Week 4 PDF

7/02/2014
Week 4 Debt
Chapters 9, 10 and 11
Mark W. Werman
MWW - 125.220 - Sem 1 2014
Learning objectives
Overview of the characteristics of various forms of
short-term debt
Main types
Trade credit, bank overdraft, commercial and
bank-accepted bills, promissory notes,
negotiable certificates of deposit, inventory
accounts receivable and factoring
Sources
Reasons and patterns of use
Advantages and disadvantages for borrowers and
lenders
Calculations relevant to discount securities
MWW - 125.220 - Sem 1 2014
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 shortterm liabilities, long term assets by long term
liabilities
The importance of this principle was highlighted by
the GFC
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9.1 Trade credit

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)
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Trade Credit
From providers perspective
Advantages include increased sales
Disadvantages include:
costs of discount and increased discount
period,
increased total credit period and accounts
receivable,
increased collection and bad debt costs
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9.1 Trade credit

The opportunity cost of the purchaser forgoing the
discount on an invoice (1/7, n/30) is: 1% discount if
paid within 7 days, otherwise pay in 30 days
Opportunity cost
% discount
365
100 % discount days difference between
early and late settlement

1.0 365
99.0 23
0.160298 or 16.03% p.a.
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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
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9.2 Bank overdrafts

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, Libor or USCP,
Fed funds rate
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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
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9.3 Commercial Bills
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9.3 Commercial Bills (cont.)

Features of commercial billsparties involved
(bank-accepted bill)

(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
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Payee
The specified party to whom the bill is 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
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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
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The flow of funds (bank-accepted bills)
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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
If the bank rediscounts a bill (sells to a third
party), the bank becomes the endorser,
creating a bank-endorsed 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
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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
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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
discount bills progressively up to an agreed
amount
Term of loan may be extended by rollover at
maturity
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9.4 Calculations: discount securities

Calculations considered
Calculating priceyield known
Calculating face valueissue price and yield
known
Calculating yield
Calculating pricediscount rate known
Calculating discount rate
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Book:
Easier:
price
FV = face value
r = yield
t = time
days/365 or
days/360
FV
1 rt
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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)
price
price
Fv
1 rt
Fv
1 rt
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$500, 000
$496,118.04
30
1 0.0952*
365
$500, 000
$496,134.23
30
1 0.0948*
365
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Calculating priceyield known (cont.)
An alternative formula for calculating price

known
Face value price[
365 (
yield
days to maturity)
100
]
365
Alternative method:
Fv Pv 1 rt
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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)
Face value $500 000[
$507 191.78
365
60
Fv Pv * 1 rt $500, 000* 1 0.0875*

$507,191.78
365
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Calculating yield
Yield
(sell price - buy price) (days in year 100)
buy price
days to maturity
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Calculating yield (cont.)

Example 7: In Example 3, a company issued a
30-day bank-accepted 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.
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Calculating yield (cont.)

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
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Price face value [1
days to maturity discountrate
]
days in year
100
(cont.)
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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
0.1475]
360
$100 000(1- 0.07375)
Price $100 000[1 $92 625.00
Note: discount rate not equal to yield!

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.
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Calculate the yield

fv 1 $100, 000 1
r 1 *
0.159244264 15.9244%
1 *
pv t $92, 625 180
360
How do you check this answer?
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Calculating discount rate
Discountrate
face value - current price days in year 100
face value
days to maturity
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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
Discountrate
16.22%
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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
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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
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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
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Promissory Notes
Issues may also be non-underwritten
Issuer may approach money market directly
Commercial bank, investment bank or merchant
bank may be retained as lead manager and
receive fees
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9.6 Negotiable certificates of deposit

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
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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
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Accounts receivable financing
A loan to a business secured against its accounts
receivable (debtors)
Mainly supplied by finance companies
Lending company takes charge of a companys
accounts receivable; however, the borrowing
company is still responsible for the debtor book
and bad debts
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financing and factoring (cont.)
Factoring
Company sells its accounts receivable to a factoring
company
Converting 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
Main providers of factor finance are the finance
companies
Factor is responsible for collection of receivables
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Factoring (cont.)
Notification basis: vendor is required to notify its
(accounts receivables) customers that payment
is to be made to the factor
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
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9.8 Summary
Short-term debt is appropriate for funding short-term
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
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Summary
Inventory loans, accounts receivable finance and
factoringalternative sources of finance for small
and medium-sized businesses
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Learning objectives
Identify the main types of medium- to long-term debt
instruments in the market
Term loans or fully drawn advances, mortgage
finance, bond markets (debentures, unsecured
notes and subordinated debt) and lease financing
Describe the main features of these facilities
Identify the financial institutions and parties involved
in the provision of these facilities
Undertake calculations related to the pricing of
these debt instruments
Discuss the availability and appropriateness of
these debt instruments for business
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10.1 Term loans or fully drawn advances

