UNSECURED SOURCES OF SHORT TERM LOAN

2 MAJOR SOURCES: banks and sales of commercial

paper.
These are negotiated and result from action taken by the
firms financial manager. Bank loan are more popular
because they are available to firms of all sizes;
commercial paper tends to be available only to large
firms. International loans to finance international
transaction.
BANK LOANS- the major type of loan made by bank to
business is the short term, self-liquidating loan.
Short-term, self-liquidating loan an unsecured shortterm loan in which the use to which the borrowed money
is put provides the mechanism through which the loan is
repaid.
These loans are intended merely to carry the firm
through seasonal peaks in financing needs that are due
primarily to buildup of inventory and accounts receivable.

Generally, the increment above the prime rate will be

lower on a floating-rate loan than on a fixed-rate loan of
equivalent risk because the lender bears less risk with a
floating-rate loan. As a result of the volatile nature of the
prime rate during recent years, today most short-term
business loans are floating-rate loans.
Method of Computing Interest
If interest is paid at maturity, the effective (or true) annual
rate the actual rate of interest paidfor an assumed
1-year period is equal to

When interest is paid in advance, it is deducted from the

loan so that the borrower actually receives less money
than is requested (and less than they must repay).
Loans on which interest is paid in advance are called
discount loans. The effective annual rate for a discount
loan, assuming a 1-year period, is calculated as

interest
amount borrowesinterest .

Banks lend unsecured, short-term funds in three basic

ways: through single-payment notes, lines of credit, and
revolving credit agreements.
LOAN INTEREST RATE- interest rate can be fixed or
floating rate, typically based on the prime rate of interest.
The prime rate of interest (prime rate) is the lowest rate
of interest charged by leading banks on business loans
to their most important business borrowers.
Banks generally determine the rate to be charged to
various borrowers by adding a premium to the prime rate
to adjust it for the borrowers riskiness.

Wooster Company, a manufacturer of athletic apparel,

wants to borrow $10,000 at a stated annual rate of 10%
interest for 1 year. If the interest on the loan is paid at
maturity, the firm will pay $1,000 (0.10 $10,000) for the
use of the $10,000 for the year. At the end of the year,
Wooster will write a check to the lender for $11,000,
consisting of the $1,000 interest as well as the return of
the $10,000 principal. Substituting into Equation 16.3
reveals that the effective annual rate is therefore

1000
10000 =10%

Fixed-rate loan=A loan with a rate of interest that is

determined at a set increment above the prime rate and
remains unvarying until maturity.
Floating-rate loan the increment above the prime rate
is initially established, and the rate of interest is allowed
to float, or vary, above prime as the prime rate varies
until maturity.

If the money is borrowed at the same stated annual rate

for 1 year but interest is paid in advance, the firm still
pays $1,000 in interest, but it receives only $9,000
($10,000 $1,000). The effective annual rate in this case
is

Bank
A
(Fixedrate
note)
Prime
rate
Increment
Rate
charged
over the
90 days

Bank B (Floating-rate note)

1000
100001000 =11.1%

Single-payment note-A short-term, one-time loan made

to a borrower who needs funds for a specific purpose for
a short period.
6%

6%
1
1/2 %
7
1/2 %

interest
amount borrowed

1%
7% (initially)

The instrument is note. Signed by the borrower, that

states the terms of the loan, including the length of the
loan and interest rate. Maturity of 30 to 9 months or
more.
Example #1 (loan interest rates)
Gordon manufacturing, a producer of rotary mower
blades, recently borrowed $100,000 from each of 2

banks - bank A and B. The loans were incurred on the

same day, when the prime rate of interest was 6%. Each
loan involved a 90-day note

with interest to be paid at the end of 90 days. The

interest rate was set at 1 1/2% above the prime rate on
bank a's fixed-rate note. Bank B set the interest rate at
1% above the prime rate on its floating-rate note.
Bank A
Total Interest Cost = $100,000 [7 1/2% (90365)] =
$1,849
90-day rate = $1,849 $100,000 = 1.85%
Effective annual rate = (1 + 0.0185) ^4.06 - 1 = 1.0773 1 = 0.0773 = 7.73%
Bank B
For instance:
Prime rate

Interest rate
(computation)

Interest
Rate

First 30
days

6% + 1%
increment

7% (30/365)

0.575%

After 30
days

6.5 % (+ 1%
increment

7.5% (30/365)

After 30
days

6.25% (+ 1%
increment)

