Mauritius - Star and Key of the Indian Ocean

Foundations of Financial Management: An Analysis (part 27)

“Money never made a man happy yet, nor will it. The more a man has, the more he wants. Instead of filling a vacuum, it makes one.”

- Benjamin Franklin

The Time Value of Money (Part B)

by

Charles Lamson

Future Value---Annuity

Our calculations up to now have dealt with single amounts rather than an annuity, which may be defined as a series of consecutive payments or receipts of equal amount. The annuity values are generally assumed to occur at the end of each period. If we invest $1,000 at the end of each year for four years and our funds grow at 10%, what is the future value of this annuity? We may find the future value for each payment and then total them to find the future value of an annuity (Figure 2).

Figure 2 (Assumption for annuity is that 1st payment doesn't come till end of first year.)

The future value for the annuity in Figure 2 is $4,641. Although this is a four period annuity, the first $1,000 comes at the end of the first period and has but three periods to run, the second $1,000 at the end of the second period, with two periods remaining---and so on down to the last $1,000 at the end of the fourth period. The final payment (period 4) is not compounded at all.

Because the process of compounding the individual values is tedious, special tables are also available for annuity computations. We shall refer to Table 3 above, the future value of an annuity of $1. Let us define A as the annuity value and use Formula 3 for the future value of an annuity. Note that the A part of the subscript on both the left- and right-hand side of the formula below indicates we are dealing with tables for an annuity rather than a single amount. Lamont. Using Table 3 for A = $1,000, and n = 4, and i = 10%:

If a wealthy relative offered to set aside $2,500 a year for you for the next 20 years, how much would you have in your account after 20 years if the funds grew at 8 percent? The answer is as follows:

A rather tidy sum considering that only a total of $50,000 has been invested over the 20 years.

Present Value---Annuity

To find the present value of an annuity, the process is reversed. In theory each individual payment is discounted back to the present and then all of the discounted payments are added up, yielding the present value of the annuity.

Table Four allows us to eliminate extensive calculations and to find our answer directly.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 242-245*

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Foundations of Financial Management: An Analysis (part 26)

“I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy.” 

– Warren Buffett

The Time Value of Money

by

Charles Lamson 

The time value of money applies to many day-to-day decisions. Understanding the effective rate on a business loan, the mortgage payment in a real estate transaction, or the true return on an investment depends on understanding the time value of money. As long as an investor can garner a positive return on idle dollars, distinctions must be made between money received today and money received in the future. The investor/lender essentially demands that a financial rent be paid on his or her funds as current dollars are set aside today in anticipation of higher returns in the future.

Relationship to the Capital Outlay Decision

The decision to purchase new plant and equipment or to introduce a new product in the market requires using capital allocating or capital budgeting techniques. Essentially we must determine whether future benefits are sufficiently large to justify current outlays. It is important that we develop the mathematical tools of the time value of money as the first step toward make making capital allocation decisions. Let us now examine the basic terminology of "time value of money."

Future Value---Single Amount

In determining the future value, we measure the value of an amount that is allowed to grow at a given interest rate over a period of time. Assume an investor has $1,000 and wishes to know its worth after 4 years if it grows at 10 percent per year. At the end of the first year, the investor will have $1,000 X 1.10, or $1,100. By the end of year two, the $1,100 will have grown to $1,210 ($1,000 X 1.10). The four-year pattern is indicated below.

After the fourth year, the investor has accumulated $1,464. Because compounding problems often cover a long period, a more generalized formula is necessary to describe the compounding procedure. We shall let:

The simple formula is:

Table 1   Future value of $1

The table tells us the amount that $1 would grow too if it were invested for any number of periods at a given interest rate. We multiply this factor times any other amount to determine the future value.  

Present Value of a Single Amount

The present value is the exact opposite of the future value. For example, earlier we determined that the future value of $1,000 for four periods at 10 percent was $1,464. We could reverse the process to state that $1,464 received four years into the future, with a 10 percent interest or discount rate, is worth only $1,000 today---its present value. The relationship is depicted in Figure 1. 

The formula for present value is derived from the original formula for future value.

