1
Short term borrowing
and investing
Chapter
25
1
Short term borrowing
and investing
Chapter
25
2
25.1 Short term finance
Long term finance consists of equity capital and debt capital. This form of finance is used to
acquire the assets of the organisation, which are used for the long term.
Short term finance is required for shorter periods of time, and is usually required to finance the
working capital (i.e. inventories, trade receivables).
It is advisable to match the types of assets with the term of finance.
Match long-term assets
For example buildings used for the long term benefit of the company should be financed with long-
term finance such as debentures or share capital.
Match short-term assets
For example inventories or trade receivables should be financed with short-term finance such as
bank overdrafts or bank loans.
The purpose of short time finance is the funding of working capital. It may also be raised to cover
temporary cash deficits.
Types of short term borrowing
Trade credit
Bank loans
Bank overdraft
Debt factoring
3
25.3 Trade credit
Buying goods on credit is an important type of short-term borrowing. Most companies trade on
credit and various terms can be negotiated depending on the relationship. The other factors
involving trade credit are:
Impact of an increase in trade credit
It is a means of short-term finance.
It decreases working capital.
It is interest free as suppliers may not charge interest.
There may be a loss in supplier goodwill, if too long is taken to pay them.
There will be a loss in early settlement discounts.
25.4 Bank loans
A bank loan also known as a term loan is a fixed amount of borrowing for an agreed period on
agreed terms.
Bank loans advantages
Bank loans disadvantages
It serves medium-term requirements of cash
Interest and repayments are set in advance and
so cash flows are known.
The bank cannot demand the money back at
short notice because of the agreed terms and so
there is no threat or early repayment.
Need to ensure that the loan doesn’t exceed the
asset life or else there is an unnecessary
interest costs.
It is possible to have a loan-overdraft mix.
It is more expensive than overdrafts,
especially if it is a fixed rate rather than a
variable rate.
Usually some form of security is needed to
obtain the bank loan.
The bank may set covenants or restrictions on
the borrowings that the company may want to
do in the future.
4
25.4 Bank overdraft
A bank overdraft is permission to overdraw on a bank account up to a specified amount for a set
period. It is a negative bank balance.
Bank overdrafts advantages
Bank overdrafts disadvantages
It is flexible and designed for day to day help
and seasonal fluctuations in cash requirements.
Interest is only paid when the current account is
overdrawn, which makes it cheaper than term
loans.
The bank has flexibility to review, and can
therefore negotiate better terms.
It will not affect gearing calculation as it
appears within current liabilities.
It is repayable on demand and therefore there
is risk that the bank could demand early
repayment of a significant portion of it at
anytime.
It is unreliable as the bank may stop the
facility at anytime.
Usually an arrangement fee is also charged for
setting up the facility.
25.5 Debt factoring
Trade receivables appear as current assets, but they are not in cash form. A factor company
specialises in buying the debts off companies to ease them with their cash flow. Factoring was
covered in detail in the previous chapters.
25.6 Export finance
Foreign trade is much more risky than domestic trade. The types of problems involved are:
1
If there is a delayed payment then it is much harder to chase customers overseas.
2
Additional time is needed to arrange exports, paperwork and transport time.
3
Additional costs are needed for insurance against non-payment of foreign debtors.
4
Loss or damage of goods in transit due to longer destinations.
5
Higher credit risk from a lack of knowledge of overseas customers.
6
Bad debt risks can also be greater as there is greater difficulty in collecting debts.
7
Exchange risk if goods are being sold in the foreign currency.
5
Ways of reducing investment in debtors and bad debt risk
1 Advances against collections
2 Bills of exchange
3 Documentary credits
4 Forfaiting
5 Export factoring
6 Export credit insurance
7 Acceptance credit
1
Advances against collections
This a short term bank-loan advanced to a seller or exporter against a draft bill accepted by a buyer
or importer. The loan amount is deducted by the bank when payment is received from the buyer or
importer; otherwise it is recovered from the seller or exporter. This has the advantage of elevating
any cash flow problems in the short–term however there are bank charges and interest to pay on
the short-term loan and would have to re-paid whether or not the importer pays the debt.
