Chapter 16. Liability Management and Short/Medium-Term Financing.

For most companies, short- and medium-term financing is the principal means by which assets are funded.

LIABILITY STRUCTURE OF A COMPANY.
If perfect and complete financial markets existed, not only would capital structure be irrelevant, but so would be the maturity and other conditions of debt. One type of instrument would be as good as the next.

Imperfections and Incompleteness.
Liability management matters when there are imperfections and incomplete markets. With imperfections and/or incompleteness in financial markets, stockholders will benefit from the firm's "packaging" its debt instruments in a way that takes advantage of these circumstances.

The imperfections that most affect debt financing are flotation costs, bankruptcy costs, costs of information, and restrictions on lenders.

Permanent and Temporary Financing.
If the firm adopts a hedging approach to financing, each asset would be offset with a financing instrument of the same approximate maturity. A firm incurs short-term debt to finance short-term or seasonal variation in current assets; it uses long-term debt or equity to finance the permanent component of current assets.

Maturity of Debt.
Although an exact synchronization of the schedule of expected future net cash flows and the payment schedule of debt is appropriate under conditions of certainty, it usually is not appropriate under uncertainty. The margin of safety that should be built into the maturity schedule to allow for adverse fluctuations in cash flows will depend on the trade-off between risk and profitability.

Maturity: The Risks Involved.
In general, the shorter the maturity schedule of a firm's debt obligations, the greater the risk that it will be unable to meet principal and interest payments. Commiting funds to a long-term asset and borrowing short carries the risk that the firm may not be able to renew its borrowings.

In addition to this sort of risk, there is also the uncertainty associated with interest costs, which is higher for short-term debt. When financing with long-term debt, the company knows precisely what its interest costs will be over the time period it needs the funds.

A mitigating factor is the possible covariance of short-term interest costs with operating income. With covariance, when operating income is low, net income will benefit from the lower interest costs at that time.

Debt maturity involves a tradeoff between interest cost and the risk of a crisis at maturity.

Maturity: The Cost Trade-off.
Differences in risk between short- and long-term financing must be balanced against differences in interest costs. The longer the maturity schedule of a firm's debt, the more costly financing is likely to be.

In addition to higher expected costs of long-term borrowings, a company may pay interest on debt over periods of time when funds are not needed. Thus, there usually is an inducement to finance funds requiremetns on a short-term basis.

Consequently, we have the familiar trade-off between risk and profitability. The margin of safety, or lag between expected net cash flows and payments on debt, will depend on the risk preferences of management.

In testing corporate debt maturity, Stohs and Mauer find that average maturity is greater the larger the size of a company, the longer term the company's assets, and the greater the quality of the earnings (less risky).

Agency and Signaling Issues.
Debt maturity may be influenced by other thoretical considerations. For example, some companies have a disincentive to invest in certain profitable investment opportunities because such projects work more to the benefit of debt holders than of stockholders.

As in capital structure and dividend decisions, the maturity of the debt a company employs may have a signaling effect. If there is asymmetric information between investors and management, the latter will want to issue short-term debt if it believes the firm is undervalued. The reason is that once expectations are realized, the company will be able to refinance at more favorable rates.


TRADE CREDIT FINANCING.
In an advanced economy, most buyers are not required to pay for goods on delivery but are allowed a short deferment period before payment is due. During this period, the seller of the goods extends credit to the buyer.

Terms of Sale.
COD and CBD - No Extension of Credit. COD terms mean cash on delivery of the goods. The only risk the seller undertakes in this type of arrangement is that the buyer may refuse the shipment (and the seller will be stuck with the shipping costs).

Ocasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. CBD terms must be distinguished from progress payments, where the buyer pays the manufacturer at various stages of production prior to actual delivery of the finished product.

Net Period - No Cash Discount. Net 30 (pay within 30 days) or net/15 EOM (goods shipped before the end of the month must by paid by the fifteenth of the following month.

Net Period with Cash Discount. The terms 2/10, net 30 indicate that the seller offers a 2 percent discount if the bill is paid within 10 days.

Datings. In seasonal business, sellers frequently use datings to encourage customers to place their orderss before a heavy selling period.

Trade Credit as a Means of Financing.
Trade credit is not a discretionary source of financing. It is entirely dependendt on the purchasing plans of the firm, which, in turn, are dependent on its productions cycle.

In examining credit as a discretionary form of financing, we want to consider situations in which (1) a firm does not take a cash discount but pays on the last day of the net period and (2) a firm pays its bills beyond the net period.