The present value can be determined by solving for a mathematical solution to the formula above, or by using cable too, the present value of a dollar. and the latter instance, we restate the value for present value as:

Let's demonstrate that the present value of $1,464 based on our assumptions, is $1,000 today. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 239-242*

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9. The Aztecs - A Clash of Worlds (Part 2 of 2)

Fundamentals of Financial Management: An Analysis (part 25)

“Time is more value than money. You can get more money, but you cannot get more time.” – Jim Rohn

Sources of Short-Term Financing (Part D)

by

Charles Lamson

Accounts Receivable Financing

Accounts receivable financing may include pledging accounts receivable as collateral for a loan or an outright sale (factoring) of receivables. Receivables financing is popular because it permits borrowing to be tied directly to the level of asset expansion at any point in time. As the level of accounts receivable goes up, a firm is able to borrow more.

A drawback is that this is a relatively expensive method of acquiring funds, so it must be carefully compared to other forms of credit. Accounts receivable represent one of the firm's most valuable short-term assets, and they should be committed only where the appropriate circumstances exist. An ill-advised accounts receivable financing plan may exclude the firm from a less expensive bank term loan.

Pledging Accounts Receivable

The lending institution will generally stipulate which of the accounts receivable is of sufficient quality to serve as collateral for a loan. On this basis, we may borrow 60 to 90 percent of the value of the acceptable collateral. The loan percentage will depend on the financial strength of the borrowing firm and on the creditworthiness of its accounts. The lender will have full recourse against the borrower if any of the accounts go bad. The interest rate in a receivables borrowing arrangement is generally well in excess of the prime rate.

The interest is computed against the loan balance outstanding, a figure that may change quite frequently, as indicated in Table 2. In the illustration, interest is assumed to be 12 percent annually, or 1 percent per month. In month 1, we are able to borrow $8,000 against $10,000 in acceptable receivables and we must pay $80 in interest. Similar values are developed for succeeding months.

Factoring Receivables

When we factor receivables, they are sold outright to the finance company. Our customers may be instructed to remit the proceeds directly to the purchaser of the account. The factoring firm generally does not have recourse against the seller of the receivables. As a matter of practice, the finance company may do part or all of the credit analysis directly to ensure the quality of the accounts. As a potential sale is being made, the factoring firm may give immediate feedback to the seller on whether the account will be purchased.

When the factoring firm accepts an account, it may forward funds immediately to the seller, in anticipation of receiving payment 30 days later as part of the normal billing process. The factoring firm is not only absorbing risk, but also is actually advancing funds to the seller a month earlier than the seller would normally receive them.

For taking the risk, the factoring firm is generally paid on a fee or commission basis equal to 1 to 3 percent of the invoices accepted. In addition, it is paid a licensing rate for advancing the funds early. If $100,000 a month is processed at a 1 percent commission and a 12 percent annual borrowing rate, the total effective cost will be 24 percent on an annual basis.

If one considers that the firm selling the accounts is transferring risk as well as receiving funds early, which may allow it to take cash discounts, the rate may not be considered exorbitant. Also the firm is able to pass on much of the credit checking cost to the factor.

Asset-Backed Public Offerings

Asset-backed securities are nothing more than the sale of receivables. Asset-backed public offerings are popular, and IBM has added a new wrinkle by selling a public offering of receivables due from state and municipal governments. The interest paid to the owners of these securities is not taxable by the federal government. This allows IBM to raise cash at below-market rates. This strategy may be available only to large companies having significant business with state and local government units. Investment bankers continue to develop new types of asset-backed securities, and they are optimistic that the use of all asset-backed securities will continue to grow because of the predictable cash flows they offer investors.

One of the benefits of the issuer is that they trade future cash flows for immediate cash. The asset-backed security is likely to carry a high credit rating of AA or better, even when the issuing firm may have a low credit rating. This allows the issuing firm to acquire long cost funds than it could with a bank loan or a bond offering. This short-term market can provide an important avenue for corporate liquidity and short-term financing.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 222-225*

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Malaysian calls on board of the Club Med 2 (Documentary, Discovery, Hist...

Foundations of Financial Management: An Analysis (part 24)

 “An investment in knowledge pays the best interest.” 

– Benjamin Franklin 

Sources of Short-Term Financing (part C)

by

Charles Lamson

Financing through Commercial Paper

For large and prestigious firms, commercial paper may provide an outlet for raising funds. Commercial paper represents a short-term, unsecured promissory note issued to the public in minimum units of $25,000.