Another form of advances is when the money is received before the goods have been dispatched.
This is risk free for the company, but the customer may not be too happy with this arrangement
and may take their business elsewhere. This depends very much on what other companies in the
industry do with respect to taking advances. If the norm is not to take advances then this approach
may not commercial and would indeed mean customers going to other competitors.
2
Bills of exchange
“A bill of exchange is a negotiable instrument, drawn by one party on another, for example
by a supplier of goods on a customer, who by accepting (signing) the bill, acknowledges the
debt, which may be payable immediately (a sight draft) or at some future date (a time draft).
The holder of the bill can, thereafter, use an accepted time draft to pay a debt to a third
party, or can discount it to raise cash.” (CIMA Official Terminology)
A negotiable instrument is a transferable signed document that promises to pay the bearer a sum of
money at a future date or on demand, common examples are bills of exchanges and cheques.
Bills of exchange are drawn up for periods of 2 to 6 months and usually for a minimum amount of
£75,000.
There are three main parties to a bill of exchange:
1
The drawer – who is the exporter.
2
The drawee – the importer.
6
3
The payee – the person the drawee must pay, (Drawer or bank/discount house)
Worked example – Bills of exchange
A sells goods to B for £1.5 million on 4 months credit. A draws up a bill of exchange, which
requires B to pay £1.5 million in 4 months time. B signs the bill and, and gives it to A.
A needs the money quite urgently and so decides to sell the bill to a discount house (which
specialises in bills of exchange). A sells the bill for £1.4 million. The discount house has therefore
discounted the bill by £100,000 compared to its face value.
The discount house pays A £1.4 million and holds onto the bill for 4 months, after which it presents
the bill to B who pays £1.5 million. The discount house has made a profit of £100,000.
Under normal trade, the exporter makes out and signs the bill either at sight (cash on demand) or
term (usance). If at term, the customer accepts it, by signing across its face as payable at a fixed
future date.
As well as the drawer’s and drawee’s name and addresses, a bill of exchange will show the date
drawn, the amount in both figures and words, terms (sight or usance) and the payee (or to order, or
to bearer). It is more often payable to specified persons rather than bearer.
Types of bill
· Trade bills are drawn by one non-bank on another; to be tradable both must have high
credit ratings.
· Bank bills are drawn and payable by banks.
A
Exporter
B
Importer
C
Payee
DRAWER
DRAWEE
Bill of exchange
Goods
7
Discounting bills
Holder of the bill, presents bill on maturity, or sells bill before maturity at discount depending on
credit quality of drawee and market condition for bills.
Bills of exchange are increasingly being used to obtain export finance. They can be discounted,
negotiated and forfaited. Advances can be obtained against bills as well as acceptance credits.
Example 14.1 – (CIMA P7 May 06)
After a bill of exchange has been accepted, there are a number of possible actions that the drawer
could take.
Which ONE of the following is NOT a possible course of action?
A Ask the customer for immediate payment.
B Discount the bill with a bank.
C Hold the bill until the due date and then present it for payment.
D Use the bill to settle a trade payable.
3
Documentary credits (DC)
Documentary credits or letter of credits are risk-free methods of payment, and means of obtaining
short-term finance.
Under DC, exporters can receive payment of goods in their own country as soon as the customer
has received the goods.
A contract is drawn up by the importer giving details of the goods and its own bank details. Once
the goods have been delivered the payment will be made to the exporter upon inspection of all the
agreed documents in the contract. Documents may include the commercial invoice, proof of
shipment, proof of receipt of goods by importer (bill of lading), and proof of insurance against loss
or damage in transit by exporter.
8
4
Forfaiting
Forfaiting is when a bank (the forfaiter) purchases a series of promissory notes (these are contracts
detailing exactly how much is owed by whom and when it will be paid by), which are signed by an
importer in favour of an exporter.
The promissory notes are usually guaranteed by the importer’s bank and then sold by the exporter
to the forfaiting bank at a discount. The bank pays the exporter, which gives them payment for the
goods, and enabling the importer to settle later.
