Chapter 9 Sources of Short-Term Debt

1. Chapter 9Sources of Short-Term Debt

2. Learning Objectives • Identify the main forms of short-term borrowing by Australian companies. • Understand the characteristics of trade credit and calculate the implied interest rate. • Understand the main forms of bank lending and appreciate when each may be suitable to a borrower’s needs.

3. Learning Objectives (cont.) • Understand debtor finance, inventory loans and bridging finance, and be able to distinguish between them. • Understand the basic features of the interbank cash market. • Understand the process of using promissory notes and bills of exchange to raise funds. • Calculate prices and yields for promissory notes and bills of exchange.

4. Introduction • ‘Short-term debt’ is defined as debt due for repayment within a period of 12 months. • The major short-term borrowing choices available to Australian companies are: • Trade credit. • Borrowing from banks and other financial institutions. • Issuing short-term marketable debt securities such as promissory notes and bills of exchange.

5. Trade Credit • When companies sell goods or services to other businesses ‘on credit’. • Usually, the seller allows the purchaser several weeks to pay. • Thus, trade credit is, in effect, a form of short-term debt in which the seller lends the purchase price to the purchaser.

6. Borrowing from Banks and Other Financial Institutions • Bank overdraft • An overdraft permits a company to run its current (cheque) account into deficit up to an agreed limit. • The cost of a bank overdraft includes the interest cost and fees. • The interest rate charged is usually at a margin above an indicator rate, published regularly by the bank, and only on the amount by which the account is overdrawn.

7. Borrowing From Banks and Other Financial Institutions (cont.) • Debtor financing • Debtor finance allows a company to raise funds by selling its accounts receivable on a continuing basis to a financier (called a discounter), who is then responsible for managing the sales ledger and collecting the debts. • The discounter earns a return by discounting the value of the receivable and charging a fee.

8. Borrowing From Banks and Other Financial Institutions (cont.) • Debtor finance with recourse • Agreement in which the discounter is reimbursed by the selling company if the debtor defaults. • Debtor finance without recourse • Agreement in which the discounter is not reimbursed by the selling company if the debtor defaults. • Invoice discounting • A discounting agreement in which the debtors of the company seeking finance are unaware of the existence of the discounting agreement.

9. Borrowing From Banks and Other Financial Institutions (cont.) • Inventory loans • Known as floor-plan or wholesale finance. • A loan, usually made by a wholesaler to a retailer, that finances an inventory of durable goods, such as motor vehicles. • Bridging finance • A short-term loan, usually in the form of a mortgage, to cover a need normally arising from timing differences between two or more transactions.

10. Interbank Deposits • Interbank market is a loan market that operates between banks that lend to each other overnight. • Facilitated by exchange settlement accounts that all banks hold with RBA. • These funds can be lent to (borrowed from) another bank at the interbank cash rate. • ‘Interbank cash rate’ is the rate changed on overnight interbank loans which is closely tied to the RBA’s cash rate.

11. Short-Term Marketable Debt • Companies can obtain short-term debt funding by issuing (selling) securities such as promissory notes and bills of exchange. • The securities are a promise to pay a sum of money on a future date. • These are generally discount securities. • A secondary market exists for the exchange of such securities.

12. Promissory Notes • A promise to pay a stated sum of money on a stated future date. • Also known as ‘one-name paper’ and ‘commercial paper’. • Face value • Sum promised to be paid in the future on the debt security. • Discounter • Purchaser of a short-term debt security such as a promissory note or a bill of exchange.

13. Promissory Notes (cont.) • To calculate the price P of a promissory note:

14. Promissory Notes (cont.) Example 9.2: • 90-day promissory note, $500k face value, and a yield of 4.926% p.a. What is the price?

15. Promissory Notes (cont.) • A promissory note can be underwritten, banks and other financial institutions are usually involved. • To facilitate trading it is usual for promissory note issues to have a credit rating from a ratings agency. • For example, Moody’s Investors Service assigned a long- and short-term rating to a WMC Resources $500m promissory note program.

16. Bills of Exchange • A marketable short-term debt security in which one party (the drawer) directs another party ( the acceptor) to pay a stated sum on a stated future date. Figure 9.1

17. Bills of Exchange (cont.) • A company will struggle to issue and sell a promissory note if it does not have a credit rating from a ratings agency. • This is one of the reasons that bills of exchange have been developed — in order to enable an unrated entity to borrow by issuing marketable securities. • In addition to the issuer of the bill, there is an acceptor who promises to redeem the bill in the event that the issuer defaults.

18. Bills of Exchange (cont.) • The face value is paid to whoever holds the bill on the maturity date. • The discounter has the choice of either holding the bill until maturity, when payment will be received from the acceptor, or selling (rediscounting) the bill. • However, if the bill is sold, the seller normally endorses the bill at the time of sale, creating a chain of protection for the bill holder.

19. Bills of Exchange (cont.) • Endorsement: • Acceptance by the seller of a bill in the secondary market, of responsibility to pay the face value if there is default by the acceptor, drawer and earlier endorsers.

20. Bills of Exchange (cont.) • Normal process of repayment Figure 9.2

21. Bills of Exchange (cont.) • Bank accepted bills • Bills of exchange that have been accepted or endorsed by a bank. • Non-bank bills • Any bill of exchange that has been neither accepted nor endorsed by a bank.

22. Bills of Exchange (cont.) • Bill facilities • Bill discount facility • Agreement in which one entity (normally a bank) undertakes to discount (buy) bills of exchange drawn by another entity (the borrower). • Bill acceptance facility • Agreement in which one entity (normally a bank) undertakes to accept bills of exchange drawn by another entity (the borrower).

23. Bills of Exchange (cont.) • Fully drawn bill facility • Bill facility in which the borrower must issue bills so that the full agreed amount is borrowed for the period of the facility. • Revolving credit bill facility • Bill facility in which the borrower can issue bills as required, up to the agreed limit.

24. Summary • Various sources of short-term finance are available to companies. • The simplest is trade credit; however, cash discounts are forgone. • Banks and other financial institutions offer a range of short-term finance: • Banks offer overdrafts, which are a common and flexible form of short-term finance. • More specialised forms of finance include debtor finance, inventory loans and bridging finance.

25. Summary (cont.) • A company can issue short-term marketable debt such as promissory notes and bills of exchange. • Promise to pay face value at a future date and sold at a discount to face value. • Promissory note, promise/guarantee made only by issuer of note. • Bill of exchange, there is an acceptor who guarantees the loan. • Secondary market for these debt instruments exists.