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this plan is its reliance on stretching payables, an extremely expensive financing device.
Remember that it costs Dynamic 5 percent per quarter to delay paying bills”20 per-
cent per year at simple interest. This first plan should merely stimulate the financial
manager to search for cheaper sources of short-term borrowing.
The financial manager would ask several other questions as well. For example:
1. Does Dynamic need a larger reserve of cash or marketable securities to guard
against, say, its customers stretching their payables (thus slowing down collections
on accounts receivable)?
2. Does the plan yield satisfactory current and quick ratios?8 Its bankers may be wor-
ried if these ratios deteriorate.
3. Are there hidden costs to stretching payables? Will suppliers begin to doubt Dy-
namic™s creditworthiness?
4. Does the plan for 2001 leave Dynamic in good financial shape for 2002? (Here the
answer is yes, since Dynamic will have paid off all short-term borrowing by the end
of the year.)
5. Should Dynamic try to arrange long-term financing for the major capital expendi-
ture in the first quarter? This seems sensible, following the rule of thumb that long-
term assets deserve long-term financing. It would also dramatically reduce the need
for short-term borrowing. A counterargument is that Dynamic is financing the cap-
Working Capital Management and Short-Term Planning 185

ital investment only temporarily by short-term borrowing. By year-end, the invest-
ment is paid for by cash from operations. Thus Dynamic™s initial decision not to seek
immediate long-term financing may reflect a preference for ultimately financing the
investment with retained earnings.
6. Perhaps the firm™s operating and investment plans can be adjusted to make the short-
term financing problem easier. Is there any easy way of deferring the first quarter™s
large cash outflow? For example, suppose that the large capital investment in the
first quarter is for new mattress-stuffing machines to be delivered and installed in
the first half of the year. The new machines are not scheduled to be ready for full-
scale use until August. Perhaps the machine manufacturer could be persuaded to ac-
cept 60 percent of the purchase price on delivery and 40 percent when the machines
are installed and operating satisfactorily.

Short-term financing plans must be developed by trial and error. You lay out
one plan, think about it, then try again with different assumptions on
financing and investment alternatives. You continue until you can think of no
further improvements.

Sources of Short-Term Financing
We suggested that Dynamic™s manager might want to investigate alternative sources of
short-term borrowing. Here are some of the possibilities.

The simplest and most common source of short-term finance is an unsecured loan from
a bank. For example, Dynamic might have a standing arrangement with its bank allow-
ing it to borrow up to $40 million. The firm can borrow and repay whenever it wants so
long as it does not exceed the credit limit. This kind of arrangement is called a line of
Lines of credit are typically reviewed annually, and it is possible that the bank may
seek to cancel it if the firm™s creditworthiness deteriorates. If the firm wants to be sure
that it will be able to borrow, it can enter into a revolving credit agreement with the
bank. Revolving credit arrangements usually last for a few years and formally commit
the bank to lending up to the agreed limit. In return the bank will require the firm to
pay a commitment fee of around .25 percent on any unused amount.
Most bank loans have durations of only a few months. For example, Dynamic
may need a loan to cover a seasonal increase in inventories, and the loan is then repaid
as the goods are sold. However, banks also make term loans, which last for several
years. These term loans sometimes involve huge sums of money, and in this case they
may be parceled out among a syndicate of banks. For example, when Eurotunnel needed
to arrange more than $10 billion of borrowing to construct the tunnel between Britain
and France, a syndicate of more than 200 international banks combined to provide the

When banks lend money, they provide two services. They match up would-be borrow-
ers and lenders and they check that the borrower is likely to repay the loan. Banks re-
cover the costs of providing these services by charging borrowers on average a higher
interest rate than they pay to lenders. These services are less necessary for large, well-
known companies that regularly need to raise large amounts of cash. These companies
have increasingly found it profitable to bypass the bank and to sell short-term debt,
known as commercial paper, directly to large investors. Banks have been forced to re-
spond by reducing the interest rates on their loans to blue-chip customers.
In the United States commercial paper has a maximum maturity of 9 months, though
most paper matures in 60 days or less. Commercial paper is not secured, but companies
generally back their issue of paper by arranging a special backup line of credit with a
bank. This guarantees that they can find the money to repay the paper, and the risk of
default is therefore small.
Some companies regularly sell commercial paper in huge amounts. For example, GE
Capital Corporation has about $70 billion of commercial paper in issue.