Forfaiting is a medium term of finance and is secure as there is more than one bank involved in
underwriting the notes, however because of this it can be very expensive but it can smooth out
needs of cash flows and maybe the only method available to trade. Other contracts are sometimes
used instead of promissory notes such as bills of exchange or documentary credits.
5
Export factoring
The exporter sells their debt to a specialist factor which deals with trade receivables abroad. They
are exactly the same as a domestic factor company but are more expensive due to the large risk
(being overseas and currency risk) they are accepting.
6
Export credit insurance
Export credit insurance is insurance against the risk of non-payment by foreign customers. Short-
term guarantees cover export trade on short-term (up to 180 days) credit.
A
Exporter
B
Importer
Goods
Promissory notes
Bank of A buys
discounted notes
Guaranteed by
Bank of B
9
7
Acceptance credit
Also known as bank bills or bankers’ acceptance is when a company uses the bank to draw a bill of
exchange. The bank grants a credit facility, whereby the company can draw bills up to an agreed
limit that the bank will accept, when presented for payment at a future specified date.
The accepted bills are sold on the money market by the bank on behalf of the company at a
discount. At the bill’s maturity date, the bank will receive the money from the company and use
that money to pay to the final holder of the bill. The bank effectively acts as a security.
Commercial paper – are IOU’s which do not involve the bank as back up like acceptance credit.
Large companies with very high credit ratings are able to issue these non trade related bills of
exchange without the backing of a bank (i.e. without being accepted).
10
25.7 Short term investing
Companies often generate cash surpluses, and they have to decide what to do with it. Keeping the
cash in the current account isn’t the best way to look after the cash, as there are more beneficial
ways of investing this money that will earn the company more income.
Investing cash for the short term should not be risky, as the money will be needed at some time in
the future. The company needs to set up guidelines for short term investments which define:
1
How much cash to invest
2
What type of investment to make (i.e. shares or bank deposits)
3
How long to invest
There are three reasons for holding cash:
§ Transaction motive - Cash needed for normal business, paying suppliers, wages etc
§ Precautionary motive - Cash held for unexpected purposes like increase in a liability
(taxation).
§ Speculative motive - Cash held for opportunities, which may arise, like a takeover of
another company.
Before investing the cash, the treasury department will need to take the following into
consideration
Factors
Reasons
Maturity
An investment matures when the amount originally invested (the principal)
can be recovered without penalties. Therefore the time period for when cash
is needed has to be established, before tying up the money in investments.
Security
The security of an investment relates to its risk. High-risk investments will
have high returns but there is a danger of default by the borrower. The
attitude of the company towards risk will have a bearing on what type of
investments to put their cash in.
Liquidity
The investments should be sufficiently liquid to match anticipated cash needs.
However the more liquid an investment (i.e. how quickly it can be converted
to cash), the lower the return.
Diversification
Portfolio theory – a diversified portfolio of investments will reduce the risk to
the company.
Return
The return on the investment will depend on all the factors highlighted above,
the higher the risk the higher the return. The more liquid the less the return.
11
25.8 Types of short-term investments
1
Interest bearing accounts
Banks provide investment in their business through various interest bearing accounts, including
current accounts, cheque accounts and deposit accounts. Banks are very secure and so this kind of
investment is virtually risk free and so the returns on these investments are very low.
2
Money market deposits
Several financial institutions, which include finance houses, merchant banks and some commercial
clearing banks, offer schemes which provide access to money market rates of interest. There is a
very large money market in the UK for inter-bank borrowing and lending ranging from overnight
to 12 months or more. Only deposits greater than £50,000 can be invested in the money markets.
3
Government stock/bonds
These can be long or medium term securities issued by the government to raise money. The
coupon interest rate is fixed and the yield varies with the market value of the stock. It’s traded on
the capital markets so can be realised easily. It is also very secure as there is no default risk. They
are referred to as short (less than 5 years), Medium (5-15 years) and Long (greater than 15 years).
4
Local authority stock/bonds
Local authority stocks are similar to government securities, but security isn’t considered as good
and the market is less active. Stocks held by a few institutions.
