CorporateFinanceFifthEditionChapter27Short-TermFinancialPlanningCopyright?2020,2017,2014PearsonEducation,Inc.

AllRightsReservedChapterOutline27.1ForecastingShort-TermFinancingNeeds27.2

TheMatchingPrinciple27.3

Short-TermFinancingwithBankLoans27.4Short-TermFinancingwithCommercialPaper27.5Short-TermFinancingwithSecuredFinancingLearningObjectives(1of2)Showhowfuturecashflowforecastsallowacompanytodeterminewhetherithasacashflowsurplusordeficit,andwhetheritisalong-orshort-termimbalance.Discusstherecommendationsofthematchingprinciplewithrespecttolong-andshort-termneedsforfunds.Describethreetypesofbankloans,andhowtheymaybeusedforshort-termcashneeds.LearningObjectives(2of2)Identifythefactorsthataffecttheeffectiveannualrateofabankloan.Definecommercialpaper,anddiscussitsadvantagesforlargecorporations.Describetheuseofinventoryandaccountsreceivableassecurityforloans.Definefactoring,floatingliens,trustreceiptsloan,andawarehousearrangement.27.1ForecastingShort-TermFinancingNeeds(1of5)Thefocusofthislectureisonshort-termfinancialplanning.Thefocalpointisanalyzingthetypesofcashsurplusesordeficitsthataretemporaryandshort-terminnature.27.1ForecastingShort-TermFinancingNeeds(2of5)AssumethatitisDecember2021.SpringfieldSnowboardsmanufacturessnowboardingequipment,whichitsellsprimarilytoretailers.Springfieldanticipatesthatin2022itssaleswillgrowby10%to$20millionanditstotalnetincomewillbe$1,950,000.Assumingsalesandproductionwilloccuruniformlythroughouttheyear,management’sforecastofitsquarterlynetincomeandstatementofcashflowsfor2022ispresentedonthefollowingslide.Table27.1ProjectedFinancialStatementsforSpringfieldSnowboards,2022,AssumingLevelSales27.1ForecastingShort-TermFinancingNeeds(3of5)Springfield’squarterlynetincomeis$488,000.Itscapitalexpendituresareequaltodepreciation.Itsworkingcapitalrequirementsincreaseinthefirstquarterduetotheincreaseinsalesbutremainconstantthereafter.27.1ForecastingShort-TermFinancingNeeds(4of5)Basedontheseprojections,Springfieldwillaccumulateexcesscashonanongoingbasis.Ifthesurplusislikelytobelongterm,Springfieldcouldreducethesurplusbypayingsomeofitoutasadividendorbyrepurchasingshares.27.1ForecastingShort-TermFinancingNeeds(5of5)Firmsrequireshort-termfinancingforSeasonalitiesNegativeCashFlowShocksPositiveCashFlowShocksSeasonalities(1of3)Formanyfirms,salesareseasonal.Whensalesareconcentratedduringafewmonths,sourcesandusesofcasharealsolikelytobeseasonal.Figure27.1SalesSeasonality(2010–2015)Seasonalities(2of3)IntheSpringfieldexample,itwaspreviouslyassumedthatsalesoccuruniformlythroughouttheyear.Nowassumethat20%ofsalesoccurduringthefirstquarter,10%duringeachofthesecondandthirdquarters,and60%ofsalesduringthefourthquarter.Thenewforecastedstatementofcashflowsisshownonthefollowingslide.Note:Itisstillassumedthatproductionoccursuniformlythroughouttheyear.Table27.2ProjectedFinancialStatementsforSpringfieldSnowboards,2022,AssumingSeasonalSalesSeasonalities(3of3)Althoughnetincomeisunchangedfromtheoriginalforecast,theintroductionofseasonalsalescreatessomedramaticswingsinSpringfield’sshort-termcashflows.Asaresult,Springfieldhasnegativenetcashflowsduringthesecondandthirdquarters.NegativeCashFlowShocks(1of4)Occasionally,acompanywillencountercircumstancesinwhichcashflowsaretemporarilynegativeforanunexpectedreason,creatingashort-termfinancingneed.NegativeCashFlowShocks(2of4)IntheSpringfieldexample,assumethatduringApril2022,managementlearnsthatsomemanufacturingequipmenthasbrokenunexpectedly.Itwillcostanadditional$1,000,000toreplacetheequipment.Theimpactisshownonthefollowingslide.Note:Theoriginalassumptionoflevelsalesisused.Table27.3ProjectedFinancialStatementsforSpringfieldSnowboards,2022,AssumingLevelSalesandaNegativeCashFlowShockNegativeCashFlowShocks(3of4)Inthiscase,theone-timeexpenditureof$1milliontoreplaceequipmentresultsinanegativenetcashflowof$513,000duringthesecondquarterof2022.NegativeCashFlowShocks(4of4)Ifitscashreservesareinsufficient,Springfieldwillhavetoborrowtocoverthe$513,000shortfall.However,thecompanycontinuestogeneratepositivecashflowinthefollowingquarters,andbythefourthquarteritwillhavegeneratedenoughcumulativecashflowtorepayanyloan.PositiveCashFlowShocks(1of5)Nowassumethatduringthefirstquarterof2022,Springfieldannouncesadealwhereitwillbetheexclusivesuppliertoanewmajorcustomer,leadingtoanoverallsalesincreaseof20%forthefirm.PositiveCashFlowShocks(2of5)Theincreasedsaleswillbegininthesecondquarter.Aspartofthedeal,Springfieldhasagreedtoaone-timeexpenseof$500,000formarketing.Anextra$1millionincapitalexpendituresisalsorequiredduringthefirstquartertoincreaseproductioncapacity.PositiveCashFlowShocks(3of5)ThesalesgrowthwillalsoaffectSpringfield’srequiredworkingcapital.Thenewcashflowforecastsareshownonthefollowingslide.Table27.4ProjectedFinancialStatementsforSpringfieldSnowboards,2022,AssumingLevelSalesandaGrowthOpportunityPositiveCashFlowShocks(4of5)Forecastednetincomeislowerduringthefirstquarter,duetothe$500,000increaseinmarketingexpenses.However,netincomeinthefollowingquartersishigher,reflectingthehighersales.Thereisanincreaseinaccountsreceivableandaccountspayableduringthefirsttwoquartersduetothehigherlevelofsales.PositiveCashFlowShocks(5of5)Eventhoughtheopportunitytogrowmorerapidlyispositive,itresultsinanegativenetcashflowduringthefirstquarter.However,becausethecompanywillbeevenmoreprofitableinsubsequentquarters,thisfinancingneedistemporary.27.2TheMatchingPrincipleMatchingPrincipleStatesthatafirm’sshort-termneedsshouldbefinancedwithshort-termdebtandlong-termneedsshouldbefinancedwithlong-termsourcesoffundsPermanentWorkingCapitalPermanentWorkingCapitalTheamountthatafirmmustkeepinvestedinitsshort-termassetstosupportitscontinuingoperations.Thematchingprinciplesuggeststhatthefirmshouldfinancethispermanentinvestmentinworkingcapitalwithlong-termsourcesoffunds.TemporaryWorkingCapital(1of4)TemporaryWorkingCapitalThedifferencebetweentheactuallevelofshort-termworkingcapitalneedsanditspermanentworkingcapitalrequirementsThematchingprinciplesuggeststhatthefirmshouldfinancethistemporaryinvestmentinworkingcapitalwithshort-termsourcesoffunds.TemporaryWorkingCapital(2of4)TheSpringfieldexamplewithseasonalsalesillustratesthedifferencebetweenpermanentandtemporaryworkingcapital.Thefollowingslideshowsthelevelsofworkingcapitalthatcorrespondtotheseasonalforecasts.Table27.5ProjectedLevelsofWorkingCapitalforSpringfieldSnowboards,2022,AssumingSeasonalSalesTemporaryWorkingCapital(3of4)Springfield’sworkingcapitalvariesfromaminimumof$2,125,000inthefirstquarterof2022to$5,425,000inthethirdquarter.Theminimumlevelofworkingcapital,$2,125,000,canbethoughtofasthefirm’spermanentworkingcapital.TemporaryWorkingCapital(4of4)ThedifferencebetweenthisminimumlevelandthehigherlevelsinsubsequentquartersreflectsSpringfield’stemporaryworkingcapitalrequirements.Forexample,in2022Q3,thetemporaryworkingrequirementsare$3,300,000.

