Chapter 4 Finance

Chapter-4
Short Term Financing

Definition of Short Term Financing
Short term financing is that form of financing which includes borrowing or lending of funds for
a short period of time. It refers to the finance obtained on short term basis, usually one year or
less in duration.
Short term financing is secured financing the current assets and inventories. Short term finance
is also known as working capital, which is the excess of current assets over current liabilities.
Current liabilities become due within the year and indicate the amount of short term financing.
Short term credit is defined as any liability originally scheduled for payment within one year. ----
Brigham.
Objective/ Nature of Short Term Financing

The funds are available for a period of one year or less is called short term finance.
Objectives/ advantage/ nature of it are given below:
 Duration: Short term financing is for a short period of time say one year or less.
 Cost of Fund: Short term credit may be obtained with lower cost than the long term
finance because of priority of creditors in general.
 Easier to Obtain: It can be obtained more easily than long term credit.
 Use of Funds: In practically all types of business, there is lesser use of short term
credit among larger concerns. The small concerns make more use of short term
financing.
 Sources of Funds: Short term finance comes from the internal and external as well as
formal and informal sources.
 Flexibility: It is flexible in the sense that the firm is able to secure funds as they are
needed and repay them as soon as the need vanished.
 Collection and Control: There are no formalities needed to raise funds for its, so it is
easy to collect and control short term financing.
 Security: Short term financing may not require any security to collect the funds.
 Risk: Funds are available from well-known sources of business, so it may be risk less
short term finance.
 Renewal: Some short term financing are refinanced continuously or automatically.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 1 of 24
Why Do Firms Need Short-term Financing?
 Cash flow from operations may not be sufficient to keep up with growth-related
financing needs.
 Firms may prefer to borrow now for their inventory or other short term asset needs
rather than wait until they have saved enough.
 Firms prefer short-term financing instead of long-term sources of financing due to:
 easier availability
 usually has lower cost
 matches need for short term assets, like inventory
Advantages and disadvantages of Short term financing:

Advantages:
 Speed
 Flexibility
 Tax saving
 Extension of credit
Disadvantages:
 Frequent maturity
 High cost- The rate of interest paid on short-term is usually higher than that on long-
term credit.
Types of Short Term Financing

1. Spontaneous Financing
2. Negotiated Financing
3. Factoring Accounts Receivable
4. Composition of Short-Term Financing
Spontaneous Financing
- Spontaneous financing is raised from the normal course of business operation.
- The major spontaneous sources of short term financing are trade credit, advance and
accrual payments.
- They are naturally from the firm's day-to-day transactions.
Types of spontaneous financing

(i) Trade credit
(ii) Advance payment and
(iii) accrued expense
Definition of Trade Credit (Accounts Payable):
Firms generally make purchases from others firms on credit, recording the debt as account
payable. This type of financing is called trade credit; trade credit is a kind business credit which
is extended by the seller of goods to the buyer of the same at levels of production and
distribution process down to the retailer.
I. Trade credit is a spontaneous source of financing in the sense that it arises from ordinary
business transactions. -Brigham.
II. Trade credit refers to accounts payable that arise from the purchase of goods & services.
-Benton.
So, trade credit has been defined as the short term credit by a supplier to a buyer connection
with the purchase of goods for ultimate resale.
Types of Trade Credit:

There are three types of trade credit- open account; note payable and trade acceptance which
are discussed below:
1. Open account: It is a far most common kind arrangement the seller ships goods to the
buyer and sends an invoice of the goods shipped, the total amount due and the term
of the sales. Open account credit derives its name from the fact that the buyer does not
sign a formal debt instrument evidencing the amount owed the seller.
2. Notes Payable: The buyer signs a note the evidences a debt to the seller. The note calls
for the payment of the obligation and some specified future date.
3. Trade Acceptance: Under the arrangement the seller draws a draft on the buyer into
which he orders the buyer to pay the draft at some future date. The draft becomes
trade acceptance when the buyer accepts the draft and designates a bank at which the
draft will be paid. It is negotiable credit instrument that can be discounted at the bank
when the seller needs cash before maturity. At final maturity the holder of the
acceptance presents it to the bank for payment.
Forms of Trade Credit