5
Corporate bonds
These are bonds issued by large companies to raise debt finance. They are traded on the capital
market but are less liquid and more risky than government bonds. However because they are more
risky they offer higher yields.
6
Certificates of deposit
These are issued by banks to certify that funds have been deposited and are earning interest. The
CD’s are traded on the money market and allow bearers to convert them into cash at any time.
Maturity ranges from 3 months to 5 years. They are therefore low risk and highly liquid.
7
Bills of exchange
As discussed earlier, bill of exchange is an unconditional order by one firm to pay another party a
given sum at a specified future date. They are tradable and usually have a short maturity. They are
highly marketable but the risk depends on the issuer’s credit worthiness.
12
Guidelines for investment
§ There should be a company policy to allow or prohibit certain investments.
§ All investments should be convertible into cash.
§ A certain proportion invested should be in lower risk items.
§ Credit ratings should be obtained for certain investments if they are risky.
25.9 Interest rates
The initial amount of money invested or borrowed is known as the principal. Interest is added to
this principal amount.
There are 2 forms of interest, simple and compound.
1
Simple interest
Simple interest is interest that is earned in equal amounts each period and which is a given
proportion of the original investment (i.e. principal amount). The interest is put in a separate
account and does not itself earn any interest.
S = X + nrX
Where:
X
=
Principal invested
r
=
Interest rate (as a proportion)
n
=
Number of periods
S
=
Sum invested after n periods (future value)
Worked example - Simple interest
If £260 was invested now for 5 years at a simple interest rate of 12%, then after 5 years the value of
the investment will be:
£260 + (5 x 12% x £260)
=
£416
For 5 years the annual interest will be 12% x £260 = £31.20
13
2
Compound interest
Compound interest is interest calculated with the principal amount plus any previous interests
added to it. Therefore unlike the simple interest the value of the compound interest is not in equal
instalments.
Therefore the formula for establishing the value of the investment after “n” number of years is:
Principal amount x {1 + interest rate %}
n
S = X (1 + r)n
Where:
X
=
Principal invested
r
=
Interest rate (as a proportion)
n
=
Number of periods
S
=
Sum invested after n periods (future value)
Worked example - Compound interest
If £260 was invested now for 5 years at a compound interest rate of 12%, then after 5 years the
value of the investment will be:
£260 x {1 + 0.12}
5
= £458.21
Find the sum of money, which, if invested now at 5% pa compound interest, will be worth £15,000
in 10 years’ time.
Rearrange the formula to find X = S / (1 + r )
n
= £15,000 / (1 + 0.05)
10
= £9,209
14
Regular investments
Regular investment is when an investment into which equal annual instalments are paid in order to
earn interest, so that by the end of a given number of years, the investment is large enough to pay
off a known commitment at that time.
The final (terminal) value of an investment to which equal annual amounts are added is:
S = A(Rn – 1)
_________
R – 1
Where:
A = annual payment into the fund
R = 1 + interest rate
n = the number of terms
S = final value
This formula is the sum of geometric progression and is used in compound interest.
An individual may make annual payments into a pension fund or monthly savings into a building
society savings account. A question might ask you to calculate the future (terminal) value of an
investment to which equal annual amounts will be added. The setting aside of a regular amount to
accrue to a particular amount is known as a sinking fund.
Worked example - Regular investments
What is the annual payment that is needed to replace an asset in three years’ time when the cost of
the assets will be £65,000 and the fund will earn interest at 10%?
S = £65,000 = A × (1.1
3
– 1)
1.1 - 1
A = £65,000 x 0.1 = £19,637
1.1
3
– 1
15
3
Non – annual interest rates
When interest rates are accrued on a daily, monthly or quarterly basis, the same formulas are used,
but you just need to ensure that the interest % corresponds to the correct ‘n’ number of periods.
For example if monthly interest rate (or nominal rate) is 3.5%, then the effective annual interest
will be (1 + 0.035)
12
= 51.1% (this is also known as the APR annual percentage rate).
Interest rates may also be quoted in annual terms but this is not the effective annual interest:
For example a bank offers 12% interest paid quarterly on deposits. 12% is the nominal rate, and
each quarter 12 / 4 = 3% is paid.