Payment on the Final Due Date.
If a cash discount is offered but not taken, there is a definite opportunity cost. If terms of sale are 2/10, net 30, the firm has the use of funds for an additional 20 days if it does not take the cash discount but pays on the final day of the net period.

The longer the time between the discount date and the time of payment, the lower the cost of discount forgone.

Stretching Accounts Payable.
Stretching accounts payable beyond the due date is a source of funds, but at the expense of supplier relations.

Advantages of Trade Credit.
The firm must balance the advantages of trade credit against the cost of forgoing a cash discount, the opportunity cost associated with possible deterioration in credit reputation if it stretches its payables, and the possible increase in selling price the seller imposes on the buyer.

Probably the major advantage of trade credit is its ready availability. There is no need to arrange financing formally; it is already there. If the firm is taking cash discounts, additional credit is readily available by not paying existing accounts payable until the end of the net period.

With other sources of short-term financing, there may be a lead time between the time the need for funds is recognized and the time the firm is able to borrow them. Trade credit is a more flexible means of financing. A supplier views an occasional delinquent payment with a far less critical eye than does a banker or other lender.

Who Bears the Cost.
Trade credit involves a cost for the use of funds over time. This use is not free. The burden may fall on the supplier, on the buyer, or on both parties.


ACCRUAL ACCOUNTS AS SPONTANEOUS FINANCING.
Perhaps even more than accounts payable, accrual accounts represent a spontaneous source of financing. The most common accrual accounts are for wages and taxes. For both accounts, the expense is incurred or accrued but not paid. Like accounts payable, accruals tend to expand with the scope of the operation.

Built-in Financing.
Built-in methods of financing include payables and accruals.

In a sense, accruals represent costless financing. Services are rendered for wage, but employees are not paid and do not expect to be paid until the end or after the end of the period.

Unfortunately for the company, they do not represent discretionary financing. For taxes, the government is the creditor, and it likes to be paid on time.

Accrued Wages and Pay Period Changes.
Accrued wages are partially discretionary in that a company can change the frequency of wage payments and thereby affect the amount of financing. The longer the pay period, the greater the amount of accrued wage financing. However, an increase in the pay period is usually a "one-shot" in that it is not possible to repeat with subsequent increase.


UNSECURED SHORT-TERM LOANS.
Almost without exception, finance companies do not offer unsecured loans, simply because a borrower who deserves unsecured credit can borrow at a lower cost from a commercial bank.

Short-term, unsecured bank loans typically are self-liquidating in that the assets purchased with the proceeds generate sufficient cash flows to pay off the loan eventually.

Line of Credit.
A line of credit is an 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.

Some Conditions. The cash budget gives the best insight into the borrower's short-term credit needs. If maximum or peak borrowing need over the forthcoming year are estimated at $800,000, a company might seek a line of credit of $1 million to give it a margin of safety.

If the banks regard borrowing under lines of credit as seasonal or temporary financing, they me require the borrower to clean up (pay off) bank debt for a period of time during the year, as evidence that the loan is truly seasonal in nature.

Moral, Not Legal Obligation. If the creditworthiness of the borrower should deteriorate over the year, the bank may not want to extend credit and would not be required to do so. Under most circumstances, however, a bank feels morally bound to honor a line of credit.

Revolving Credit Agreement.
Revolvers are legal obligations of banks to provide credit, in contrast to lines of credit, which are a moral obligation.

For the privilege of having this formal commitment, the borrower usually is required to pay a commitment fee on the unused portion of the revolving credit.

Transaction Loans.
A contractor may borrow from a bank in order to complete a job. For this type of loan, a bank evaluates each request by the borrower as a separate transaction.

Interest Rates.
Most business loans are determined through personal negotiation between the borrower and the lender. One index used by banks for pricing business loans is the primer rate. This rate is set by large money market banks and tends to be uniform throughout the country.

Rates other than Prime. Despite the term prime rate implying the price a bank charges its most creditworthy customers, this has not been the recent practice. With banks becoming more competitive for corporate customers, a company may be able to borrow at a lower rate. The rate charged is based on the bank's marginal cost of funds, as typically reflected by LIBOR or the rate paid on money market certificates of deposit. An interest-rate margin is added to the cost of funds, and the sum becomes the rate charged the customer.

Other borrowers will pay either the prime rate or a rate above prime, the bank's pricing of the loan being relative to the prime rate.

Loan pricing for floating-rate loans can be off of the prime rate or off of LIBOR.

Methods of Computing Interest Rates.
There are three ways in which interest on a loan may be paid:
 On a collect basis. The interest is paid at the maturity of the note.
 On a discount basis. Interest is deducted from the initial loan.
 On an add-on basis. Interest is added to the funds disbursed in order to determine the face value of the note. Then installments are to be paid at the end of each period (e.g. monthly).