Credit term refers to the conditions under which the supplier sells on credit to the buyer and
the buyer is required to repay the credit. We can explain the terms of trade credit by analyzing
their elements.
1. Cash on Delivery (COD): The only risk the seller undertakes is that the buyer may refuse
the shipment. Under such circumstances the seller will be struck with the shipping costs.
2. Cash before Delivery (CBD): Occasionally a seller might ask for CBD to avoid all risk. Under
either COD or CBD terms, the seller does not extend credit.
3. Net Period- No Cash Discount: When credit is extended the seller specifies the period of
time allowed for payment. For example, the term- net 30 indicate that the invoice /bill
must be paid within 30 days.
4. Net Period with Cash Discount: In addition to expending credit, the seller may offer a
cash discount if the bill is paid during the early part of the net period. For example, the
term 2/10, net 30 indicate that the seller offers a 2 percent discount if the bill is paid
within 10 days, otherwise the buyer must pay the full amount within 30 days.
5. Seasonal Dating: In a seasonal business, sellers frequently use dating to encourage
customers to place their order before a heavy selling period.
Features, Advantages and Disadvantages of Trade credit
Features:
 Purchase and sales on credit

 Mutual reliance of buyer and seller
 Availability
 Low cost
 Low risk
 Repayment
Advantages:
 Availability
 Low cost
 Low risk
 Flexibility
 Increasing sales
 Increasing profit
 Firm’s Solvency
Disadvantages:
 Quick repayment
 Deprive of discount
 Increasing of tax
 Purchase of high rate
Trade credit can be divided into two components:
 Free trade credit: Credit which received during the discount period is called free trade
credit
 Costly trade credit: Credit which taken is excess of free credit whose cost is equal to the
discount is called costly trade credit.
Cost of Trade Credit
A. There is no cost of trade credit in two ways:
(i) If, there is no cash discount on the transactions.
(ii) There is cash discount on the transactions and the buyer accepts the opportunity.
So, the buyer can get to rebate the full payment
B. There is cost of trade credit in two ways:
i) Mention the amount of discount and payment date.
ii) The buyer would not be able to receive the opportunity. The buyer pays the full some
specified future date. This arrangement is employed when the seller wants the amount at
last date, so the cost of trade credit is raised.
Nominal Annual Cost of Trade Credit under simple interest:

The cost on an annual percentage basis of not taking a cash discount can be generalized as
simple interest rate.
Discount rate 360

Nominal Annual Cost of Trade Credit= 
100 - Discount Rate Credit Period  Discount Period
Effective Annual Rate of Trade Credit under Compound Interest:

The effective annual rate formula does take account of compounding at compound interest
rate and in effective annual rate term, the cost of trade credit is even higher.
EAR= (1+Rate of Periodic Cost)M-1
Where: EAR = Effective Annual Rate
M = Number of Period
Rate of Periodic Cost =
360
M 
Credit Period  Discount Period
Stretching Trade Credit:

Postponing payment beyond the end of the net period is known as “stretching accounts
payable” or “leaning on the trade.”
 Stretching discount Period: If the length of the discount period is longer in relation
to payment period, the cost of trade credit increases.
 Stretching Payment Period: If the length of the payment period is longer in relation
to discount period the cost of trade credit declines.
Who Bears the Cost of Trade Credit?
Since the use of funds over time is not free someone must bear the cost of trade credit. It may
be borne by the supplier or the buyer or by both the parties.
 Suppliers -- when trade costs cannot be passed on to buyers because of price competition
and demand.
 Buyers -- when costs can be fully passed on through higher prices to the buyer by the seller.
 Both -- when costs can partially be passed on to buyers by sellers.
Example-01: Lemon & Company has purchased goods on 2/10, net 30 credit terms. If the
company would not able to get the cash discount opportunity, what is the cost of the trade
credit?
Discount rate 360