The effective annual interest is then be (1 + 0.03)
4
- 1 = 12.56%
Effective annual interest = Equivalent annual rate = Effective annual rate = Annual percentage
rate (APR) = Compound annual rate (CAR) = Annual money rate = Adjusted nominal rate
4
Coupon rates and yield to maturity
Coupon rate on debt is the actual annual rate of interest payable on the nominal value of the debt.
All debt is issued in blocks of £100 (this is known as the par, face or nominal value).
Yield to maturity or gross redemption yield – is the internal rate of return of the cash flows
(interest payments and redemption premium), associated with a loan stock.
For example in the financial times, data of government stock will be shown as follows:
Treasury Gilts 10% 2003 – gross redemption yield = 6.38%
This means the treasury gilt will pay £10 interest on £100 nominal value of the stock. But the
market value of the stock is 6.38%.
The yield to maturity or gross redemption yield is established by taking into account all the future
cash flows associated with that instrument, which when discounted at an appropriate rate gives a
net present value of zero. This is also known as the internal rate of return.
Step by step technique of establishing the yield to maturity is as follows:
1. Establish all the cash flows within the bond / loan stock / debentures. These will be the
interest payments and redemption value.
2. Discount these cash flows twice. Once using a discount rate that will give a positive net
present (low discount rate), and the other discount rate giving a negative net present value
lower (high discount rate).
3. Using interpolation find the internal rate of return which will give the yield to redemption.
16
Method to calculate the yield to maturity
Calculate a positive NPV and a negative NPV of redeemable debts cash flows (usually use 5% and
15% discount factors).
Apply formula to find IRR (interpolation).
A + [ a
x (B-A)]
a – b
Where
A
=
lower discount factor
B
=
higher discount factor
a
=
positive NPV
b
=
negative NPV
A graphical method below can also be used to estimate the yield to maturity.
Discount rate
15%
NPV (£)
5%
0
Positive NPV
Negative NPV
Point of intersection is yield to
maturity
17
Worked example – Yield to maturity
Madonna plc has purchased bonds with a face value total of £1000 and paid £900, the following
details are relevant:
Coupon rate 7%
Redemption in 10 years
Current market value of all the bonds £900
Calculate the percentage yield to maturity?
(Always work in block of £100 for your workings as this is easier and gives the same answer)
Year
Cash flow
DF 5 %
PV
DF 15%
PV
0
Market value (90)
1.000 (90.00)
1.000 (90.00)
1-10
Interest
7
7.722
54.05
5.019
35.13
10
Capital repay 100
0.614
61.40
0.247
24.70
NPV
25.45 (30.17)
Using IRR interpolation
(5 + (25.45 / 25.45 - -30.17) x (15-5)
= 9.6%
Alternative method:
Year
Cash flow
DF 5 %
PV
DF 15%
PV
1-10
Interest
(7)
7.722
(54.05)
5.019
(35.13)
10
Capital repay (100)
0.614
(61.40)
0.247
(24.70)
NPV
(115.45)
(59.83)
Using IRR interpolation (ignore negative signs)
Lower discount rate (DR)
+ {lower DR NPV – market value} x (high DR – low DR)
Lower DR NPV – higher DR NPV
5 + {(115.45 – 90) / (115.45 -59.83)} x (15-5)
= 5 + (25.45 / 55.62) x 10
= 9.6%
The yield to maturity is the return from the investor’s point of view. From the company that issued
the bonds this is called their cost of debt. Both are the same %.
18
Example 25.2 – (Past CIMA question)
A bond with a coupon rate of 7% is redeemable in 8 years’ time for $100. Its current purchase price
is $82.
What is the percentage yield to maturity?
5
Financial liabilities
(IAS 39 Financial Instruments: Recognition and measurement)
Financial liabilities are initially recognised at fair value (just like financial assets). This would be
issue proceeds less direct costs. The subsequent measurement is at amortised cost using the
effective interest rate method.
Worked example - Financial liability (amortised cost)
A company issued bonds with a nominal value of £10 million at the beginning of its financial year.
Issue costs were £200,000 and interest payable on the bonds is 5% at the end of the year. The
bonds will be redeemable in 3 years time for a total value of £12.264 million.
Show how the company will account for the bond over the 3 years.
Firstly the interest rate implicit on the bond needs to be calculated as follows:
£’000
Net proceeds
(£10,000 - £200)
9,800
Total payable
Interest payments (£10m x 5% x 3 yrs)
1,500
Redemption value
12,264
13,764
Total finance cost (net proceeds – total payable)
3,964
Net proceeds
=
9,800 / 13,764 = 0.712
Total payable
Using the present value tables, for 3 years the discount rate is 12%.
This means 12% will be used to allocate the finance cost over 3 years.
At inception Debit Bank (SOFP)
£9,800,000
Credit Bond liability (SOFP)
£9,800,000
19
Year
Open liability
£’000
Finance
cost x 12%
£’000
Interest
payment
(10m x 5%)
£’000
Closing
liability
£’000
1
9,800
1,176
(500)
10,476
2
10,476
1,257
(500)
11,233
3
11,233
1,531 (bal)
(500)
12,264
Total
3,964
The balance sheet liability has increased to £12.264 million and when the bonds are redeemed,
therefore:
Debit
Bond liability
£12.264m
Credit
Bank
£12.264m
Each year the finance cost on the outstanding liability is charged to the income statement. The
outstanding liability is increased with the finance charge and reduced by the interest payments.
For year one the journal entry would be:
£’000
£’000
Debit
Finance charge – income statement 1,176
Credit
Bond
676
Credit
Bank
500
The above workings would also be used for other items, such as loan stock, debentures and
preference shares.
20
6
Market value of financial instruments
Worked example
AB plc purchases 400 bonds on 1
st
January 20X6 issued by ZY plc. The bonds were issued at par
value of $100 per bond. Coupon interest rate is 8% pa, and the bonds are redeemable at par on 31
st
December 20X9. AB plc wants to now sell these bonds.
Similar bonds have a yield to maturity of 10%.
Calculate the current market price for the bonds.
The current market value of the bonds is the present value of all cash flows. The cash flows are
the interest payments and redemption value.
§
Total value of the bonds - $100 x 400 = $40,000
§
Annual interest payments – 8% x $40,000 = $3,200
§
Term of bond – 4 years
§
Market interest rates = discount factor – 10%
§
Redemption value - $40,000
Present value of interest payments =
$3,200 x (CDF for 4 years at 10%) 3.17
=
$10,144
Present value of redemption
=
$40,000 x (DF of 4 years at 10%) 0.683
=
$27,320
Current market value of bond ($10,144 + $27,320) = $37,464
Example 25.3 – (Past CIMA question)
CX purchased $10,000 of unquoted bonds when they were issued by Z. CX now wishes to
sell the bonds to B. The bonds have a coupon rate of 7% and will repay their face value at the
end of five years. Similar bonds have a yield to maturity of 10%.
Calculate the current market price for the bonds.
21
7
Yield curve theory
The yield curve demonstrates the variation of returns on securities with respect to their maturity
and market conditions.
% Interest rate
(Gross redemption yield)
Years to maturity
Normally the yields to maturity increases as the term increases so you have an upward sloping
curve. This is because:
· The longer the investment, the greater the return investors require due to the fact that their
monies are tied up.
· Greater risk in long-term lending
Why might curve slope downwards?
§ Expectations – when interest rates are expected to fall, short-term rates might be higher than
long-term rates, and the yield curve would be downward sloping.
§ Government policy on short-term rates – policy might be to keep short-term interest high than
long term.
§ Rates in different market segments – major investors are confined to a particular segment of
the market and will not switch segment even if the forecast of likely future interest rate
changes.
The structure of the yield curve is normally based on government securities, but it can be adapted
for corporations.
Upward sloping yield
curve
Downward sloping yield
curve
22
The yield curves shows how interest rates are likely to move in the future.
It is important to note that relying purely on the yield curve to make decisions on future interest
rates is dangerous. Other factor could affect future interest rates like levels of inflation and general
economics.
