I. Short-term credit can come from several sources, all of which have a cost.

A. The annual financing cost, AFC, annualizes the cost of short-term borrowing:

Interest + Fees 365

AFC = x
Usable funds Maturity(days)

This is a simple interest rate, not a compound rate.

B. The true annual percentage rate, APR, that does consider compounding is:
m
Interest + Fees
APR = 1+ - 1
Usable funds

where m is the number of times per year the loan is compounded per year, i.e., m =
365/maturity (days).

II. The most important source of short-term financing for business firms is trade credit.

A. Trade credit arises whenever a firm receives merchandise from a supplier and is
permitted to wait a specified period of time before paying for it.

1. Most trade credit is extended on open account. Open account trade credit is
recognized on the books of the firm as accounts payable. No formal debt
instrument is created.

2. An alternative to open account credit involves issuance of a promissory note

carried on the books under notes payable.

3. Trade credit is considered a spontaneous source of financing since it tends to

expand naturally as the firm's business expands.

B. The cost of trade credit can be inferred from the credit terms. Credit terms specify the
conditions under which a business is required to repay the credit that a supplier has
extended. Credit terms include the length, beginning date of the credit period, and cash
discount (if any) for prompt payment.

1. When a cash discount is offered, an identifiable expense of trade credit arises in

the form of lost discounts if payment is not made within the discount period.

2. If a firm does not take the cash discount but pays on the last day of the credit
period, the annual financing cost of missing the discount is given by:

% discount 365
AFC =
100% - % discount Credit period - Discount period

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 3. The cost of lost cash discounts can be reduced by late payment. This is called
stretching accounts payable. Intangible costs in terms of lowered credit rating
and ability to obtain future credit may result. Tangible costs of late charges or
specific interest may offset the savings.

III. Accruals and deferred income are additional sources of spontaneous financing.

A. Accruals of wages, taxes, and interest increase the firm's short-term liabilities and hence
provide short-term financing. Use of these is determined by legal and practical
considerations regarding the timing of payment, however.

B. Deferred income consists of payments received for goods and services to be delivered at
a future date. Until the firm earns these advance payments through the fulfillment of its
obligation, they represent a liability on the balance sheet.

IV. Loans from commercial banks are an important source of negotiated short-term financing.

A. Bank loans may be secured or unsecured. Bank loans usually appear as notes payable on
the balance sheet.

B. Bank credit is commonly available under three different arrangements: single loans, lines
of credit, and revolving credit agreements.

1. Single loans are usually arranged for specific financing needs.

a. The interest rate charged on a single loan is usually related to the prime
rate.

b. The effective annual percentage cost of a bank loan depends on the

payment schedule and whether a compensating balance is required.

c. If the interest is payable at maturity, the effective cost is equal to the

stated interest rate.

d. If the loan is discounted, the bank deducts the amount of interest from
the loan proceeds. This increases the actual interest rate above the stated
rate.
2. A line of credit is an agreement that permits the firm to borrow up to a
predetermined limit at any time during the life of the agreement.

a. A line of credit is usually negotiated for a one year period.

b. The interest rate on a line of credit is usually stated in terms of the prime
rate and varies as the prime rate changes during the year.

c. A line of credit may contain restrictive covenants on working capital,

allowable debt, and so on.

d. A line of credit frequently requires that the firm have no loans

outstanding under the agreement for a portion of the year.

e. A line of credit does not guarantee that the bank will lend the firm the

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 requested funds. The bank is not legally obligated to make loans if the
firm's financial position has deteriorated or the bank lacks sufficient
loanable funds to honor all commitments.

3. A revolving credit agreement legally commits the bank to making loans up to the
credit limit specified in the agreement.

a. Revolving credit agreements are usually secured.

b. Revolving credit agreements usually require the firm to pay a

commitment fee on the unused portion of the funds.

c. The effective annual interest cost on a revolving credit agreement

contains both actual interest costs and the commitment fee.

Interest Commitment
+
costs fee 365
AFC =
Usable funds Maturity(days)

V. Commercial paper consists of short-term unsecured promissory notes issued by large well-known
corporations.

A. Maturities of commercial paper range from a few days to a maximum of 9 months.

Maturity longer than 9 months would require SEC registration.

B. Commercial paper is sold on a discount basis so that the firm receives less than the stated
amount and repays the full amount. The annual financing cost is computed as follows:

Interest Placement
+
costs fee 365
AFC =
Usable funds Maturity(days)
C. Purchasers of commercial paper include corporations with idle cash, banks, insurance
companies, pension funds, money market funds, and other financial institutions.