Nominal Annual Cost of Trade Credit= 
Here,
Discount Rate = 2
Discount Period = 10
Credit Period = 30
Kt= Nominal Annual Cost of Trade Credit =?
2 360 2 360
 Kt      0.020408  18  0.3673  36.73%
100 - 2 30  10 98 20
Example-02: Khokon & Company has bought goods on 2/10, net 30 credit terms. If the company
would not able to receive the cash discount opportunity, what is the effective cost of the trade
credit?
Solution:
EAR= (1 + Rate of Periodic Cost) M-1

Where: EAR = Effective Annual Rate =?
Rate of Periodic Cost = 0.020408
M = Number of Period=18
Rate of Periodic Cost = 360

M 
Credit Period - Discount Period
= 360

30 - 10
=
360

=0.020408 20
 18
Here,
EAR  1  Rate of Periodic Cost   1

M
 EAR  1  0.020408  1
18
 EAR  0.4385  43.85%
Example-03:
Shoton& Company has purchased some goods on 2/10, net 30 credit terms. If the
discount period is stretched by 5 days, what is the cost of the trade credit?
Solution:
Cost of the trade credit = *
= *
= *
=0.020408*24
=48.98%
Example-04:
Emdad & Company has purchased some goods on 2/10, net 30 credit terms. If the
payment period is stretched by 10 days, what is the cost of the trade credit?
Cost of the trade credit = *
= *
= *
=0.020408*12
=0.2449
=24.49%
Advance Payment
Advance payment is the amount made by customers constitutes the main item of different
income. Deferred income represents funds received by the firm for goods and services which it
has agreed to supply in future. These receipts increase the firm’s in the form of cash, therefore
this constitute an important source of financing.
Advance payment is the payment that is not recorded as revenue until goods, services have
been delivered to the customers.
These payments are common in case] expensive products or services like possession of shop,
connection of phone, gas line, electricity line where the product or service is short supply.
Accrued Expenses
Accrued expenses represent a liability that a firm has to pay for the services which it has
already received. Thus they represent a spontaneous, interest free source of finance.
Accrued expenses represent the amounts that have been earned by parties but have not been
paid by the company. The most important accruals are wages, salaries, taxes and interest
expenses.
Negotiated Financing
The principal sources of short-term negotiated loans are commercial banks and finance
companies. With both money market credit and short-term loans, financing must be arranged
on a formal basis.
Types of negotiated financing:
i) Money Market Credit

 Commercial Paper
 Bankers’ Acceptances
ii) Unsecured Loans
 Line of Credit
 Revolving Credit Agreement
 Transaction Loan
Definition of money market:

Financial market is divided in two classes, the money market and the capital market. Money
market is the market for short term (less than one year original maturity) securities. It also
includes government securities issued with maturities of more than year but that now have a
year or less until maturity.
Money markets refer to those markets dealing with short term securities that have life of one
year or less. The important instruments of money market are commercial paper, banker's
acceptance, certificate of deposits etc.
Commercial Paper:
Commercial paper represents an unsecured, short term negotiable promissory note sold in
the money market. Generally quite large firms of unquestionable financial soundness are
able to issue commercial paper. Most paper has maturities ranging from 3 to 270 days.
Commercial paper is unsecured promissory notes issued by the most creditworthy companies
to borrow funds on a short term basis.
Commercial paper market is composed of the (1) dealer and (2) direct-placement markets.
Advantage:
 Cheaper than a short-term business loan from a commercial bank.
 Dealers require a line of credit to ensure that the commercial paper is paid off.
“Bank-Supported” Commercial Paper