U
U
p
p
w
w
a
a
r
r
d
d
s
s
l
l
o
o
p
p
i
i
n
n
g
g
y
y
i
i
e
e
l
l
d
d
c
c
u
u
r
r
v
v
e
e
H
H
i
i
g
g
h
h
e
e
r
r
f
f
u
u
t
t
u
u
r
r
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
s
s
e
e
x
x
p
p
e
e
c
c
t
t
e
e
d
d
B
B
o
o
r
r
r
r
o
o
w
w
l
l
o
o
n
n
g
g
t
t
e
e
r
r
m
m
n
n
o
o
w
w
.
.
A
A
v
v
o
o
i
i
d
d
v
v
a
a
r
r
i
i
a
a
b
b
l
l
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
b
b
o
o
r
r
r
r
o
o
w
w
i
i
n
n
g
g
D
D
o
o
w
w
n
n
w
w
a
a
r
r
d
d
s
s
l
l
o
o
p
p
i
i
n
n
g
g
y
y
i
i
e
e
l
l
d
d
c
c
u
u
r
r
v
v
e
e
L
L
o
o
w
w
e
e
r
r
f
f
u
u
t
t
u
u
r
r
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
s
s
e
e
x
x
p
p
e
e
c
c
t
t
e
e
d
d
B
B
o
o
r
r
r
r
o
o
w
w
s
s
h
h
o
o
r
r
t
t
t
t
e
e
r
r
m
m
n
n
o
o
w
w
.
.
M
M
a
a
k
k
e
e
u
u
s
s
e
e
o
o
f
f
v
v
a
a
r
r
i
i
a
a
b
b
l
l
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
b
b
o
o
r
r
r
r
o
o
w
w
i
i
n
n
g
g
23
Key summary of chapter
Types of short term borrowing
Trade credit
Bank loans
Bank overdraft
Debt factoring
Impact of an increase in trade credit
It is a means of short-term finance.
It decreases working capital.
It is interest free as suppliers may not charge interest.
There may be a loss in supplier goodwill, if too long is taken to pay them.
There will be a loss in early settlement discounts.
Bank loans
A bank loan also known as a term loan is a fixed amount of borrowing for an agreed period on
agreed terms.
Bank overdraft
A bank overdraft is permission to overdraw on a bank account up to a specified amount for a set
period. It is a negative bank balance.
24
Ways of reducing investment in debtors and bad debt risk
1 Advances against collections
2 Bills of exchange
3 Documentary credits
4 Forfaiting
5 Export factoring
6 Export credit insurance
7 Acceptance credit
Short-term investments
1
Interest bearing accounts
2
Money market deposits
3
Government stock/bonds
4
Local authority stock/bonds
5
Corporate bonds
6
Certificates of deposit
7
Bills of exchange
Simple interest
Simple interest is interest that is earned in equal amounts each period and which is a given
proportion of the original investment.
S = X + nrX
Where:
X
=
Principal invested
r
=
Interest rate (as a proportion)
n
=
Number of periods
S
=
Sum invested after n periods (future value)
25
Compound interest
Compound interest is interest calculated with the principal amount plus any previous interests
added to it.
S = X (1 + r)n
Where:
X
=
Principal invested
r
=
Interest rate (as a proportion)
n
=
Number of periods
S
=
Sum invested after n periods (future value)
Regular investments
Regular investment is when an investment into which equal annual instalments are paid in order to
earn interest, so that by the end of a given number of years, the investment is large enough to pay
off a known commitment at that time.
S = A(Rn – 1)
_________
R – 1
Where:
A = annual payment into the fund
R = 1 + interest rate
n = the number of terms
S = final value
26
Coupon rate on debt is the actual annual rate of interest payable on the nominal value of the debt.
All debt is issued in blocks of £100 (this is known as the par, face or nominal value).
Yield to maturity or gross redemption yield is the internal rate of return of the cash flows
(interest payments and redemption premium), associated with a loan stock.
Method to calculate the yield to maturity
Calculate a positive NPV and a negative NPV of redeemable debts cash flows (usually use 5% and
15% discount factors).