SECURED LENDING ARRANGEMENTS.
Many firms cannot obtain credit on an unsecured basis. With security, lenders have two sources of loan payment: the cash-flow ability of the firm to service the debt and, if the source fails for some reason, the collateral value of the security.

Some Theoretical Notions.
We know that secured lending arrangements are more costly to administer than unsecured loans and that the incremental cost is passed on to the borrower in the form of fees and higher interest costs than would otherwise be the case. This is because the market for loans is a competitive one, so if unsecured credit is available somewhere else at less total cost, one can be sure the borrower will go there to get it. Beyond a point in risk, however, all lenders in the market will want some type of safeguard in addition to the general credit standing of the company.

With secured loans, a company’s cash flows are segregated with respect to payments to creditors. This may reduce conflict between creditors and reduce monitoring, enforcement, and foreclosure costs, which, in turn, can work to the advantage of a company and its stockholders, at the expense of existing debt holders. The idea, then, is that a company plays one set of debt holders off against another, thereby extracting gain in the option pricing model context.

Collateral Value.
The excess of the market value of the security pledged over the amount of the loan determines the lender’s margin of safety. This way, secured loans involve percent advance against collateral value, the percent varying with marketability and price volatility.

Uniform Commercial Code. A lender who requires collateral of a borrower obtains a security interest in the collateral. The collateral may be accounts receivable, inventory, equipment, or other assets of the borrower. The security interest in the collateral is created by a security agreement, also known as a security device.

Assignment of Accounts Receivable.
Accounts receivable are one of the most liquid assets of the firm; consequently, the make desirable security for a loan. From the standpoint of the lender, the major difficulties with this type of security are the cost of processing the collateral and the risk of fraud.

Quality and Size of Receivables.With an accounts receivable loan, the lender has a lien on the collateral.

In evaluating the loan request, the lender will analyze the quality of the firm’s receivables to determine how much to lend against them.

The lender is also concerned with the size of the receivables. The smaller the average size of accounts, the more it costs per dollar of loan to process them.

Procedure. A receivable loan can be either a nonnotification or a notification basis. Under a nonnotification arrangement, customers of the firm are not notified that their accounts have been pledged to the lender.

With notification arrangement, the account is notified of the assignment, and remittances are made directly to the lender.

Advantages of the Lending Agreement.
An accounts receivable loan is a more or less continuous financing agreement. New receivables replace the old, and the security base and the amount of loan fluctuate accordingly. Also, a “cleanup” of the loans is not required, because it is regarded as a more or less permanent source of financing.

Factoring receivables.
Factoring involves the sale of receivables to a factor. By factoring, a firm frequently relieves itself of the expense of maintaining a credit department and making collections. Any account that the factor is unwilling to buy is an unacceptable credit risk unless, of course, the firm want to assume this risk on its own and ship the goods.

Factoring Costs. For bearing risk and servicing the receivables, the factor receives a commission, typically 1 to 3 percent of the face value of the receivables. A firm may wish to receive payment for the sale of its receivables before they are collected, so for advancing payment the factor requires additional compensation.

Flexibility. The typical factoring agreement is continuous. Though factoring appears to be expensive, one must remember that the factor relieves the company of credit checks, of the cost of processing receivables, and of collection of expenses. Factoring also has the advantage of economies of scale, lowering costs and having more extensive credit information.

Inventory Loans.
Inventory loans can be made against inventory in general or against specific inventory.

Lenders determine the percentage that they are willing to advance by considering marketability, perishability, market price stability, and the difficulty and expense of selling the inventory to satisfy the loan.

Floating Lien. The borrower may pledge inventories “in general” without specifying the kind of inventory involved.

Chattel Mortgage. With a chattel mortgage, inventories are identified by serial number of by some other means. This inventory cannot be sold unless the lender consents. Chattel mortgages are well suited for certain capital assets, such as machine tools.

Trust Receipt Loans. Under a trust receipt financing arrangement, the borrower holds in trust for the lender the inventory and the proceeds from its sale. Trust receipt loans sometimees are known as floor planning. Inventory in trust, unlike inventory under a floating lien, is specifically identified by serial number or by other means.

Terminal Warehouse Receipt Loans. A borrower secures a terminal warehouse receipt loan by storing inventory with a public, or terminal, warehousing company. Warehouse receipts may be either nonnegotiable (the lender has the sole authority to release them) or negotiable (useful when transferring the title of the goods from one party to another).