Many short-term loans are unsecured, but sometimes the company may offer assets as
security. Since the bank is lending on a short-term basis, the security generally consists
of liquid assets such as receivables, inventories, or securities. For example, a firm may
decide to borrow short-term money secured by its accounts receivable. When its cus-
tomers pay their bills, it can use the cash collected to repay the loan. Banks will not usu-
ally lend the full value of the assets that are used as security. For example, a firm that
puts up $100,000 of receivables as security may find that the bank is prepared to lend
only $75,000. The safety margin (or haircut, as it is called) is likely to be even larger in
the case of loans that are secured by inventory.

Accounts Receivable Financing. When a loan is secured by receivables, the firm as-
signs the receivables to the bank. If the firm fails to repay the loan, the bank can col-
lect the receivables from the firm™s customers and use the cash to pay off the debt. How-
ever, the firm is still responsible for the loan even if the receivables ultimately cannot
be collected. The risk of default on the receivables is therefore borne by the firm.
An alternative procedure is to sell the receivables at a discount to a financial institu-
tion known as a factor and let it collect the money. In other words, some companies
solve their financing problem by borrowing on the strength of their current assets; oth-
ers solve it by selling their current assets. Once the firm has sold its receivables, the fac-
tor bears all the responsibility for collecting on the accounts. Therefore, the factor plays
three roles: it administers collection of receivables, takes responsibility for bad debts,
and provides finance.

To illustrate factoring, suppose that the firm sells its accounts receivables to a factor at
a 2 percent discount. This means that the factor pays 98 cents for each dollar of accounts
receivable. If the average collection period is 1 month, then in a month the factor should
be able to collect $1 for every 98 cents it paid today. Therefore, the implicit interest rate
Working Capital Management and Short-Term Planning 187

is 2/98 = 2.04 percent per month, which corresponds to an effective annual interest rate
of (1.0204)12 “ 1 = .274, or 27.4 percent.

While factoring would appear from this example to be an expensive source of fi-
nancing for the firm, part of the apparently steep interest rate represents payment for
the assumption of default risk as well as for the cost of running the credit operation.

Inventory Financing. Banks also lend on the security of inventory, but they are
choosy about the inventory they will accept. They want to make sure that they can iden-
tify and sell it if you default. Automobiles and other standardized nonperishable com-
modities are good security for a loan; work in progress and ripe strawberries are poor
Banks need to monitor companies to be sure they don™t sell their assets and run off
with the money. Consider, for example, the story of the great salad oil swindle. Fifty-
one banks and companies made loans for nearly $200 million to the Allied Crude Veg-
etable Oil Refining Corporation in the belief that these loans were secured on valuable
salad oil. Unfortunately, they did not notice that Allied™s tanks contained false com-
partments which were mainly filled with seawater. When the fraud was discovered, the
president of Allied went to jail and the 51 lenders stayed out in the cold looking for their
$200 million. The nearby box presents a similar story that illustrates the potential pit-
falls of secured lending. Here, too, the loans were not as “secured” as they appeared:
the supposed collateral did not exist.
To protect themselves against this sort of risk, lenders often insist on field ware-
housing. An independent warehouse company hired by the bank supervises the inven-
tory pledged as collateral for the loan. As the firm sells its product and uses the revenue
to pay back the loan, the bank directs the warehouse company to release the inventory
back to the firm. If the firm defaults on the loan, the bank keeps the inventory and sells
it to recover the debt.

The Cost of Bank Loans
Bank loans often extend for several years. Interest payments on these loans are some-
times fixed for the term of the loan but more commonly they are adjusted up or down
as the general level of interest rates changes.
The interest rate on bank loans of less than a year is almost invariably fixed for the
term of the loan. However, you need to be careful when comparing rates on these
shorter term bank loans, for the rates may be calculated in different ways.