Commercial paper falls into two categories. First, there are finance companies that issue paper primarily to institutional investors such as pension funds, insurance companies, and money market mutual funds. It is probably the growth of money market mutual funds that has had such a great impact on the ability of companies to sell such an increased amount of commercial paper in the market. Paper sold by financial firms is referred to as finance paper, and since it is usually sold directly to the lender by the finance company, it is also referred to as direct paper. The second type of commercial paper is sold by industrial companies, utility firms, or financial companies too small to have their own selling network. These firms use an immediate dealer network to distribute their paper, and so this type of paper is referred to as dealer paper.

Traditionally commercial paper is just that. A paper certificate is issued to the lender to signify the lender's claim to be repaid. This certificate could be lost, stolen, misplaced, or damaged and, and in rare cases, someone could fail to cash it in at maturity. There is a growing trend among companies that sell commercial paper directly to computerize the handling of commercial paper with what is called book-entry transactions, in which no actual certificate is created. All transactions simply occur on the books. The use of computer-based electronic issuing methods lowers cost and simplifies administration, as well as linking the lender and the issuing company. As the market becomes more accustomed to this electronic method, large users ($500 million or more) will likely find it profitable to switch from physical paper to the book entry system, where all transfers of money are done by wiring cash between lenders and commercial paper issuers.

Advantages of Commercial Paper

The growing popularity of commercial paper can be attributed to other factors besides the rapid growth of money market mutual funds and their need to find short-term securities for investment. For example, commercial paper may be issued at below the prime interest rate. This rate differential is normally 2 to 3 percent.

A second advantage of commercial paper is that no compensating balance (a minimum bank account balance that a borrower agrees to maintain with a lender) requirements are associated with its issuance, though the firm is generally required to maintain commercial bank lines of approved credit equal to the amount of the paper outstanding (a procedure somewhat less costly than compensating balances). Finally, a number of firms enjoy the prestige associated with being able to float their commercial paper and what is considered a "snobbish market" for funds.

Limitations on the Issuance of Commercial Paper

Although the funds provided through the issuance of commercial paper are cheaper than bank loans, they are also less predictable. While a firm may pay a higher rate for a bank loan, it is also buying a degree of loyalty and commitment that is unavailable in the commercial paper market.

Foreign Borrowing

An increasing source of funds for you U.S. firms has been overseas banks. This trend started several decades ago with the Eurodollar market centered in London. A Eurodollar loan is a loan denominated in dollars and made by a foreign bank holding dollar deposits. Such loans are usually short-term to intermediate-term in maturity. London Interbank Offer Rate (LIBOR) is the base interest rate paid on such loans for companies of the highest quality. As Figure 1 shows, Eurodollar loans at LIBOR rather than the prime interest rate can be cheaper than U.S. domestic loans. International companies are always looking in foreign markets for cheaper ways of borrowing.

Figure 1 The prime rate versus the London Interbank Offered Rate on U.S. dollar deposits

One approach to borrowing has been to borrow from international banks in foreign currencies either directly or through foreign subsidiaries. In using a subsidiary to borrow, the companies may convert the borrowed currencies to dollars, which are then sent to the United States to be used by the parent company. While international borrowing can often be done at lower interest rates than domestic loans, the borrowing firm may suffer a currency risk. That is, the value of the foreign funds borrowed may rise against the dollar and the loan will take more dollars to repay. Companies generating foreign revenue streams may borrow in those same currencies and thereby reduce or avoid any currency risk. Currency risk will be given greater coverage in the next post.

Use of Collateral in Short-Term Financing

Almost any firm would prefer to borrow on an unsecured (no-collateral) basis; but if the borrower's credit rating is too low or its need for funds too great, the lending institution will require that certain assets be pledged. A second credit arrangement might help the borrower obtain funds that would otherwise be unavailable.

In any loan the lenders primary concern, however, is whether the borrowers capacity to generate cash flow is sufficient to liquidate the loan as it comes due. Few lenders would make a loan strictly on the basis of collateral. Collateral is merely a stopgap device to protect the lender when all else fails. The bank or finance company is in business to collect interest, not to repossess and resell assets.

