.e. the
party who receives the funds
Usually the drawer, but the drawer can specify some other
party as payee
Discounter
The party that discounts the face value and purchases the
bill
The provider or lender of the funds
May also be the acceptor of the bill

9-15
9.3

Endorser
The party that was previously a holder of the bill
Signs the reverse side of the bill when selling, or
discounting, the bill
Order of liability for payment of the bill runs from acceptor to
drawer and then to endorser

9-16
9.3
The flow of funds (bank-accepted bills)

9-17
9.3
The flow of funds (non-bank bills)

Alternatively, a bill can be drawn by the bank and
accepted by the borrower
The bank is both drawer and discounter of the bill
Funds are lent to borrower as payee
At maturity date the borrower, as acceptor of the bill, is
liable to pay face value to the holder of the bill

9-18
9.3
Establishing a bill financing facility
Borrower approaches bank or merchant bank

Assessment made of borrowers credit risk
Credit rating of borrower affects size of discount
Maturity usually 30, 60, 90, 120 or 180 days
Minimum face value usually $100 000

9-19
9.3
Advantages of commercial bill financing

Lower cost than other short-term borrowing forms, i.e.
overdraft, fully-drawn advances
Borrowing cost (yield) determined at issue date (not
affected by subsequent changes in interest rates)
A bill line
Arrangement with a bank where it agrees to progressively
discount bills up to an agreed amount
Term of loan may be extended by rollover at maturity

9-20
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-21
9.4
Calculations considered
Calculating priceyield known

Calculating face valueissue price and yield known
Calculating yield
Calculating pricediscount rate known
Calculating discount rate

9-22
Calculating priceyield known

9-23
Calculating priceyield known (cont.)
Example 3: A company decides to fund its short-term

inventory needs by issuing a 30-day bank-accepted bill with
a face value of $500 000. Having approached two
prospective discounters, the company has been quoted
yields of 9.52% per annum and 9.48% per annum. Which
quote should the company accept, and what amount will the
company raise?
$500 000 365
$496 118.04
365 (0.0952 30)
or
$500 000 365
$496 134.23
365 (0.0948 30

9-24
Calculating priceyield known (cont.)
An alternative formulae for calculating price

9-25
Calculating face valueissue price and

yield known
Face value price[
365 (
yield
days to maturity)
100
]
365
(9.4)

9-26
Calculating face valueissue price and

yield known (cont.)
Example 4: A company needs to raise additional funding
of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day
bank-accepted bill rollover facility. The bank has agreed
to discount the bill at a yield of 8.75%. At what face value
will the initial bill be drawn?
365 (0.0875 60)

]
365
$507 191.75
Face value $500 000[

9-27
Calculating yield
Yield
(sell price - buy price) (days in year 100)
buy price
days to maturity
(9.5)

9-28
Calculating yield (cont.)

Example 7: In Example 3, a company issued a 30-day bankaccepted bill with a face value of $500 000. The bill was
discounted at a yield of 9.48% per annum, representing a price
of $496 134.23. After seven days the discounter sells the bill in
the short-term money market for $497 057.36. The bill is not
traded again in the market. Calculate the yield to the original
discounter and to the holder at maturity.
Yield to original discounter:
(497 057.36 496 134.23) 36 500
9.70%
496 134.23
7
Yield to holder at maturity:
(500 000.00 497 057.36) 36 500
9.39%
497 057.36
23
9-29
Price face value [1
days to maturity discount rate
]
days in year
100
(9.6)

9-30

(cont.)
Example 8: The price of a 180-day bill, with a face value
of $100 000, selling at a discount of 14.75%, would be:
180
Price $100 000[1 0.1475]
365
$100 000(1 - 0.0727)
$92 726.03
The discount in this formula is effectively the rate of
return to the buyer of the bill (or the cost of funds to the
drawer of the bill), expressed as a percentage per
annum, in relation to the face value of the bill.

9-31
Calculating discount rate
Discount rate
face value - current price days in year 100
face value
days to maturity
(9.7)

9-32
Calculating discount rate (cont.)