7.25% (30/365) 0.596%

Total
Interest
rate

0.616%

1.787%

Total interest cost = $100,000 1.787% = $1787

90-day rate = $1787 $100,000 = 1.79%
effective annual rate = (1 + 0.01787) ^4.06 - 1 = 1.0746 1 = 0.0746 = 7.46%
example (loan interest rates)
Megan Schwartz has been approved by Clinton national
bank for a 180-day loan of $30,000 that will allow her to
make the down payment and close the loan on her new
condo. She needs the funds to bridge the time until the
sale of her current condo, from which she expects to
receive $42,000.
Clinton national offered Megan the following two
financing options for the $30,000 loan: (1) a fixed rate
loan at 2% above the prime rate or (2) a variable rate
loan at 1% above the prime rate. Currently, the prime
rate of interest is 8% and the consensus forecast of the
group of mortgage economists for changes in the prime
rate over the next 180 days is as follows:

60 days from today the prime rate will rise by 1%

90 days from today the prime rate will rise another 1/2%
150 days from today the prime rate will drop by 1%
Fixed-rate Loan : Total Interest cost over 180 days
= $30,000 (0.08 + 0.02) (180/365)
= $30,000 0.04932
= $1,480
Variable-rate Loan : Total interest cost over 180 days
=$30,000 [(0.09 60/365) + (0.10 30/365) + (0.105
60/365) + (0.095 30/365)]
=$30,000 (0.01479+0.00822+0.01726+0.00781)
=$30,000 0.04808
=$1,442
LINE OF CREDIT- an agreement between a commercial
bank and a business specifying the amount of
unsecured short term borrowing the bank will make
available to the firm over a given period of time.
It is not a guaranteed loan but indicates that if the bank
has sufficient funds available, it will allow the borrower to
owe it up to a certain amount of money. The amount of a
line of credit is the maximum amount the firm can owe
the bank at any point in time.
Interest Rates- the interest rate on line of credit is
normally stated as a floating rate- the prime rate plus a
premium. The more creditworthy the borrower, the lower
the premium (interest increment) above prime, and vice
versa.
Operating-change restrictions Contractual restrictions
that a bank may impose on a firms financial condition or
operations as part of a line-of- credit agreement.
Compensating Balances To ensure that the borrower
will be a good customer, many short-term unsecured
bank loanssingle-payment notes and lines of credit
require the borrower to maintain, in a checking account,
a
Compensating balance equal to a certain percentage of
the amount borrowed.
Revolving Credit Agreements-is nothing more than a
guaranteed line of credit.
The commercial bank assures the borrower that
specified amount of funds will be made available
regardless of the scarcity of money.
A commitment fee is a banking term used to describe
a fee charged by a lender to a borrower to compensate
the lender for its commitment to lend. Commitment fees
are typically associated with unused credit lines or
undisbursed loans.
-Normally it is .5% of the average unused portion of the
credit line.

Commercial paper is a form of financing that

consists of short-term, unsecured promissory notes
issued by firms with a high credit standing. Generally,
only large firms of unquestionable financial soundness
are able to issue commercial paper. Most commercial
paper issues have maturities ranging from 3 to 270 days.
Interest on commercial paper is sold at discount from
its par, or face, value. The size of the discount and
length of time to maturity determine the interest paid by
the issuer of commercial paper.
Example:
Bertram Corporation, a large shipbuilder, has just issued
$1 million worth of commercial paper that has a 90-day
maturity and sells for $990,000. At the end of 90 days,
the purchaser of this paper will receive $1 million for its
$990,000 investment. The interest paid on the financing
is therefore $10,000 on a principal of $990,000. The
effective 90-day rate on the paper is 1.01%
($10,000/$990,000). Assuming that the paper is rolled
over each 90-days throughout the year (that is 365/90 =
4.06 times per year), the effective annual rate for
Bertrams commercial paper is 4.16% [(1+0.0101)4.06-

1].
INTERNATIONAL LOAN/ TRANSACTION- the
important difference between international and domestic

transactions is that payments are often made or received

in a foreign currency. Not only must a U.S. company pay
the costs of doing business in the foreign exchange
market, but it also is exposed to exchange rate risk.
Although exchange rate risk can often be hedged by
using currency forward, futures, or options markets,
doing so is costly and is not possible for all foreign
currencies.
Typical international transactions are large in size and
have long maturity dates. Therefore, companies that are
involved in international trade generally have to finance
larger dollar amounts for longer time periods than
companies that operate domestically.
Financing International Trade=Perhaps the most
important financing vehicle is the letter of credit, a letter
written by a companys bank to the companys foreign
supplier, stating that the bank guarantees payment of an
invoiced amount if all the underlying agreements are
met. The Eurocurrency loan markets allow creditworthy
borrowers to obtain financing on attractive terms.
Transactions between Subsidiaries-the parent can
minimize foreign exchange fees and other transaction
costs by netting what affiliates owe each other and
paying only the net amount due, rather than having both
subsidiaries pay each other the gross amounts due.