D. If a firm's financial position deteriorates, it may be difficult or impossible to sell

commercial paper.

VI. Accounts receivable are one of the most common forms of collateral for secured short-term
borrowing.

A. Accounts receivable are fairly liquid and are easier to handle than physical assets in the
event of default.

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B. Accounts receivable financing is subject to fraud if the borrower pledges nonexistent
accounts. Administrative costs to the lender may be high.

C. Accounts receivable financing takes two common forms--pledging and factoring.

1. When accounts receivable are pledged, the firm retains title to them and
continues to carry them on its balance sheet.

a. The firm sends copies of invoices to the lender who determines the
amount he will advance depending on the credit-worthiness of the
receivable. The borrower signs a note for the amount advanced.

b. If the loan is on a non-notification basis, the borrower receives payment

on the invoices and then pays the lender.

c. If the loan is on a notification basis, the customer is notified to send

payment directly to the lender.

d. The annual percentage cost of a loan involving pledged receivables

consists of both the interest expense on the loan and the service fees
charged for processing the receivables.

2. Factoring receivables involves the outright sale of the receivables to a financial

institution known as a factor.

a. When receivables are factored, title passes to the factor and they no
longer appear on the balance sheet of the firm.

b. Most factoring is on a non-recourse basis; as a result, the factor assumes

the risk of default.

c. The firm may receive proceeds from the receivables from the factor as
they are received (which is called maturity factoring) or may obtain an
advance which constitutes a loan against the future collections (which is
called advance factoring).

d. Costs of factoring include the fees and charges for the services as well as
explicit interest on advances.

e. The cost of factoring may be offset by a reduction in the firm's own costs
of collection, credit administration, etc.

3. Because domestic banks and lenders may be unfamiliar with foreign customers,
special arrangements are used to obtain financing from foreign receivables.

a. Some factors will finance foreign receivables that are insured by the
Export-Import Bank.

b. A forfait company will finance receivables based on contracts guaranteed

by a foreign bank or government.

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 c. Trading companies take title to goods and arrange shipment to foreign
buyers. Trading companies work with sales contracts guaranteed or
insured by programs of U.S. and foreign governments.

VII. Inventories constitute another common source of collateral for secured loans.

A. The suitability of inventory for collateral depends on the nature of the inventory.
Particularly important characteristics include perishability, identifiability, marketability,
and price stability.

B. Inventory loans are available from commercial banks and finance companies.

C. A number of arrangements are available with regard to possession of the collateral by the
borrower or by a third party.

1. A floating lien is a general claim on the firm's entire inventory.

a. Floating liens offer the lender little security.

b. The loan amount as a percentage of inventory value is usually small.

c. Floating liens are used for large-volume, small-value, high-turnover

inventory held by turnover.

2. A trust receipt is another form of inventory loan with the inventory held by the
borrower.

a. As the inventory is sold, the proceeds are forwarded to the lender along
with notification of the goods sold.

b. Trust receipts require specifically identifiable units of inventory.

c. Trust receipt arrangements are common for items such as automobiles

and appliances. These arrangements are also known as floor planning.

3. Terminal warehouse plans require that the inventory be held in a bonded

warehouse operated by a public warehouse company.

a. The warehouse issues a receipt for the merchandise that then becomes
the collateral for the lender.

b. As the loan is paid off, the lender authorizes the warehouse to release the
inventory.

c. In addition to specific interest on the amount advanced, warehouse fees

must be paid. These may be offset by reductions in the firm's own
handling and storage costs.

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 4. Under field warehouse agreements, the goods are kept in a segregated portion of
the firm's premises under the control of a warehouse company. Other portions of
the operation are similar to those under terminal warehousing.

VIII. A term loan, or intermediate-term credit, is defined as any debt obligation having an initial
maturity between one and ten years.

A. Term loans are available from a wide variety of sources including banks, insurance
companies, pension funds, small business investment companies, government agencies
and equipment suppliers.

B. Particularly in smaller amounts, term loans are usually less expensive than issuing bonds
or common stock.

C. Term loans are often better suited for financing than short-term loans because of a
reduction of the problems of future interest rate variability and ability to renew the loan.
This is particularly true for financing small additions to plant and equipment where the
cash flows from the investment often cover the servicing requirements of the debt.

D. Term loans can also be used to finance moderate increases in working capital if the length
of the loan approximately matches the time the working capital will be needed or until
the debt can be amortized out of earnings.

E. Term loans usually require that the principal be amortized over the life of the loan.
Amortization requires that the borrower make regular periodic payments of principal and
interest.