Apply formula to find IRR (interpolation).
A + [ a
x (B-A)]
a – b
Where
A
=
lower discount factor
B
=
higher discount factor
a
=
positive NPV
b
=
negative NPV
A graphical method below can also be used to estimate the yield to maturity.
27
Yield curve theory
The yield curve demonstrates the variation of returns on securities with respect to their maturity
and market conditions.
The yield curves shows how interest rates are likely to move in the future.
It is important to note that relying purely on the yield curve to make decisions on future interest
rates is dangerous. Other factor could affect future interest rates like levels of inflation and general
economics.
U
U
p
p
w
w
a
a
r
r
d
d
s
s
l
l
o
o
p
p
i
i
n
n
g
g
y
y
i
i
e
e
l
l
d
d
c
c
u
u
r
r
v
v
e
e
H
H
i
i
g
g
h
h
e
e
r
r
f
f
u
u
t
t
u
u
r
r
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
s
s
e
e
x
x
p
p
e
e
c
c
t
t
e
e
d
d
B
B
o
o
r
r
r
r
o
o
w
w
l
l
o
o
n
n
g
g
t
t
e
e
r
r
m
m
n
n
o
o
w
w
.
.
A
A
v
v
o
o
i
i
d
d
v
v
a
a
r
r
i
i
a
a
b
b
l
l
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
b
b
o
o
r
r
r
r
o
o
w
w
i
i
n
n
g
g
D
D
o
o
w
w
n
n
w
w
a
a
r
r
d
d
s
s
l
l
o
o
p
p
i
i
n
n
g
g
y
y
i
i
e
e
l
l
d
d
c
c
u
u
r
r
v
v
e
e
L
L
o
o
w
w
e
e
r
r
f
f
u
u
t
t
u
u
r
r
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
s
s
e
e
x
x
p
p
e
e
c
c
t
t
e
e
d
d
B
B
o
o
r
r
r
r
o
o
w
w
s
s
h
h
o
o
r
r
t
t
t
t
e
e
r
r
m
m
n
n
o
o
w
w
.
.
M
M
a
a
k
k
e
e
u
u
s
s
e
e
o
o
f
f
v
v
a
a
r
r
i
i
a
a
b
b
l
l
e
e
i
i
n
n
t
t
e
e
r
r
e
e
s
s
t
t
r
r
a
a
t
t
e
e
b
b
o
o
r
r
r
r
o
o
w
w
i
i
n
n
g
g
28
Solutions to Lecture Examples
Example 25.1
The answer is A.
A
Ask the customer for immediate payment.
The bill of exchange is the payment from the customer, so this is not a possible action to take.
B
Discount the bill with a bank.
Holder of the bill, presents bill on maturity, or sells bill before maturity at discount depending on
credit quality of drawee and market condition for bills.
C
Hold the bill until the due date and then present it for payment.
Holder of the bill, presents bill on maturity, or sells bill before maturity at discount depending on
credit quality of drawee and market condition for bills.
D Use the bill to settle a trade payable.
Holder of the bill, presents bill on maturity, or sells bill before maturity at discount depending on
credit quality of drawee and market condition for bills.
Example 25.2
Year
Cash flow
$
DF 5%
PV
DF 15%
PV
0
MV
(82)
1.000
(82.00)
1.000
(82.00)
1-8
Interest
7
6.463
45.24
4.487
31.41
8
Capital
repayment
100
0.677
67.70
0.327
32.70
30.94
(17.89)
Using IRR interpolation
(5 + (30.94 / (30.94 - -17.89) x (15-5)
= 11.3% yield to maturity.
29
Example 25.3
The current market value of the bonds is the present value of the all the cash flows
Annual interest payments – 7% x $10,000 = $700
Term of bond – 5 years
Market interest rates = discount factor – 10%
Redemption value - $10,000
Present value of interest payments =
$700 x (CDF for 5 years at 10%) 3.791
=
$2,654
Present value of redemption
=
$10,000 x (DF of 5 years at 10%) 0.621
=
$6,210
Current market value of bond ($2,654 + $6,210) = $8,864