Example 9: A 180-day bill with a face value of $100 000
and selling currently at $92 000, with a full 180 days to
run to maturity, has a discount rate of:
(100 000 - 92 000 36 500
100 000
180
0.08 202.778
16.22%
Discount rate

9-33
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-34
9.5
Promissory Notes
Also called P-notes or commercial paper, they are

discount securities, issued in the money market
with a face value payable at maturity but sold
today by the issuer for less than face value
Typically available to companies with an excellent
credit reputation because
There is no acceptor or endorser
They are unsecured instruments

9-35
9.5
Promissory Notes (cont.)
Calculationsuse discount securities formulae

Issue programs
Usually arranged by major commercial banks and money
market corporations
Standardised documentation
Revolving facility
Most P-notes are issued for 90 days
By tender, tap issuance or dealer bids

9-36
9.5
Promissory Notes (cont.)
Underwritten issues
Underwriting guarantees the full issue of notes is
purchased and typical fee is 0.1% per annum
Underwriter is usually a commercial bank, investment
bank or merchant bank
The underwritten issue can incorporate a rollover facility,
effectively extending the borrowers line of credit beyond
the short-term life of the P-note issue
Issues may also be non-underwritten

9-37
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-38
9.6
Short term discount security issued by banks to

manage their liabilities and liquidity
Maturities range up to 180 days
Issued to institutional investors in the wholesale
money market
The short-term money market has an active
secondary market in CDs
Calculationsuse discount securities formulae

9-39
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-40
9.7 Inventory Finance, Accounts

Receivable Financing and Factoring
Inventory finance
Most common form is floor plan finance
Particularly designed for the needs of motor vehicle
dealers to finance their inventory of vehicles
Bailment commonfinance company holds title to
dealerships stock
Dealer is expected to promote financiers financial

products

9-41

Receivable Financing and Factoring (cont.)
Accounts receivable finance
A loan to a business secured against its accounts
receivable (debtors)
Mainly supplied by finance companies
Lending company takes charge over a companys
accounts receivable; however, the borrowing company is
still responsible for the debtor book and bad debts

9-42

Factoring
Company sells its accounts receivable to a factoring
company and in doing so
In doing so it converts a future cash flow (receivables) into a
current cash flow
Factoring provides immediate cash to the vendor; plus it

removes administration costs of accounts receivable

9-43

Factoring (cont.)
Main providers of factor finance are the finance
companies
Factor is responsible for collection of receivables
Notification basis: vendor is required to notify its
(accounts receivables) customers that payment is to be
made to the factor

9-44

Factoring (cont.)
Recourse arrangement
Factor has a claim against the vendor if a receivable is not
paid
Non-recourse arrangement
Factor has no claim against vendor company

9-45
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Trade Credit
Bank Overdrafts
Commercial Bills
Promissory Notes
Summary

9-46
9.8
Summary
Short-term debt is appropriate for funding shortterm assets (matching principle)

Trade creditsimple and common
Bank overdraftcommon
Discount securities
Bill financingimportant source of funds
Promissory-notes (P-notes)good credit rating required
Certificates of deposit (CDs)issued by banks to
manage liabilities and liquidity

9-47
9.8
Summary (cont.)
Inventory loans, accounts receivable finance and

factoringalternative sources of finance for small
and medium-sized businesses (SMEs)

9-48

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Chapter 9

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

Short-term debt is a financing arrangement for a

Copyright 2007 McGraw-Hill Australia Pty Ltd

Trade Credit (cont.)

A supplier provides goods or services to a

Copyright 2007 McGraw-Hill Australia Pty Ltd

Trade Credit (cont.)

The opportunity cost of the purchaser foregoing

100 % discount days difference between

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

Major source of short-term finance

Copyright 2007 McGraw-Hill Australia Pty Ltd

Bank Overdrafts (cont.)

Interest rates negotiated with bank at a margin

Indicator rate typically a floating rate based on a

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

A bill of exchange is a discount security issued with

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Features of commercial billsparties involved (bankaccepted bill)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Features of commercial billsparties involved

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Features of commercial billsparties involved

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Features of commercial billsparties involved

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

The flow of funds (bank-accepted bills)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

The flow of funds (non-bank bills)

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Establishing a bill financing facility

Borrower approaches bank or merchant bank

Copyright 2007 McGraw-Hill Australia Pty Ltd

Commercial Bills (cont.)

Advantages of commercial bill financing

Term of loan may be extended by rollover at maturity

Copyright 2007 McGraw-Hill Australia Pty Ltd

Copyright 2007 McGraw-Hill Australia Pty Ltd

Calculations: Discount Securities

Calculating priceyield known

Copyright 2007 McGraw-Hill Australia Pty Ltd

Calculating priceyield known

Copyright 2007 McGraw-Hill Australia Pty Ltd

Calculating priceyield known (cont.)

Example 3: A company decides to fund its short-term

Copyright 2007 McGraw-Hill Australia Pty Ltd

Calculating priceyield known (cont.)

An alternative formulae for calculating price

Copyright 2007 McGraw-Hill Australia Pty Ltd

Calculating face valueissue price and