1. A common arrangement is for the borrower to make regular equal payments so

that the present value of the annuity of payments is equal to the amount of the
loan.

2. Another arrangement calls for equal reductions in principal during the life of the
loan together with payment of interest on the outstanding balance.

3. Partial amortization may be used which results in a lump payment called a

"balloon payment" at the maturity of the loan.

4. Term loans may call for periodic payment of interest with a final balloon
payment equal to the amount of the loan (bullet loan).

F. Interest costs on term loans depend on a number of factorsparticularly, the general

level of interest rates. Variable rates dependent on the prime rate or another indicator are
sometimes used.

G. Term loan agreements often call for the borrower to keep a percentage of the loan balance
on deposit as a compensating balance. This can increase the effective interest rate on the
loan.

H. In the case of higher risk loans to companies with promising growth potential, a term loan
agreement may call for issuance to the lender of a warrant giving the lender an option to

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 purchase equity in the company at a future date.

I. Security provisions in term loans are dependent on the credit standing of the borrower.
Security provisions can take many forms:

1. Assignment of payments due under a particular contract.

2. Assignment or pledging of inventories, receivables or securities.

3. The use of a floating lien on inventories and receivables.

4. A mortgage on property, plant or equipment.

5. An assignment of the cash surrender value of a life insurance policy.

6. A pledge of marketable securities by the borrower.

J. Affirmative covenants outline actions that a firm agrees to take during the term of the
loan. These include such things as providing financial statements and cash budgets,
carrying insurance on assets and against insurable business risks, maintaining minimum
levels of net working capital, and maintaining personnel acceptable to the lender.

K. Negative covenants outline actions which a firm agrees not to take during the term of the
loan. These may include agreements not to merge with other firms, not to pledge assets
as security to other lenders, or not to make or guarantee loans to other firms.

L. Restrictive covenants limit the firm's potential actions but do not prohibit them.
Restrictions might limit dividends, limit employee compensation, limit additional
borrowing and limit investment activities.

M. Term loan agreements contain default provisions which permit the lender to insist on
immediate repayment under certain conditions.

IX. Term loans are available from a number of sources.

A. Banks prefer loans having relatively short maturities, yet they are a major source of term
loans.

B. Insurance companies and pension funds are a source of term loans.

1. Insurance companies and pension funds prefer longer term loans.

2. Prepayment of loans from these sources may involve penalties.

3. Loans from insurance companies and pension funds are usually secured.

4. Due to the longer maturity and lack of compensating balance arrangements, loans
from these institutions tend to have slightly higher stated interest rates than term
loans from banks.

C. The Small Business Administration (SBA), an agency of the Federal government, was
established to make credit available to small businesses.

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 1. SBA loans are usually secured.

2. Most SBA loans are participation loans obtained from a bank with the SBA
guaranteeing up to 90% of the amount.

3. Direct loans are available from the SBA on a limited basis.

4. Economic opportunity loans up to $25,000 and 15 years maturity are available

from SBA to assist economically and socially disadvantaged individuals who
own their own firms.

D. Small business investment companies (SBIC's) are licensed by the government to make
debt or equity investments in small firms.

1. SBIC's obtain capital by borrowing from the SBA and other sources.

2. SBIC's specialize in firms with growth potential.

3. Because the borrowers tend to have above average risk, these loans tend to be
more expensive than bank loans.

E. Industrial Development Authorities (IDA's), organized by state and local governments,

issue bonds and use the proceeds to build facilities which are then leased to a firm.
Because the bonds are tax exempt, the financing costs are often lower than on directly
issued corporate bonds.

F. Municipalities issue pollution control revenue bonds. The proceeds are used to assist
industry in acquiring pollution control equipment. Because the bonds are tax exempt, the
financing costs are lower than if industry raised the funds directly.

G. Equipment financing loans are loans to purchase equipment which then serves as
collateral on the loan.

1. The equipment is usually of a type that is readily marketable such as motor

vehicles.

2. These loans are usually amortized over the expected life of the equipment.

3. Equipment financing loans are available from the usual financial intermediaries
as well as from equipment sellers themselves.
4. Two legal forms are common for equipment financing loans.

a. Conditional sales contracts are common when financing is from the

equipment seller. In a conditional sales contract, the purchaser usually
makes a down payment and a series of periodic payments. Title does not
pass to the purchaser until the contract is fulfilled.

b. Chattel mortgages are often used by financial intermediaries. A chattel

mortgage is a mortgage on property other than real estate.