The interest rate on bank loans frequently is quoted as simple interest. For example, if
the bank quotes an annual rate of 12 percent on a simple interest loan of $100,000 for
1 month, then at the end of the month you would need to repay $100,000 plus 1 month™s
interest. This interest is calculated as
annual interest rate .12
Amount of loan — = $100,000 — = $1,000
number of periods in the year 12

The Hazards of Secured Bank Lending

were safe. Sometimes a suspicious banker would ask
The National Safety Council of Australia™s Victoria Divi-
to inspect a particular container. Friedrich would then
sion had been a sleepy outfit until John Friedrich took
explain that it was away on exercise, fly the banker
over. Under its new management, NSC members
across the country in a light plane and point to a con-
trained like commandos and were prepared to go any-
tainer well out in the bush. The container would of
where and do anything. They saved people from drown-
course be empty, but the banker had no way to know
ing, they fought fires, found lost bushwalkers and went
down mines. Their lavish equipment included 22 heli-
Six years after Friedrich was appointed CEO, his
copters, 8 aircraft and a mini-submarine. Soon the NSC
massive fraud was uncovered. But a few days before a
began selling its services internationally.
warrant could be issued, Friedrich disappeared. Al-
Unfortunately the NSC™s paramilitary outfit cost mil-
though he was eventually caught and arrested, he shot
lions of dollars to run” far more than it earned in rev-
himself before he could come to trial. Investigations re-
enue. Friedrich bridged the gap by borrowing $A236
vealed that Friedrich was operating under an assumed
million of debt. The banks were happy to lend because
name, having fled from his native Germany, where he
the NSC™s debt appeared well secured. At one point the
was wanted by the police. Many rumors continued to
company showed $A107 million of receivables (that is,
circulate about Friedrich. He was variously alleged to
money owed by its customers), which it pledged as se-
have been a plant of the CIA and the KGB and the NSC
curity for bank loans. Later checks revealed that many
was said to have been behind an attempted counter-
of these customers did not owe the NSC a cent. In
coup in Fiji. For the banks there was only one hard truth.
other cases banks took comfort in the fact that their
Their loans to the NSC, which had appeared so well se-
loans were secured by containers of valuable rescue
cured, would never be repaid.
gear. There were more than 100 containers stacked
around the NSC™s main base. Only a handful contained
any equipment, but these were the ones that the Source: Adapted from Chapter 7 of T. Sykes, The Bold Riders (St.
bankers saw when they came to check that their loans Leonards, NSW, Australia: Allen & Unwin, 1994).

Your total payment at the end of the month would be
Repayment of face value plus interest = $100,000 + $1,000 = $101,000
Earlier you learned to distinguish between simple interest and compound interest. We
have just seen that your 12 percent simple interest bank loan costs 1 percent per month.
One percent per month compounded for 1 year cumulates to 1.0112 = 1.1268. Thus the
compound, or effective, annual interest rate on the bank loan is 12.68 percent, not the
quoted rate of 12 percent.
The general formula for the equivalent compound interest rate on a simple interest
loan is

( )
quoted annual interest rate m
Effective annual rate = 1 + “1
where the annual interest rate is stated as a fraction (.12 in our example) and m is the
number of periods in the year (12 in our example).

The interest rate on a bank loan is often calculated on a discount basis. Similarly, when
companies issue commercial paper, they also usually quote the interest rate as a dis-

Working Capital Management and Short-Term Planning 189

count. With a discount interest loan, the bank deducts the interest up front. For exam-
ple, suppose that you borrow $100,000 on a discount basis for 1 year at 12 percent. In
this case the bank hands you $100,000 less 12 percent, or $88,000. Then at the end of
the year you repay the bank the $100,000 face value of the loan. This is equivalent to
paying interest of $12,000 on a loan of $88,000. The effective interest rate on such a
loan is therefore $12,000/$88,000 = .1364, or 13.64 percent.
Now suppose that you borrow $100,000 on a discount basis for 1 month at 12 per-
cent. In this case the bank deducts 1 percent up-front interest and hands you

( )
quoted annual interest rate
Face value of loan — 1 “
number of periods in the year

( )
= $100,000 — 1 “ = $99,000


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