FinancingPolicyChoices(1of2)AggressiveFinancingPolicyFinancingpartorallofafirm’spermanentworkingcapitalwithshort-termdebtOneriskofanaggressivefinancingpolicyisfundingrisk.FundingRiskTheriskofincurringfinancialdistresscostsshouldafirmnotbeabletorefinanceitsdebtintimelymanneroratareasonablerate.FinancingPolicyChoices(2of2)ConservativeFinancingPolicyFinancingallofafirm’spermanentworkingcapitalwithlong-termdebt27.3Short-TermFinancingwithBankLoansPromissoryNoteAwrittenstatementthatindicatestheamountofaloan,thedatepaymentisdue,andtheinterestrateSingle,End-of-PeriodPaymentLoan(1of2)Thesimplesttypeofbankloanisasingle,end-of-period-paymentloan.Thistypeofloanrequiresthatthefirmpayinterestontheloanandpaybacktheprincipalinonelumpsumattheendoftheloan.Theinterestratemaybefixedorvariable.Withavariableinterestrate,thetermsoftheloanmayindicatethattheratewillvarywithsomespreadrelativetoabenchmarkrate.Single,End-of-PeriodPaymentLoan(2of2)PrimeRateTheratebankschargetheirmostcreditworthycustomersLondonInter-BankOfferedRate(L

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B

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R)TherateofinterestatwhichbanksborrowfundsfromeachotherintheLondoninter-bankmarketItisquotedformaturitiesofonedaytooneyearfor10majorcurrenciesLineofCredit(1of5)LineofCreditAbankloanarrangementinwhichabankagreestolendafirmanyamountuptoastatedmaximum.Thisflexibleagreementallowsthefirmtodrawuponthelineofcreditwheneveritchooses.LineofCredit(2of5)UncommittedLineofCreditAlineofcreditthatdoesnotlegallybindabanktoprovidethefundsaborrowerrequests.LineofCredit(3of5)CommittedLineofCreditAlegallybindingagreementthatobligatesabanktoprovidefundstoafirm(uptoastatedcreditlimit)aslongasthefirmsatisfiesanyrestrictionsintheagreement.LineofCredit(4of5)CommittedLineofCreditAcommittedlineofcreditmayhaveAcompensatingbalancerequirementand/orrestrictionsregardingthelevelofthefirm’sworkingcapital.Acommitmentfeeontheunusedportionofthelineofcreditinadditiontointerestontheamountthatthefirmborrowed.Astipulationthatatsomepointintimetheoutstandingbalancemustbezero.Thispolicyensuresthatthefirmdoesnotusetheshort-termfinancingtofinanceitslong-termobligations.LineofCredit(5of5)RevolvingLineofCreditAcreditcommitmentforaspecifictimeperiod,typicallytwotothreeyears,whichacompanycanuseasneeded.EvergreenCreditArevolvinglineofcreditwithnofixedmaturity.BridgeLoanBridgeLoanAtypeofshort-termbankloanthatisoftenusedto“bridgethegap”untilafirmcanarrangeforlong-termfinancing.DiscountLoanAtypeofbridgeloaninwhichtheborrowerisrequiredtopaytheinterestatthebeginningoftheperiod.Thelenderdeductstheinterestfromtheloanproceedswhentheloanismade.CommonLoanStipulationsandFees(1of3)CommitmentFeesThecommitmentfeeassociatedwithacommittedlineofcredit,whichincreasestheeffectivecostoftheloantothefirm.CommonLoanStipulationsandFees(2of3)CommitmentFeesAssumethatafirmhasnegotiatedacommittedlineofcreditwithastatedmaximumof$1millionandaninterestrateof10%(E

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R)withabank.Thecommitmentfeeis0.5%(E

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R).CommonLoanStipulationsandFees(3of3)CommitmentFeesAtthebeginningoftheyear,thefirmborrows$800,000Itthenrepaysthisloanattheendoftheyear,leaving$200,000unusedfortherestoftheyear.ThetotalcostoftheloanisLoanOriginationFee(1of4)LoanOriginationFeeAbankchargethataborrowermustpaytoinitiatealoanAloanoriginationfeereducestheamountofusableproceedsthatthefirmreceivesandincreasestheeffectivecostoftheloan.LoanOriginationFee(2of4)LoanOriginationFeeAssumethatTimmonsisoffereda$500,000loanforthreemonthsatanA

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Rof12%.Thisloanhasaloanoriginationfeeof1%.Theloanoriginationfeeischargedontheprincipaloftheloan,sointhiscasethefeeamountsto$5000,andtheactualamountborrowedis$495,000.

