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*

 end