Term loan
A loan advanced for a specific period (three to
15 years), usually for a known purpose; e.g.
purchasing land, premises, plant and
equipment
Secured by mortgage over asset purchased or
other assets of the firm
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Term Loan
Fully drawn advance
A term loan where the full amount is provided at
the start of the loan
Provided by:
mainly commercial banks and finance
companies
to a lesser degree, investment banks, merchant
banks, insurance offices and credit unions
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Term loan structures
Interest only during term of loan and principal
repayment on maturity
Amortised or credit foncier loan
Periodic loan instalments consisting of
interest due and reduction of principal
Deferred repayment loan
Loan instalments commence after a
specified period related to project cash
flows and the debt is amortised over the
remaining term of the loan
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Term loan structures
Interest may be fixed (for a specified period of
time; e.g. two years) or variable
Interest rate charged on term loan is based on:
an indicator rate (e.g. BBSW or a banks own
prime lending rate)
(cont.)
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Term loans
Interest rate charged is also influenced by:
credit risk of borrowerrisk that borrower
may default on loan commitment, giving rise
to a risk premium
term of the loan
usually longer term attracts a higher interest rate
repayment schedule frequency of loan
repayments
e.g. monthly or quarterly
form of the repayment (e.g. amortised or interestonly loan)
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Term loan structures (cont.)
Other fees include:
establishment fee
service fee
commitment fee
line fee
bill option clause fee
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Loan covenants
Restrict the business and financial activities of the
borrowing firm
Positive covenant
Requires borrower to take prescribed
actions; e.g. maintain a minimum level of
working capital
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Loan Covenants
Negative covenant
Restricts the activities and financial
structure of borrower; e.g. maximum D/E
ratio, minimum working-capital ratio,
unaudited periodic financial statements
Breach of covenant results in default of the loan
contract, entitling lender to act
Penalty payments
Call entire loan due
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Calculating the loan instalmentordinary annuity
R
[
1 (1 i )n
]
i
where :
R the instalmentamount
A the loan amount (present value)

i the current nominalinterest rate per period expressedas a decimal
n the number of compounding periods.
Note: this formula calculates annual payments

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Annuity formula a different view
pmt
k
m
n*m
k
1 1
m
Pva *
Where:
pmt is the payment
k is the interest rate charged
Pva is the amount borrowed (present value)
n number of years
m is the frequency that payments (pmt) are to be
made
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(cont.)
Example 1: Floppy Software Limited has
approached Mega Bank to obtain a term loan to
finance the purchase of a new high-speed CD
burner. The bank offers a $150 000 loan,
amortised over five years at 8% per annum,
payable monthly. Calculate the monthly loan
instalments.
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Example 1 (cont.)
R
1 (1 i )n
[
]
i
A $150 000
0.08
0.006667
12
n 5 years 12 months 60
$150 000
R
1 (1 0.006667)60
[
]
0.006667
R $3041.49 per month
i
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Calculating the loan instalmentannuity due
1 (1 i )n
[
](1 i )
i
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Calculating the loan instalmentannuity due
Example 2: A business proprietor is purchasing a
computer system for the business at a cost of $21
500. A finance company has offered a term loan
over seven years at a rate of 12% per annum. The
loan will be repaid by equal monthly instalments at
the beginning of each month. Calculate the amount
of the loan instalments.
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Example 2
A $21500
0.12
i
0.01
12
n 7 12 84
$21500
1 (1 0.01)84
[
] (1 0.01)
0.01
$21500
57.21494
$375.78 monthly instalment
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10.2 Mortgage finance
A mortgage is a form of security for a loan

The borrower (mortgagor) conveys an interest in
the land and property to the lender (mortgagee)
The mortgage is discharged when the loan is
repaid
If the mortgagor defaults on the loan the
mortgagee is entitled to foreclose on the property,
i.e. take possession of assets and realise any
amount owing on the loan
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Use of mortgage finance
Mainly retail home loans
Up to 30-year terms
To a lesser degree commercial property loans
Up to 10 years as businesses generate cash
flows enabling earlier repayment
Providers (lenders) of mortgage finance
Commercial banks, building societies, life
insurance offices, superannuation funds, trustee
institutions, finance companies and mortgage
originators
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10.2 Mortgage finance (cont.)

