SHORT TERM CREDIT FOR FINANCING CURRENT ASSETS

Short-Term Funds
- Defined as those that are due and payable within a year.

Factors in selecting a source of short-term funds:

1. The effective cost of credit
2. The availability of credit in the amount needed and for the period of time when financing
is required
3. The influence of the use of a particular credit source on the cost and availability of other
sources of financing
4. Any additional covenants of the loans that are unique to the sources mentioned
previously

Estimating Cost of Short-term credit

1. Cost of trade Credit

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐴𝑁𝐶)

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 360 𝑑𝑎𝑦𝑠
= 𝑥
100 − 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑 𝐷𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 − 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑

Illustrative Problem:

Calculate the nominal annual cost of non-free trade credit under each of the following
items:

1. 2/10, n/60
2. 1/15, n/20

Answer:

2% 360
1. 𝐴𝑁𝐶 = 𝑥 = 14.69%
100%−2% 60−10
1% 360
2. 𝐴𝑁𝐶 = 100%−1%
𝑥 20−15
= 72.7%
3. Cost of Bank Loan
a. Simple interest
b. Discount Interest
c. Add-on Interest
d. Simple Interest with Compensating Balances
e. Discount Interest with Compensating Balances

o Simple Interest
 In a single interest loan, the borrower receives the face value of the loan and
repays the principal and interest at maturity date.

Formula to compute the effective interest rate:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠𝑖𝑚𝑝𝑙𝑒 =
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Example:

Compute the effective annual rate for a one-year loan of P100,000 at 12% annual
interest per year payable at maturity.

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠𝑖𝑚𝑝𝑙𝑒 =
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑃ℎ𝑝. 12,000
=
𝑃ℎ𝑝. 100,000

= 12%

On a simple interest loan of 1 year or more, the nominal rate equals the effective rate. If
the loan had a term of less than a year, say 90 days, the effective annual rate would be
calculated as follows:

1 4
Eff. annual Rate (simple) = ( 1 + 12% ) − 1
4

= (1.03)4 − 1

= 12.56%

o Discount Interest
 In a discount interest loan, the bank deducts the interest in advance or discounts
the loan. Formula to compute the effective annual rate is
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Eff. Annual ratediscount = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑

Example:

On a one-year Php 100,000 loan with a 12% (nominal) rate, discount basis, the
effective interest rate is:

𝑃ℎ𝑝12,000
= 13.64%
𝑃ℎ𝑝100,000 − 𝑃ℎ𝑝12,000

If the discount loan is for a period of less than 1 year, say 90 days, its effective
annual interest rate is found as follows:

12,000 4
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + ) −1
88,000

= (1 + 0.136)4 − 1

= 66.75%

o Add-On Interest
 Add-on interest is interest that is calculated and added to funds received to
determine the face amount of an installment loan:

Formula
2 𝑥 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑜.𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
1. 𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 𝑎𝑑𝑑−𝑜𝑛 = (𝑇𝑜𝑡𝑎𝑙 𝑁𝑜.𝑜𝑓 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠+1)𝑥 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

2. The effective annual rate may be computed using the procedure in getting
internal rate of return or effective yield.

To illustrate: Determine the effective interest rate on a Php100,000 loan on a add-on basis
at a nominal rate of 12% payable in 12 monthly installments.

1. The approximate annual interest rate is computed as follows:

2 𝑥 12 𝑥 12,000
= (12+1)𝑥 100,000

288,000
=
1,300,000

= 22.15%

2. Effective annual interest rate is obtained as follows:

100,000 + 12,000
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 =
12
 = 9,333.33

100,000 = 9,333.33 𝑥 𝐹

𝐹 = 10.71429

Using the PV of an annuity of P1 table, n = 12, the effective interest rate will fall between 1 to 2
% per period.

To compute for the exact rate, interpolation may be used:

11.2551 − 10.71429
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑 = 1% + ( 𝑥 1%)
11.2551 − 10.5753
0.54081
= 1% ( 𝑥 1%)
0.6798

= 1.795%

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (1 + 0.01795)12 − 1

= 23.8%

o Simple Interest with Compensating Balance

Compensating balance is the minimum account balance that a lending bank
requires the borrower to maintain. Its effect is to raise the effective rate on a loan
because the net withdrawable amount is reduced.

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒𝑠𝑖𝑚𝑝𝑙𝑒 =
𝐶𝐵 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 − 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
OR
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 (%)
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒𝑠𝑖𝑚𝑝𝑙𝑒 =
𝐶𝐵 1.0 − 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 (%)

To illustrate, assume that the bank offers to lend the company Php100,000 for 1
year at a 12% simple rate but the company must maintain a compensating balance
equal to 10% of the loan amount. What is the effective annual rate of the loan?

The effective annual interest rate is computed as follows:

𝑃ℎ𝑝12,000
= 13.33%
𝑃ℎ𝑝100,000 − 𝑃ℎ𝑝10,000
OR
12%
= 13.33%
100% − 10%
 o Discount interest with compensating balance
The formula to compute for the effective annual rate if the loan is on a discount
basis is:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
OR
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 (%)
1.0 − 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 − 𝐶𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑟𝑎𝑡𝑒

Illustration:
Assume the same data as in number 4 except, that the loan is a discount loan.
What is the effective annual rate of the loan?

The effective annual interest rate is computed as follows:

𝑃ℎ𝑝. 12,000
= 15.38%
𝑃ℎ𝑝. 100,000 − 𝑃ℎ𝑝12,000 − 𝑃ℎ𝑝. 10,000
OR
12%
= 15.38%
100% − 10% − 12%

Cost of Commercial Paper

To calculate the effective cost of credit, through the issuance of commercial paper, the following formula
may be used:

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝐼𝑠𝑠𝑢𝑒 𝐶𝑜𝑠𝑡𝑠 1
= 𝑥
𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑁𝑜𝑡𝑒𝑠 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐼𝑠𝑠𝑢𝑒 𝐶𝑜𝑠𝑡𝑠 𝐷𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
360 𝐷𝑎𝑦𝑠

Example:

The Choeneqck Company uses commercial paper regularly to support its needs for short-term financing.
The firm plans to sell Php. 100 Million in 270-day-maturity paper on which it expects to have to pay
discounted interest at an annual rate of 12 percent per annum. In addition, Choeneqck expects to incur a
cost of approximately Php100,000 in dealer placement fees and other expenses of issuing the paper. What
is the effective cost of credit of Choeneqck?

Solution:

The effective annual cost to Choeneqck can be calculated as follows:

 𝑃ℎ𝑝9,000,000∗ + 𝑃ℎ𝑝. 100,000 1
𝑅𝑎𝑡𝑒 = 𝑥
𝑃ℎ𝑝 100 𝑀𝑖𝑙𝑙𝑖𝑜𝑛 − 𝑃ℎ𝑝 100,000 − 𝑃ℎ𝑝. 9 𝑀𝑖𝑙𝑙𝑖𝑜𝑛 270
360

= 13.35%

270
∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃ℎ𝑝100 𝑀𝑖𝑙𝑙𝑖𝑜𝑛 𝑥 12% 𝑥
360

= 𝑃ℎ𝑝9 𝑀𝑖𝑙𝑙𝑖𝑜𝑛