Though a number of different types of assets may be pledged, our attention will be directed to accounts receivable and inventory. All states have now adopted the Uniform Commercial Code, which standardizes and simplifies the procedures for establishing security on a loan. It is to accounts receivable financing that we turn to in the next post. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 219-222*

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Foundations of Financial Management: An Analysis (part 23)

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson

Sources of Short-Term Financing (Part B)

by

Charles Lamson

Bank Credit

Banks may provide funds for the financing of seasonal needs, product line expansion, and long-term growth. The typical banker prefers a self-liquidating loan in which the use of funds will enter a built-in or automatic repayment ssceme. Actually, two-thirds of bank loans are short-term in nature. Nevertheless, through the process of renewing old loans, many of these 90- or 180-day agreements take on the characteristics of longer-term financing.

Major changes occurring in banking today are centered on the concept full service banking. The modern bankers function is much broader than merely accepting deposits, making loans, and processing checks. A banking institution may be providing trust and investment services, a credit card operation, real estate lending, data processing services, cash management services both domestically and internationally, pension fund management, and many other services for large and small businesses.

The banking scene today has become more international to accommodate increased world trade and the rise of international corporations. The largest International banks are expanding into the United States through bank acquisitions and branch offices. Every major financial center from New York to San Francisco has experienced an increase in the number of foreign banks.

Bank deregulation has created greater competition among financial institutions, such as commercial banks, savings and loans, credit unions, brokerage houses, and new companies offering financial services.

Also, large banks made acquisitions to either expand their geographical reach, or to become more competitive in their own market area.

We will look at a number of terms generally associated with banking (and other types of lending activity) and consider the significance of each. Attention is directed to the prime interest rate, LIBOR, compensating balances, the term loan arrangement, and methods of computing interest.

Prime Rate and LIBOR

The prime rate is the rate a bank charges its most creditworthy customers, and it usually increases as a customer's credit risk gets higher. At certain slack loan periods In the economy, or because of international competition, banks may actually charge top customers less than the published prime rate; however, such activities are difficult to track. The average customer can expect to pay one or two percentage points above prime, while in tight money periods a builder in a speculative construction project might have to pay five or more percentage points over prime.

Since the U.S. dollar is the world's International currency, and because the United States has run up huge foreign trade deficit over the last 25 years, as of October 7, 2020, there are $1.99 trillion floating around the world's money markets (federalreserve.gov). London is the center of Eurodollar deposits and a majority of these U.S. dollars can be found there. Because U.S. companies can borrow dollars from London banks quite easily, large borrowers shop for the lowest interest rate in either London, New York, or any other major money market center. This means that the U.S. prime rate competes with the London Interbank Offered Rate (LIBOR) for those companies with an international presence or those sophisticated enough to use the London Eurodollar market for loans.

Figure 1 shows the relationship between LIBOR and the prime rate between January 2005 and January 2014. Notice that during this period the prime rate was always higher than LIBOR (Kurt D., Sep. 9, 2020, The Federal Funds, Prime and LIBOR Rates, Investopedia.com).

Figure 1 The prime rate versus the London Interbank Offered Rate on U.S. dollar deposits

Compensating Balances

In providing loans and other services, a bank may require that business customers either pay a fee for the service or maintain a minimum average account balance, referred to as a compensating balance. In some cases both fees and compensating balances are required. As interest rates go down this compensating balance rises. Because the funds do not generate as much revenue at lower interest rates, the compensating balance amount is higher.

When compensating balances are required to obtain a loan, the required amount is usually computed as a percentage of customers loans outstanding, or as a percentage of bank commitments toward future loans to a given account. A common ratio is 20 percent against outstanding loans or 10 percent against total future commitments, though market conditions tend to influence the percentages.

If you borrow $100,000, paying 8 percent interest on the full amount with a 20 percent compensating balance requirement, you will be paying $8,000 for the use of $80,000 in funds, or an effective rate of 10 percent.

The amount that must be borrowed to end up with the desired sum of money is simply figured by taking the needed funds and dividing by (1 - c), where c is the compensating balance expressed as a decimal. For example, if you need $100,000 in funds, you must borrow $125,000 to ensure the intended amount will be available. This would be calculated as follows:

A check on this calculation can be done to see if you actually end up with the use of $100,000.