Interest rates
Both variable and fixed interest rate loans With
fixed interest loans, interest rates reset every five
years or less
With interest-only mortgage loans, interest-only
period is normally a maximum of five years
Mortgagee (lender) may reduce their risk exposure to
borrower default by:
requiring the mortgagor to take out mortgage
insurance up to 100% of the mortgage value
Loan to value ratios
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Calculating the instalment on a mortgage loan

(ordinary annuity formula)
R
[
1 (1 i )n
]
i
k
m
pmt
n*m
k
1 1
m
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Pva *
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Calculating the instalment on a mortgage loan (cont.)
Example 3: A company is seeking a fully amortised
commercial mortgage loan of $650 000 from its
bank. The conditions attached to the loan include
an interest rate of 8% per annum, payable over five
years by equal end-of-quarter instalments. The
company treasurer needs to ascertain the quarterly
instalment amount.
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Calculating the instalment on a mortgage loan (cont.)
Example 3 :
A $650 000
0.08
0.02
4
n 5 4 20
$650 000
R
1 (1 0.02)20
[
]
0.02
$39 751.87 monthly instalment
i
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Securitisation and mortgage finance
Mortgage originators, commercial banks and other
institutions use securitisation to manage their
mortgage loan portfolios
Involves conversion of non-liquid assets into new
asset-backed securities that are serviced with
cash flows from the original assets
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Mortgage back securities

Original lender sells bundled mortgage loans to a
special-purpose vehicle
That is, a trust set up to hold securitised
assets and issue asset-backed securities like
bonds, providing investors with security and
payments of interest and principal
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MBS
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The securitisation of mortgage finance suffered a
large contraction during the GFC.
Securitised mortgage assets in 2007: $215
billion
Securitised mortgage assets in 2010: $112
billion
These falls were recorded in Australia despite the
much lower default rates experienced on
mortgages compared to other parts of the world.
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10.3 Debentures, unsecured notes and

subordinated debt
These securities are issued in the corporate bond market
Markets for the direct issue of longer term debt
securities
Lenders attract higher:
risk compared with lending indirectly through
intermediaries
yield owing to sharing in the profit margin usually
taken by intermediaries
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subordinated debt (cont.)
Debentures and unsecured notes
Are corporate bonds
Specify that the lender will receive regular interest
payments (coupon) during the term of the bond and
receive repayment of the face value at maturity
Unsecured notes are bonds with no underlying
security attached
(cont.)
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Debentures etc
Debentures:
are secured by either a fixed or floating charge
over the issuers unpledged assets
are listed and traded on the stock exchange
have a higher claim over a companys assets
(e.g. on liquidation) than unsecured note
holders
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subordinated debt
Issuing debentures and notes
There are three principal issue methods
1. Public issueissued to the public at
large, by prospectus
2. Family issueissued to existing
shareholders and investors, by prospectus
3. Private placementissued to institutional
investors, by information memorandum
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Debentures
Usually issued at face value, but may be
issued at a discount or with deferred or zero
interest
A prospectus contains detailed information
about the business
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subordinated debt
Subordinated debt
More like equity than debt, i.e. quasi-equity
Claims of debt holders are subordinated to all
other company liabilities
Agreement may specify that the debt not be
presented for redemption until after a certain
period has elapsed
May be regarded as equity in the balance sheet,
improving the credit rating of the issuer
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10.4 Calculations: fixed-interest securities

Price of a fixed-interest bond at coupon date
The price of a fixed-interest security is the sum
of the present value of the face value and the
present value of the coupon stream.
Text book formula
Note: two cash flows!
P C[
1 (1 i )n
] A(1 i )n
i
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Alternative formula
n*m

k
1 1
pmt m
Fv
price
*
n*m
k

m
k
1
Where:
Pmt is the annual payment
m frequency of payments
k yield
n number of years
Fv future value (par value or face value)
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Price of a fixed-interest bond at coupon date (cont.)
Example 4: Current AA+ corporate bond yields in
the market are 8% per annum. What is the price
of an existing AA+ corporate bond with a face
value of $100 000, paying 10% per annum halfyearly coupons (semi-annual payments), and
exactly six years to maturity?
A = $100 000
C = $100 000 x 0.10/2 = $5000
i = 0.08/2 = 0.04
n = 6 x 2 = 12
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Example 4 :

