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Foundations of Financial Management, 12th Canadian Edition Lecture notes and Assignment Work
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Buad 195 Chapter 8 Outline Page 1 of 4Objectives:
1. Describe trade credit as an important form of short-term financing and be able to calculate its cost
to the firm if a discount is forgone.
2. Calculate the rate of interest on bank loans using the formula i= prt
3. Calculate interest rates for discounted loans and loans where compensating balances are required.
Reading: Pages
Financing, Trade credit (end at Cash Discount Policy)254 - 255 Bank
credit258 - 263
SOURCES OF SHORT-TERM FINANCING
The two main sources of short-term financing for businesses are:
1. Bank credit – loans, lines of credit
2. Trade credit – accounts payable
Bank Credit
Banks are happy to supply short term financing to businesses with proven track records. They charge
interest based on the prime bank rate and the borrower’s credit rating. They charge an amount above prime
on loans to businesses; how much above prime is based on the bank’s perceived risk of not being repaid.
Different Possible Costs of Borrowing
1. Interest rate: always expressed on an annual basis.
2. Lender’s (or administration) fee – there could be a flat fee for extending the loan. This amounts to
additional interest cost. If paid at the beginning of the loan period this also reduces the useable funds
available to the borrower, thus increasing the effective rate of borrowing.
3. Compensating balance – the bank may require a certain base amount be kept by the business in
their bank account. This represents a certain amount of the loan that the business can’t use, reducing
the amount of useable funds available to the borrower and thus increasing the effective rate of
borrowing.
4. Discounted interest – in some cases, the interest is deducted from the loan proceeds up front,
which also increases the effective rate of borrowing by reducing the useable funds available.
5. The bank may require periodic repayments (for example monthly), which also affects the
effective rate of borrowing. Periodic repayments are not covered in this course.
The bank will state a nominal interest rate, but the actual effective rate may be quite different, depending on
the terms of the loan. Most of the problems in this chapter deal with finding the effective interest rate of the
loan, also called the cost of borrowing.
There is one basic formula, which can be used to solve all the problems of this chapter. The formula is
just a rearrangement of the basic interest formula i = prt. The rearrangement is:
i
r= pt
Where
r is the effective annual interest rate (or cost of borrowing),
i is the amount of interest paid to the lender in dollars. It is calculated with i = PRt, where P is the
full amount of the loan, and R is the rate stated by the lender.
p is the useable amount of funds received from the loan from the borrower’s point of view
t is the time period over which the interest is accrued, expressed in years.
© Walt Burton 2015, updated by Barbara Nudd 2018
, Buad 195 Chapter 8 Outline Page 2 of 4
Example 1:
a) Your company borrowed $10,000 for 90 days at an interest rate of 8%. Calculate the interest,
in dollars, to be paid.
b) Your company borrowed $10,000 for one year and paid interest of $800. Calculate the annual rate of
interest.
c) Your company borrowed $10,000 for 90 days and paid interest of $222. Calculate the annual rate
of interest.
Example 2: Problem 11, page 277 (ignore effective annual rate)
Discounted Loans: Bank requires interest to be paid in advance.
Interest is deducted up front, reducing the useable funds, and so reducing the value of P to a smaller p.
Example 3: Goolio’s Sports borrowed $5,000 from the bank for 3 months at 12%, on a discounted basis.
(a) What were the usable proceeds received by Goolio?
(b) What was the effective annual rate on the loan?
Compensating Balance: Bank requires business to maintain a minimum cash balance in bank account. In this
case, the amount that the borrower has to keep in the bank account is not useable, so this reduces the value of
P to a smaller p.
Example 4: Two commercial artists, Delbert Dhumm and Roberta Rilly operate a company called Rilly
Dhumm Graphics Inc. They are currently broke, and have approached their bank for a loan of
$12,000, to tide them over until they receive payment for a rilly big job, for which payment will
be received in 90 days. The bank is going to charge 12% interest, and will demand a 10%
compensating balance.
(a) What is the annual effective percentage cost of the loan?
(b) Suppose that before taking this loan Rilly Dhumm was already required to keep a
minimum balance of $800 in their bank account, under the terms of an old loan
agreement. What would the annual effective percentage cost of the new loan be in this
case?
Example 5: Problem 22, page 278
Example 6: Spicer Corporation plans to borrow some funds for 6 months – they have not decided on the
exact amount yet. Northwest Bank will lend the money at ½% over prime. Prime is 5 ½%.
The bank requires a 20% compensating balance. Find the annual effective rate of interest.
Example 7: If you borrow $5 million for 9 months, calculate your annual effective rate of interest under
each of the following independent terms:
(a) $350,000 interest payable at the end of the loan period.
(b) $350,000 interest payable at the beginning of the loan period (discounted loan).
(c) 9% interest with a 10% compensating balance.
(d) 9% interest with a $50,000 lender’s fee, both payable at the end of the loan period.
(e) 9% interest with a compensating balance of $400,000.
(f) Discounted interest at a rate of 7.5%.
© Walt Burton 2015, updated by Barbara Nudd 2018
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