Field Warehouse Receipt Loans. Field warehousing secures the inventory loan on property. A field warehousing company sets off a designated storage area for the inventory pledged as collateral.


INTERMEDIATE-TERM DEBT.
Typically, intermediate-term financing is self-liquidating and in that way resembles short-term financing. However, it also can satisfy more permanent funds requirements and, in addition, it can serve as an interim substitute for long-term financing.

Term Loans.
A bank or insurance company term loan is a business loan with a final maturity of more than 1 year, repayable according to a specified schedule. Sometimes the loan is amortized in equal periodic installments except for the final payment, known as a “balloon” payment, which is larger than any of the others.

Term loans can be fixed rate or floating rate.

The advantage of a term loan is flexibility. The borrower deals directly with the bank or insurance company, and then the loan can be tailored to the borrower’s needs through direct negotiation. The disadvantage? Usually, a higher interest cost than could be obtained with a public issue.

Equipment Financing.
Equipment varies in its desirability as collateral for a loan.

Sources of Equipment Financing. Commercial banks, finance companies, and the sellers of equipment are among the sources of equipment financing. Equipment loans may be secured either by a chattel mortgage or by a conditional sales contract arrangement.

Chattel Mortgage. A chattel mortgage is a lien on property other than real estate.

Conditional Sales Contract. With a conditional sales contract arrangement, the seller of the equipment retains title to it until the purchaser has satisfied all the terms of contract.

Medium-Term Notes.
Unlike loans arranged with a financial institution, medium-term notes (MTNs) are sold to investors through an investment banks. For some companies, MTNs are a major funding device.

Medium-term notes are a financing vehicle only for larger, creditworthy companies.


PROTECTIVE COVENANTS AND LOAN AGREEMENTS.
The provisions for protection contained in a loan agreement (in case the borrower’s financial condition deteriorates) are known as protective covenants.

Remedies under Default.
Protective covenants allow the lender to control the situation if any are breached.

The important protective provisions of a loan agreement may be classified as follows:
(1) general provisions used in most loan agreements, which are variable to fit the situation;
(2) routine provisions used in most agreements, which usually are not variable; and
(3) specific provisions that are used according to the situation.

Restrictions are designed to safeguard the liquidity of the borrower

General Provisions.
Working Capital. Its purpose is to preserver the company’s current position and ability to pay the loan.

Dividends/Share Repurchase. Its purpose is to limit cash going outside the business, thus preserving the liquidity of the company.

Capital Expenditures. This is another tool the lender uses to ensure the maintenance of the borrower’s current position.

Other Debt. This provision protects the lender, inasmuch as it prevents future lenders from obtaining a prior claim on the borrower’s assets.

Routine Provisions.
 Furnish the bank with financial statements.
 Maintain adequate insurance.
 The borrower must not sell a significant portion of its assets.
 Pay all taxes and other liabilities.
 A provision forbidding the pledging or mortgaging of any of the borrower’s assets (negative pledge cause).
 The company is required not to discount or sell its receivables.
 The borrower is prohibited from entering into any leasing arrangement of property.
 There is a restriction on the acquisition of other companies.

Special Provisions.
The bank uses special provisions to achieve a desired total protection of its loan.

For example, it may require that the company carries life insurance on executives that are essential to the firm’s operation. Aggregate executive salaries and bonuses are sometimes limited. Finally, an agreement may also contain a management clause under which certain key individuals must remain actively employed.

Negotiating Restrictions and the Option Pricing Theory.
Option pricing can be used to model protective-covenant determination.

The OPT Setting. The application of the option pricing theory visualizes the debt holder-equity holder relationship as being essentially an option arrangement.

Debt holders receive the lesser of the contractual amount of the debt obligation (D) or the value of the firm (V) if this obligation cannot be entirely paid.

Equity holders are the residual owners of the company and are entitled to any value of the firm that remains after the debt has been paid, V-D. In this sense, the equity holders have an option to the total value of the firm at time T. If V is less than D, the option is worth zero. The greater the variance of the distribution of possible values of the firm at time T, the greater the value of the option, all other things the same.

Equity Holder Motivation. In the context of our example, it behooves the equity holders to increase the risk of the firm to increase the variance of its total value.

Lender Restraint. Increasing the risk is done at the expense of the option writer, the debt holders. Therefore protective covenants are put in place to safeguard against these occurrences before making the loan.

There are monitoring costs associated with the writing of protective covenants and with their enforcement. There are trade-off between the increase of safeguards and costs, so the final position will be a compromise between the borrower and the lender, one that is influenced by relative conditions in the financial markets and by the costs of monitoring.