Price of a fixed-interest bond between coupon
dates
1 (1 i )n
n
k
P C
A(1 i ) (1 i )
i

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Price of a fixed-interest bond between coupon dates
Example 5: Current AA+ corporate bond yields in
the market are 8% per annum. An existing AA+
corporate bond with a face value of $100 000,
paying 10% per annum half-yearly coupons,
maturing 31 December 2016, would be sold on
20 May 2011 at what price?
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Example 5 :

Example 5 :
Credit Rating Agencies

Moodys
Standard & Poors
Fitch Ratings
Control approximately 95% of the ratings
business
Dagong Global Credit Rating not
authorized in US
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11.6 Credit rating agencies

An organisation specialising in assessing the credit
quality associated with financial obligations, e.g.
S&P (Standard & Poors)
The rating methodology develops a profile balancing
business risk, financial risk and environmental risk
factors
S&P provide:
long-term credit ratings (AAA to D), with BBB and
above being investment grade
short-term credit ratings (A-1 to D)
a rating of a corporation overall
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S&P provide (cont.):
issue-specific credit ratings on the creditworthiness of an
obligor with respect to a specific financial obligation
credit ratings of specific issues into international markets
include the following:
Country riskrisk of changes in the laws of a foreign country
affecting financial transactions
Sovereign riskrisk of a foreign government defaulting on its
obligations
Foreign exchange risk risk of the value of one currency, relative to
another, changing
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Credit ratings agencies have been accorded a lot of

attention over the past several years
First, credit ratings agencies were criticised heavily
for providing favourable ratings on securitised
mortgage products that later turned toxic
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Credit Rating Agencies
Second, as the GFC became a sovereign debt

crisis, the ratings accorded to different countries
(especially Greece, Spain and Italy) attracted much
interest
Commentators and investors have been most
interested in much-publicised ratings downgrades
of various countries
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7/02/2014

MWW - 125.220 - Sem 1 2014

9.1 Trade credit

9.1 Trade credit

MWW - 125.220 - Sem 1 2014

MWW - 125.220 - Sem 1 2014

9.1 Trade credit

100 % discount days difference between

early and late settlement

MWW - 125.220 - Sem 1 2014

9.2 Bank overdrafts

9.2 Bank overdrafts

9.3 Commercial bills

MWW - 125.220 - Sem 1 2014

9.3 Commercial Bills

MWW - 125.220 - Sem 1 2014

9.3 Commercial Bills (cont.)

9.3 Commercial Bills

MWW - 125.220 - Sem 1 2014

9.3 Commercial Bills

9.3 Commercial Bills

9.3 Commercial Bills

9.3 Commercial Bills

9.3 Commercial Bills (cont.)

MWW - 125.220 - Sem 1 2014

9.3 Commercial Bills (cont.)

9.4 Calculations: discount securities

MWW - 125.220 - Sem 1 2014

Calculating priceyield known

MWW - 125.220 - Sem 1 2014

Calculating priceyield known

MWW - 125.220 - Sem 1 2014

Calculating priceyield known (cont.)

An alternative formula for calculating price

Calculating face valueissue price and yield

Face value price[

MWW - 125.220 - Sem 1 2014

Calculating face valueissue price and yield

Fv Pv * 1 rt $500, 000* 1 0.0875*

MWW - 125.220 - Sem 1 2014

(sell price - buy price) (days in year 100)

MWW - 125.220 - Sem 1 2014

Calculating yield (cont.)

MWW - 125.220 - Sem 1 2014

Calculating yield (cont.)

Yield to holder at maturity:

MWW - 125.220 - Sem 1 2014

Calculating pricediscount rate known

Price face value [1

days to maturity discountrate

Calculating pricediscount rate known

Price $100 000[1 $92 625.00

Note: discount rate not equal to yield!

Calculate the yield

How do you check this answer?

MWW - 125.220 - Sem 1 2014

Calculating discount rate

face value - current price days in year 100

MWW - 125.220 - Sem 1 2014

Calculating discount rate (cont.)

MWW - 125.220 - Sem 1 2014

9.5 Promissory notes