- A bank provides a letter of credit, for a fee, guaranteeing the investor that the
company’s obligation will be paid.
Letter of credit (L/C) -- A promise from a third party (usually a bank) for payment in the event
that certain conditions are met. It is frequently used to guarantee payment of an obligation.
Best for lesser-known firms to access lower cost funds.
Bankers’ Acceptances
- Short-term promissory trade notes for which a bank (by having “accepted” them) promises
to pay the holder the face amount at maturity.
- Used to facilitate foreign trade or the shipment of certain marketable goods.
- Liquid market provides rates similar to commercial paper rates.
Short-Term Business Loans
 Unsecured Loans -- A form of debt for money borrowed that is not backed by the pledge
of specific assets.
 Secured Loans -- A form of debt for money borrowed in which specific assets have been
pledged to guarantee payment.
Definition of Bank Loan (Unsecured)
Banks are a major source of unsecured short term loans to business. The major type of loan
made by banks to business is the short-term, self-liquidating loan. These loans at intended
merely to carry the firm through seasonal peaks in financing needs,
Unsecured short-term financing is short term financing obtained without pledging specific
assets as collateral. -L.J. Gitman.
So, unsecured short term bank loan is typically regarded as self-liquidating in the sense that the
assets purchased with the proceeds generate sufficient cash flows to pay the loan in less than
one year.
Types /Features of Bank Loan (Unsecured)

Line of Credit:
- The regular borrowers can borrow from bank on a line of credit on unsecured basis.
- A line of credit is an informal arrangement between a bank and its customer specifying the
maximum amount of unsecured credit the bank will permit the firm to owe at any one
time.
- One-year limit that is reviewed prior to renewal to determine if conditions necessitate a change.
- The amount of the line is based upon the banks assessment of the creditworthiness of the
borrower and upon his credit needs.
- At the end of the period for which credit has been extended, the line of credit may be renewed
after another investigation of the financial soundness of the firm.
- “Cleanup” provision (the borrower would be required to clean up bank debt) requires the firm to
owe the bank nothing for a period of time.
Revolving Credit Agreement:

- A formal, legal commitment to extend credit up to some maximum amount over a stated
period of time.
- A revolving credit is credit which is automatically renewed or restored from time to time
after the bills draw under it have been duly honored by payment.
- Firm receives revolving credit by paying a commitment fee (A fee charged by the lender for
agreeing to hold credit available) on any unused portion of the maximum amount of credit.
- Agreements frequently extend beyond 1 year.
Differences between line of credit and revolving credit agreements
Subject Line of credit Revolving credit agreements

Definition A line of credit is an agreement A revolving credit is a formal line of
between a bank and a borrower credit often used by large firms
indicating the maximum credit will
extend to the borrower.
Time period The agreements cannot be more than The agreement may be made for 1 year
1 year or more than 1 year.
Legal obligation Bank has no legal obligation for line of Bank has a legal obligation to honor a
credit revolving credit agreement
Fee It does not receive any fee It receives a commitment fee
Withdrawn The total amount of loan must be There is no obligation to withdrawn the
withdrawn completely or entirely money
Important When any firm applied for loan than In this method these paper may not be
papers the firm must be submitted audited submitted.
financial statement of cash budget
with application
Transaction Loan:
- Borrowing under a line of credit or a revolving credit agreement is not appropriate when
the firm needs short term funds for only one specific purpose.
- Transaction Loan -- A loan agreement that meets the short-term funds needs of the firm for
a single, specific purpose.
- For these types of loan, a bank evaluates each request by the borrower as a separate
transaction. In these evaluations, the cash flow ability of the borrower to pay the loan is
usually of paramount importance.
- The loan is paid off at the completion of the project by the firm from resulting cash flows.
Compensating Balance:
- In addition to charging interest on loans, banks may require the borrower to maintain not-
interest bearing demand deposit balance at the bank in direct proportion to the amount of
fund borrowed either the commitment. This minim balance is known as compensating
balance.
- For Example: If a firm needs TK. 80, 00,000 to pay off outstanding obligation, but it must
maintain a 20% compensating balance, then it must borrow 100, 00,000 to obtain a usable
TK. 80,00,000.
- So, Non-interest bearing demand deposits maintained by a firm to compensate a bank:
services/provided, credit line or loan is called compensating balance.
Cost of Borrowing/ Cost of Bank Loan (Unsecured)
Effective Interest Rate is used to determine the cost of the credit to be able to compare
differing terms.
Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000
interest at the end of the year.
Your effective rate is the same as the stated rate: $1,000/$10,000 = .10 = 10%
Prime Rate -- Short-term interest rate charged by banks to large, creditworthy customers
Discount Basis: With a discount interest loan, the bank deducts the interest in
advance. Thus, the borrower receives less than the face value of the loan.
EAR=
1000 1000
Effective Annual Rate=   0.1111  11.11%
10,000  1000 9000
Example:
On a one year TK. 100,000 loan with a 10% rate discount basis, what is the effective cost of
the loan?
EAR=
=11.11%
Effective Annual Rate of Credit =11.11%
Revolving Credit:
In revolving credit agreement, the bank assures the borrower that a specified amount of funds will
be made available regardless of the scarcity of money the bank guarantees the availability of funds,
a commitment fee is normally charged on the average unused balance of the loan amount.
EAR=
Example:
$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was
$600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee
on $400,000 of unused credit.
What is the cost of borrowing?
Interest: ($600,000) x (10%) = $ 60,000