LoanOriginationFee(3of4)LoanOriginationFeeTheinterestpaymentforthreemonthsis$15,000.Thetimelinewouldlooklikethis:LoanOriginationFee(4of4)LoanOriginationFeeTheactualthree-monthinterestpaidis4.04%.Theeffectiveannualrateis17.17%.CompensatingBalanceRequirements(1of4)Assumenow,ratherthanchargingaloanoriginationfee,Timmons’bankrequiresthatthefirmkeepanamountequalto10%oftheloanprincipalinanon-interest-bearingaccountwiththebankaslongastheloanremainsoutstanding.CompensatingBalanceRequirements(2of4)Givena$500,000loan,Timmonsmusthold$50,000inanaccountatthebankThusthefirmhasonly$450,000oftheloanproceedsactuallyavailableforuse,althoughitmustpayinterestonthefullloanamount.CompensatingBalanceRequirements(3of4)Attheendoftheloanperiod,thefirmowes$515,000.Andsomustpay$465,000afterusingitscompensatingbalance.CompensatingBalanceRequirements(4of4)Thetimelinewouldlooklikethis:Theactualthree-monthinterestpaidis3.33%.Theeffectiveannualrateis14.01%.TextbookExample27.1(1of3)CompensatingBalanceRequirementsandtheEffectiveAnnualRateProblemAssumethatTimmonsTowelandDiaperService’sbankpays1%(A

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Rwithquarterlycompounding)onitscompensatingbalanceaccounts.WhatistheE

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RofTimmons’three-monthloan?TextbookExample27.1(2of3)SolutionThebalanceheldinthecompensatingbalanceaccountwillgrowtoThus,thefinalloanpaymentwillbeNoticethattheinterestonthecompensatingbalanceaccountsoffsetssomeoftheinterestthatTimmonspaysontheloan.Puttingthenewcashflowsonatimeline:TextbookExample27.1(3of3)Theactualthree-monthinterestratepaidisExpressingthisasanE

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RgivesAlternativeExample27.1(1of4)ProblemR

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XHousehasa$1,000,000bankloanat8%(A

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Rwithmonthlycompounding).ThebankrequiresthatR

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XHousemaintaina20%compensatingbalance.IfRackHouseearns2%(A

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Rwithmonthlycompounding)onitscompensatingbalanceaccounts,whatistheE

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Rofasix-monthloan?AlternativeExample27.1(2of4)SolutionAttheendofsixmonths,R

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XHousewillowethebank$1,040,673.AlternativeExample27.1(3of4)SolutionHowever,the20%compensatingbalancewillgrowfrom$200,000to$202,008.AlternativeExample27.1(4of4)SolutionApplyingthecompensatingbalancetowardtheloan,R

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XHousewillneedtopayofftheloan.Thesix-monthinterestratepaidisThus,theE

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Ris27.4Short-TermFinancingwithCommercialPaper(1of2)CommercialPaperShort-term,unsecureddebtissuedbylargecorporationsthatisusuallyacheapersourceoffundsthanashort-termbankloan.Mostcommercialpaperhasafacevalueofatleast$100,000.Averagematurityis30days,andthemaximummaturityis270days.Commercialpaperisratedbycreditratingagencies.27.4Short-TermFinancingwithCommercialPaper(2of2)DirectPaperCommercialpaperthatafirmsellsdirectlytoinvestorsDealerPaperCommercialpaperthatdealersselltoinvestorsinexchangeforaspread(orfee)fortheirservicesThespreaddecreasestheproceedsthattheissuingfirmreceives,thusincreasingtheeffectivecostofthepaper.TextbookExample27.2(1of2)TheEffectiveAnnualRateofCommercialPaperProblemAfirmissuesthree-monthcommercialpaperwitha$100,000facevalueandreceives$98,000.Whateffectiveannualrateisthefirmpayingforitsfunds?TextbookExample27.2(2of2)SolutionLet’sputthefirm’scashflowsonatimeline:Theactualthree-monthinterestratepaidisExpressingthisasanE

