Intro to Finance: Working Capital Management - Short-Term Financing, Bank Loans Commercial Paper Factoring

What This Is

Short-term financing refers to the temporary borrowing of funds by a company to meet its immediate cash needs. This can include bank loans, commercial paper, factoring, and other forms of short-term debt. For example, Apple Inc. might issue a $100 million commercial paper to finance its working capital requirements.

Key Formulas & Symbols

• Bank Loan Interest Rate (r): The interest rate charged on a bank loan, expressed as a decimal (e.g., 6% = 0.06).
• Commercial Paper Rate (CP Rate): The interest rate offered on commercial paper, expressed as a decimal (e.g., 5% = 0.05).
• Factoring Fee (F): The fee charged by a factor for converting accounts receivable into cash, expressed as a percentage (e.g., 2% = 0.02).
• Bank Loan Amortization (A): The periodic payment made on a bank loan, calculated as A = P × r × (1 + r)^n / ((1 + r)^n - 1) where P = principal, r = interest rate, and n = number of periods.
• Commercial Paper Amortization (CP A): The periodic payment made on commercial paper, calculated as CP A = CP P × CP Rate × (1 + CP Rate)^n / ((1 + CP Rate)^n - 1) where CP P = principal, CP Rate = commercial paper rate, and n = number of periods.
• Factoring Cost (FC): The total cost of factoring, calculated as FC = F × Accounts Receivable where F = factoring fee and Accounts Receivable = the value of accounts receivable being factored.
• Bank Loan Balance (BL): The outstanding balance on a bank loan, calculated as BL = P - ?(A) where P = principal, A = periodic payment, and-= the sum of all periodic payments.
• Commercial Paper Balance (CP B): The outstanding balance on commercial paper, calculated as CP B = CP P - ?(CP A) where CP P = principal, CP A = periodic payment, and-= the sum of all periodic payments.

Step-by-Step Calculation

1. Determine the company's short-term financing needs, such as working capital requirements or seasonal fluctuations.
2. Evaluate the cost of bank loans, commercial paper, and factoring, considering interest rates, fees, and other costs.
3. Calculate the amortization schedule for each financing option, using the formulas above.
4. Compare the total cost of each financing option, including interest, fees, and other expenses.
5. Select the most cost-effective financing option, considering the company's cash flow, creditworthiness, and other factors.

Common Mistakes

• Mistake: Confusing bank loan interest rates with commercial paper rates.
• Correction: Bank loan interest rates are typically higher than commercial paper rates, but both are expressed as decimals.
• Mistake: Failing to consider factoring fees when evaluating short-term financing options.
• Correction: Factoring fees can be significant, especially for large accounts receivable balances.
• Mistake: Ignoring the impact of interest rates on short-term financing costs.
• Correction: Changes in interest rates can significantly affect the cost of bank loans and commercial paper.

Exam / CFA Tips

• Tip: Be prepared to calculate amortization schedules and compare financing costs.
• Tip: Understand the differences between bank loans, commercial paper, and factoring.
• Tip: Consider the impact of interest rates and fees on short-term financing costs.

Quick Practice Problem

Apple Inc. issues a $100 million commercial paper with a 5% coupon rate and a 6-month maturity. What is the bond's yield to maturity?

Answer: 5.25% (using the formula for yield to maturity: YTM = (1 + (1 + r)^(-n)) / (1 + r)^(-n) - 1 where r = coupon rate and n = number of periods).

Last-Minute Cram Sheet

• The factoring fee is typically a percentage of the accounts receivable balance.
• The bank loan interest rate is typically higher than the commercial paper rate.
• The amortization schedule for bank loans and commercial paper is calculated using the formulas above.
• Factoring fees can be significant, especially for large accounts receivable balances.
• Changes in interest rates can significantly affect the cost of bank loans and commercial paper.
• The yield to maturity on commercial paper is calculated using the formula above.
• The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• The weighted average cost of capital (WACC) is calculated using the formula: WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc) where E = market value of equity, V = total market value, Re = cost of equity, D = market value of debt, Rd = cost of debt, and Tc = corporate tax rate.
• The capital asset pricing model (CAPM) requires a risk-free rate and a beta coefficient.