Commitment Fee: ($400,000) x (0.5%) = $ 2,000
Compensating
Balance: ($600,000) x (5%) = $ 30,000
Usable Funds: $600,000 - $30,000 = $570,000
Interest amount  Commitment Fees 60000  2000

Cost of borrowing=   10.88%
Usable Fund 600000  30000
Compensating balance:
If the bank requires a compensating balance, the amount of the required balance exceeds the
amount of the firm would normally hold on deposit. Then the excess must be deducted at
starting time and then has the effect added back when the loan matures. It has the effect of
raising the effective rate on the loan.
Regular or Simple Interest:

With a simple interest loan, the borrower receives the principal amount of the loan and
repays both the principal and the interest at maturity.
EAR = (1+R/M) M - 1
Where:
EAR = Effective Annual Rate
R = Interest Rate
M = Number of period within 1 Year
Example:
With a simple interest loan of TK. 100,000 at 12% for 3 months, what is the effective cost
of the loan?
Solution:
EAR= (1+ ) M-1

Where:
R= interest Rate = 12% = .12

= (1+ ) 4-1
M = Number of period within 1 Year
= (1.03)4-1 = 12 Month / 3 Month = 4
EAR = Effective Annual Rate =?

=1.1255-1
=.1255
=12.55%
Installment Basis:
Bank charges add-on interest on various types of installment loans. The term add-on means that
the interest is calculated and then added to the amount borrowed to obtain the total amount to be
paid back in equal installments.
EAR=
P = Annual Installments
C = Amount of Interest
A = Amount of Loan
N = Number of Installments
Secured (or Asset-Based) Loans

Security (collateral) -- Asset (s) pledged by a borrower to ensure repayment of a loan. If the
borrower defaults, the lender may sell the security to pay off the loan.
Collateral value depends on:
 Marketability
 Life
 Riskiness
Accounts-Receivable-Backed Loans
Financing by Accounts Receivable

Two commonly used means of obtaining short term financing with receivable art pledging and
factoring accounts receivable. Actually, only a pledge of accounts receivable creates a secured
short term loan. Factoring really entails the sale of accounts receivable at a discount. Although
factoring is not actually a form of secured short term borrowing, it does involve the use of
accounts receivable to obtain needed short term funds.
A. Pledging Accounts Receivable:

Pledging accounts receivable is using accounts receivable as collateral for a loan. Some firms
pledge their receivables on a seasonal basis, others on a continuing basis, adding new
receivables as the old ones are retired. Before accepting receivables as collateral, the lender
evaluates the credit ratings of firms owing them and the age of the accounts.
Accounts from firms with weak credit ratings and substantially overdue accounts may not be
acceptable as collateral. The amount of the loan is less than the full face value of the accounts
receivable pledged as collateral.
The pledging accounts receivable are two types:
(i) Notification Basis:

Customers of the borrowing firm may or may not be told that their accounts have been pledged
as collateral for a loan. If the loan is made on a notification basis, customers are advised that
their accounts have been pledged, and they make subsequent payments directly to the lender.
(ii)Non-notification Basis:
If the loan is made on a non-notification basis, the borrowing customers do not know their
accounts have been pledged, and they continue to pay the borrower in the usual manner. The
borrower is supposed to repay the lender as payments are received. Non notification reduces
the lenders administrative expense but its success depends on the honesty of the borrower.
Factoring by Accounts Receivable:
The selling of receivables to a financial institution, the factor, usually “without recourse
(meaning that the selling firm would not be liable for any receivables not collected by the
factor).”
Here, instead of offering a lender a claim against accounts receivable, the firm sells them
outright. The factor selects the accounts receivable it is willing to buy from a manufacturer.
Factors prefer to buy accounts that are not overdue and that are from high quality firms.
- Factor is often a subsidiary of a bank holding company.
- Factor maintains a credit department and performs credit checks on accounts.
- Allows firm to eliminate their credit department and the associated costs.
- Contracts are usually for 1 year, but are renewable
- Factor receives a commission on the face value of the receivables.
The factoring accounts receivable are three types:

i) Without recourse Basis: Factors generally buy accounts receivable on a non-recourse
basis. That means the factor accepts the credit risk for the accounts it purchases. If the
accounts cannot be collected, the factor takes the loss. This is why factors carefully
select the accounts receivable they will buy.
ii) Notification Basis: As with pledging, notification means that customer are advised of
the transfer of their accounts receivable. All customers affected are told their accounts
have been sold and are instructed to make payments directly to the factor.
iii) Advance Loan Basis: Although the manufacturer sells the accounts receivable to a
factor, it receives only 80 or 90 percent of the funds immediately. The factor keeps the
remaining 10 to 20 percent as a reserved against merchandise returns and other claims
by customers. Thus, the factor advances to manufacturer funds until the accounts
receivable are collected or until some predetermined date.
Inventory-Backed Loans
Inventory is the stock of the product a company is manufacturing for sale and components that
make up the product. There are three of inventories: raw materials, work in process and
finished goods.
Inventories’ represent a reasonably liquid asset and are, therefore suitable as security for short
term loan. The lender determines a percentage advantage against the market value of the
inventory as collateral. Funds are obtained against the security of inventory in order to finance
the storage, processing or goods. Inventory is widely used as collateral against loans.
Loan evaluations are made on:

 Marketability
 Perishability
 Price stability
 Difficulty and expense of selling for loan satisfaction
 Cash-flow ability
Types of Inventory-Backed Loans

 Floating Lien -- A general, or blanket, lien against a group of assets, such as inventory or
receivables, without the assets being specifically identified.
 Chattel Mortgage -- A lien on specifically identified personal property (assets other than
real estate) backing a loan.
 Trust Receipt -- A security device acknowledging that the borrower holds specifically
identified inventory and proceeds from its sale in trust for the lender.
 Terminal Warehouse Receipt -- A receipt for the deposit of goods in a public warehouse
that a lender holds as collateral for a loan.
 Field Warehouse Receipt -- A receipt for goods segregated (separated) and stored on
the borrower’s premises (but under the control of an independent warehousing
company) that a lender holds as collateral for a loan.
Summary:
Short Term Financing
1. Spontaneous Financing 2. Money Market 3. Bank Loan

(a) Trade Credit (a) Unsecured Bank Loan
(i) Open Account (a) Commercial Paper (i) Transaction Credit
(ii) Notes Payable (ii) Line of Credit
(b) Banker's Acceptance
(iii) Trade Acceptance (iii) Revolving Credit
(b) Advance Payment (iv) Compensating Balance
(c) Accrued Expenses
(b) Secured Bank Loan
(i) Accounts Receivable
(ii) Inventories
Composition of Short-Term Financing
The best mix of short-term financing depends on:
 Cost of the financing method
 Availability of funds
 Timing
 Flexibility
 Degree to which the assets are encumbered
Problem
Discount rate 365

Cost of Trade Credit= 
Note; For ease of calculation, 360 rather than 365 is used as the number of days in the year.