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RgivesAlternativeExample27.2(1of2)ProblemAfirmissues180-daycommercialpaperwitha$1,000,000facevalueandreceives$950,000.Whateffectiveannualrateisthefirmpayingforitsfunds?AlternativeExample27.2(2of2)Solution27.5Short-TermFinancingwithSecuredFinancing(1of2)SecuredLoansAtypeofcorporateloaninwhichspecificassetsarepledgedasafirm’scollateralFactorsFirmsthatpurchasethereceivablesofothercompaniesandarethemostcommonsourcesforsecuredshort-termloans27.5Short-TermFinancingwithSecuredFinancing(2of2)Commercialbanks,financecompanies,andfactorsarethemostcommonsourcesforsecuredshort-termloans.AccountsReceivableasCollateral(1of5)PledgingofAccountsReceivableAnagreementinwhichalenderacceptsaccountsreceivableascollateralforaloanThelendertypicallylendsapercentageofthevalueoftheacceptedinvoices.AccountsReceivableasCollateral

(2of5)FactoringofAccountsReceivableAnarrangementinwhichafirmsellsreceivablestothelender(thefactor)andthelenderagreestopaythefirmtheamountduefromitscustomersattheendofthefirm’spaymentperiod.AccountsReceivableasCollateral(3of5)FactoringofAccountsReceivableForexample,ifafirmsellsitsgoodsonnet30terms,thenthefactorwillpaythefirmthefacevalueofitsreceivables,lessafactor’sfee,attheendof30days.Thefirmmaybeabletoborrowasmuchas80%ofthefacevalueofitsreceivables,therebyreceivingitsfundsinadvance.Insuchacase,thelenderwillchargeinterestontheloaninadditiontothefactor’sfee.Thelenderchargesthefactor’sfee,whichmayrangefrom1%to2%ofthefacevalueoftheaccountsreceivable,whetherornotthefirmborrowsanyoftheavailablefunds.AccountsReceivableasCollateral(4of5)FactoringofAccountsReceivableWithRecourseAloaninwhichthelendercanclaimalltheborrower’sassetsintheeventofadefault,notjustexplicitlypledgedcollateral.Inotherwords,thelendercanseekpaymentfromtheborrowershouldtheborrower’scustomersdefaultontheirbills.AccountsReceivableasCollateral(5of5)FactoringofAccountsReceivableWithoutRecourseAloaninwhichthelender’sclaimontheborrower’sassetsintheeventofdefaultislimitedtoonlyexplicitlypledgedcollateral.Inotherwords,thelenderbearstheriskofbad-debtlosses.InventoryasCollateral(1of6)FloatingLienAfinancialarrangementinwhichallofafirm’sinventoryisusedtosecurealoanAlsoknownasGeneralLienorBlanketLienThisistheriskiestsetupfromthestandpointofthelenderbecausethevalueofthecollateralusedtosecuretheloandwindlesasinventoryissold.InventoryasCollateral(2of6)TrustReceiptLoanAtypeofloaninwhichdistinguishableinventoryitemsareheldinatrustassecurityfortheloanAstheseitemsaresold,thefirmremitstheproceedsfromtheirsaletothelenderinrepaymentoftheloan.AlsoknownasFloorPlanningInventoryasCollateral(3of6)WarehouseArrangementWhentheinventorythatservesascollateralforaloanisstoredinawarehouseAwarehousearrangementistheleastriskycollateralarrangementfromthestandpointofthelender;however,warehousearrangementsareexpensive.Thebusinessoperatingthewarehousechargesafeeontopoftheinterestthattheborrowermustpaythelenderfortheloan.InventoryasCollateral(4of6)PublicWarehouseAbusinessthatexistsforthesolepurposeofstoringandtrackingtheinflowandoutflowofinventoryIfalenderextendsaloantoaborrowingfirm,basedonthevalueoftheinventory,thisarrangementprovidesthelenderwiththetightestcontrolovertheinventory.InventoryasCollateral(5of6)FieldWarehouseAwarehousearrangementthatisoperatedbyathirdpartybutissetupontheborrower’spremisesinaseparatearea.Inventoryheldinthefieldwarehousecanbeusedassecurecollateralforborrowing.TextbookExample27.3(1of3)CalculatingtheEffectiveAnnualCostofWarehouseFinancingProblemTheRow