The intent here is not to suggest that the compensating balance requirement represents an unfair or hidden cost. If it were not for compensating balances, quoted interest rates would be higher or gratuitous services now offered by banks would carry a price tag.

In practice, some corporate clients pay a fee for cash management or similar services while others eliminate the direct fee with compensating balances. Fees and compensating balances vary widely among banks. As  the competition heats up among the providers of financial services, corporations can be expected to selectively shop for high-quality, low-cost institutions.

Maturity Provisions

As previously indicated, bank loans have been traditionally short-term in nature (though perhaps renewable). In the last decade there has been a movement to the use of the term loan, in which credit is extended for one to seven years. The loan is usually repaid in monthly or quarterly installments over its life rather than in one single payment. Only superior credit applicants, as measured by working capital strength, potential profitability, and competitive position, can qualify for term loan financing.  

Bankers are hesitant to fix a single interest rate to a term loan. The more common practice is to allow the interest rate to change with market conditions. Thus the interest rate on a term loan may be tied to the prime rate or LIBOR. Often loans will be priced at a premium over one of these two rates reflecting the risk of the borrower. For example a loan may be priced at 1.5 percentage points above LIBOR and the rate will move up and down with changes in the base rate.

Cost of Commercial Bank Financing

The effective interest rate on a loan is based on the loan amount, the dollar interest paid, the length of the loan, and the method of repayment. It is easy enough to observe the $60 interest on a $1,000 loan for 1 year would carry a 6 percent interest rate, but what if the same loan were 120 days? We use the formula:

Since we have use of the funds for only a hundred twenty days, the effective rate is 18 perent. To highlight the impact of time, if you borrowed $20 for only ten days and paid back $21, the effective interest rate would be 180 percent---a violation of almost every usury law. 

Not only is the time dimension of a loan important, but also the way in which interest is charged. We have assumed that interest would be paid when the loan comes due. If the bank uses a discounted loan and deducts the interest in advance, the effective rate of interest increases. For example, a $1,000 one-year loan with $60 of interest deducted in advance represents the payment of interest on only $940, or an effective rate of 6.38 percent.

Interest Costs with Compensating Balances

When a loan is made with compensating balances, the effective interest rate is the stated interest rate divided by (1 - c), where is c is the compensating balance expressed as a decimal. Assume that 6 percent is the stated annual rate and that a 20 percent compensating balance is required.

Formula 4

In the prior examples, if dollar amounts are used and the stated one is unknown, Formula 5 can be used. The assumption is that we are paying $60 interest on a $1,000 loan, but are able to use only $800 of the funds. The loan is for a year.

Formula 5

Only when a firm has idle cash balances that can be used to cover compensating balance requirements would the firm not use the higher effective cost formulas (Formulas 4 and 5)

. 

Rate on Installment Loans

The most confusing borrowing arrangement to the average bank customer or consumer is the installment loan. An installment loan calls for a series of equal payments over the life of the loan. Though federal legislation prohibits a misrepresentation of interest rates on loans to customers, a loan officer or an overanxious salesperson may quote a rate on an installment loan that is approximately half the true rate.

Assume that you borrow $1,000 on a 12-month installment basis, with regular monthly payments to apply to interest and principal, and the interest requirement is $60. While it might be suggested that the rate on the loan is 6 percent, that is clearly not the case. Though you are paying a total of $60 in interest, you do not have the use of $1,000 for one year rather, you are paying back the $1,000 on a monthly basis, with an average outstanding loan balance for the year of approximately $500. The effective rate of interest is 11.08%.

Annual Percentage Rate

Because the way interest is calculated often makes the effective rate different from the stated rate, Congress passed the Truth in Lending Act in 1968 (Block & Hirt, 2005, p. 218). This act required that the annual percentage rate (APR) be given to the borrower. The APR is really a measure of the effective rate we have presented. Congress was primarily trying to protect the unwary consumer from paying more than the stated rate without his or her knowledge. For example, the stated rate on an installment loan might be 8 percent but the APR might be 14.8 percent. it has always been assumed that businesses should be well versed in business practices and financial matters and, therefore, the Truth in Lending Act was not intended to protect business borrowers but, rather, individuals.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 212-219*

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