M
365
 Discount Rate  Credit Period  Discount Period
 EAR  1   1
 100 - Discount Rate 
Cost
Effective Interest Rate=
Usable Fund
Cost=Interest+Fees
Usable fund=Loan-Compensating Balance-Amount of Interest [if interest payment in

advance]
Problem-1
The Roman & company is going to buy its raw materials on following credit terms:
 Forgo cash discount granted on basis of 2/10, net 40.
 Forgo cash discount granted on basis of 3/10, net 50.
You are required to calculate the cost of following trade credit.
Solution:
Discount rate 365
Cost of Trade Credit= 
Option-I:
Credit Period=40
Discount Period=10
Discount rate=2
2 365
 
100  2 40  10
 0.2482  24.82%
Option-II
Credit Period=50
Discount Period=10
Discount rate=3
3 365
 
100  3 50  10
 0.2822  28.22%
If it is asked to find effective cost of trade credit then for option-I

M
365
2
 EAR  (1  ) 4010  1
100  2
 EAR  (1  0.020408)12.166  1  0.2786  27.86%
Problem-2
Kona & Company wants to buy materials on the following credit terms:
A. 2/20, net 50, if account payable is stretched by 20 days.
B. 3/15, net 60, if discount period is stretched by 5 days.
Find out the cost of trade credit and which alternative is better?
Solution:
Alternative-A
Credit Period=50+20=70
Discount Period=20
Discount rate=2
2 365
 
100  2 70  20
 0.1489  14.89%
Alternative-B
Credit Period=60
Discount Period=15+5=20
Discount rate=3
3 365
 
100  3 60  20
 0.2822  28.22%
As alternative-A has the cost of trade credit is lower than the alternative-B, so alternative A is
better.
Problem-03
A company wants to borrow Tk.5 lac from a bank for its working capital requirement. It has the
following alternatives:
A. 15% interest with 10% compensating balance
B. 16% interest with 15% compensating balance
Which alternative is the better for the company?
Solution:
Cost Interest  Fee

Effective Interest Rate= 
Usable Fund Loan amount  Compensating Balance
Alternative-A
Loan amount=5,00,000
Interest=5,00,000 X 0.15=75,000
Compensating Balance=5,00,000 X0.10=50,000
75,000
EAR=  100  16.67%
500,000  50,000
Alternative-B
Interest=5,00,000 X 0.16=80,000
Compensating Balance=5,00,000 X0.15=75,000
80,000
EAR=  100  18.82%
500,000  75,000
Financing Decision Table
Alternatives Actual Cost Decision
Alternative-A 16.67% Better Alternative
Alternative-B 18.82%
Problem-04
A company wants to borrow Tk.1 lac from a bank for its working capital requirement. It has the
following alternatives:
A. 12% advance interest with 15% compensating balance
B. 10% advance interest with 20% compensating balance
C. 16% advance interest with compensating balance
Which alternative is the best for the company?
Solution:
Alternative-A
Where,
Loan Amount =100000
Interest =100000  0.12  12000
Com. Bal. =100000  0.15  15000
EAR=Effective Annual Rate?
Interest
EAR=
Loan  CompensatingBalabce  Interest
12000

100000  15000  12000
=16.44%
Alternative-B
Where,
Interest =100000  0.10  10000
Com.Bal=100000  0.20  20000
EAR= Effective Annual Rate?
Interest
EAR=
Loan  CompensatingBalabce  Interest
12000

100000  15000  12000
=16.44%
Alternative-C
Where,
Interest =100000  0.16  16000
EAR=Effective Annual Rate?
Interest  CommitmentFee
EAR=
LoanAmount  InterestAmount
16000

100000  16000
=19.05%
Financing Decision Table

Alternatives Actual Cost Decision
Alternative-A 16.44%
Alternative-B 14.29% Best Alternative
Alternative-C 19.05%
Problem -5
Lubahoney Company has got a loan of Tk 80000 from a bank on revolving credit agreement.
The bank will charge 12% interest per year & 2% commitment fee on an unused portion of the
credit. If the company uses 80% of this loan, What is the effective cost?
Solution:
Where,
Usable loan= 80000  0.80  64000
Interest= 64000  0.120  7680
Commitment Fee= (80000-64000)X0.02= 16000  0.02  320
EAR=?
Interest  commitmentFee
EAR=
UsableLoan
7680  320
=
64000
=12.50%
Answer: Effective cost of the Revolving credit is 12.50%
Problem -6
Muaz& company can borrow Tk.1o lac at the rate of interest 10% from a bank payment would
be made monthly installment for 1 year. What is the effective annual rate of the loan?
Where,
P=Annual Installments=12
C= Amount of interest = 1000000  0.10  100000
A=Amount of loan=10,00,000
N= Number of Installments=12
EAR= Effective Annual Rate=?
2 PC
EAR=
A N  1
2  12  100000
=
100000012  1
=18.46%
Answer: Effective cost of the credit is 18.46%
Problem -7
Muaz & company can borrow Tk.12 lac at the rate of 10% advance interest from a bank.
Payment would be made monthly installment for 9 months. What is the effective annual rate of
the loan?
P = Annual Installments =12

C= Amount of Interest = 12,00,000 x 0.10 = 1,20,000
A = Amount of Loan= 12,00,000- 1,20,000 = 10,80,000
N = Number of installment = 09
2 PC
EAR 
A( N  1)
2  12  1,20,000
 EAR   0.2667  26.67%
10,80,000(9  1)
Problem-08:
Kona Real Estate Ltd. borrows TK. 5 million on monthly installment basis at interest fate of 9%, with
the loan to be repaid in a year at monthly installments. What is the effective cost of the loan?
Here,
P=12
C= Amount of Interest = 5,00,000 x 0.09 = 45,000
N=12
A=5,00,000.
EAR =
=16.62%
Answer: Effective Annual Rate of Credit = 16.62%

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Chapter-4

Short Term Financing

Objective/ Nature of Short Term Financing

Advantages and disadvantages of Short term financing:

Types of Short Term Financing

Types of spontaneous financing

Types of Trade Credit:

Forms of Trade Credit

Features, Advantages and Disadvantages of Trade credit

 Purchase and sales on credit

Trade credit can be divided into two components:

Nominal Annual Cost of Trade Credit under simple interest:

Discount rate 360

Effective Annual Rate of Trade Credit under Compound Interest:

EAR= (1+Rate of Periodic Cost)M-1

Where: EAR = Effective Annual Rate

Rate of Periodic Cost =

Stretching Trade Credit:

Discount rate 360

EAR= (1 + Rate of Periodic Cost) M-1

Rate of Periodic Cost = 360

EAR  1  Rate of Periodic Cost   1

 EAR  0.4385  43.85%

Cost of the trade credit = *

Cost of the trade credit = *

Types of negotiated financing:

i) Money Market Credit

Definition of money market:

“Bank-Supported” Commercial Paper

Short-Term Business Loans

Types /Features of Bank Loan (Unsecured)

Revolving Credit Agreement:

Subject Line of credit Revolving credit agreements

Interest: ($600,000) x (10%) = $ 60,000

Interest amount  Commitment Fees 60000  2000

Regular or Simple Interest:

EAR= (1+ ) M-1

R= interest Rate = 12% = .12

EAR = Effective Annual Rate =?

Secured (or Asset-Based) Loans

Financing by Accounts Receivable

A. Pledging Accounts Receivable:

The pledging accounts receivable are two types:

(i) Notification Basis:

Factoring by Accounts Receivable:

The factoring accounts receivable are three types:

Loan evaluations are made on:

Types of Inventory-Backed Loans

Short Term Financing

1. Spontaneous Financing 2. Money Market 3. Bank Loan

Discount rate 365

EAR  1  Rate of Periodic Cost   1

Usable fund=Loan-Compensating Balance-Amount of Interest [if interest payment in

If it is asked to find effective cost of trade credit then for option-I

EAR  1  Rate of Periodic Cost   1

Cost Interest  Fee

Which alternative is the best for the company?

Financing Decision Table

Answer: Effective cost of the Revolving credit is 12.50%

Answer: Effective cost of the credit is 18.46%

P = Annual Installments =12

Answer: Effective Annual Rate of Credit = 16.62%

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