SHORT TERM CREDIT FOR FINANCING CURRENT

ASSETS
Short-Term Funds
-

Defined as those that are due and payable within a year.

Factors in selecting a source of short-term funds:

1. The effective cost of credit
2. The availability of credit in the amount needed and for the period of time when financing
is required
3. The influence of the use of a particular credit source on the cost and availability of other
sources of financing
4. Any additional covenants of the loans that are unique to the sources mentioned
previously

Estimating Cost of Short-term credit

1. Cost of trade Credit

Nominal Annual Cost ( ANC )=

Discount Period
360 days
x
100Discount Period Days credit is outstandingDiscount Period

Illustrative Problem:
Calculate the nominal annual cost of non-free trade credit under each of the following
items:
1. 2/10, n/60
2. 1/15, n/20
Answer:

1.
2.

ANC =

2
360
x
100 2 6010

= 14.69%

ANC =

1
360
x
100 1 2015

= 72.7%

3. Cost of Bank Loan

a.
b.
c.
d.
e.

Simple interest
Discount Interest
Add-on Interest
Simple Interest with Compensating Balances
Discount Interest with Compensating Balances

o Simple Interest
In a single interest loan, the borrower receives the face value of the loan and
repays the principal and interest at maturity date.
Formula to compute the effective interest rate:
Effective interest ratesimple =

Interest
Face ValueInterest

Example:
Compute the effective annual rate for a one-year loan of P100,000 at 12% annual
interest per year payable at maturity.
Effective interest ratesimple =

Interest
Face ValueInterest

Php .12,000
Php .100,000

12
On a simple interest loan of 1 year or more, the nominal rate equals the effective rate. If
the loan had a term of less than a year, say 90 days, the effective annual rate would be
calculated as follows:
Eff. annual Rate (simple) =

1 4
1+12
1
4

4
= ( 1.03 ) 1

= 12.56%

o Discount Interest
In a discount interest loan, the bank deducts the interest in advance or discounts
the loan. Formula to compute the effective annual rate is
Interest
Amount Received

Eff. Annual ratediscount =

Example:

On a one-year Php 100,000 loan with a 12% (nominal) rate, discount basis, the
effective interest rate is:
Php 12,000
=13.64
Php 100,000Php 12,000
If the discount loan is for a period of less than 1 year, say 90 days, its effective
annual interest rate is found as follows:

Effective annualrate= 1+

12,000 4
1
88,000

( 1+ 0.136 )4 1
66.75
o Add-On Interest
Add-on interest is interest that is calculated and added to funds received to
determine the face amount of an installment loan:
Formula
1.

( Total No. of Payments+1 ) x Principal

2 x Annual No .of Payments x Interest

Approximate annualrateadd on=

2. The effective annual rate may be computed using the procedure in getting
internal rate of return or effective yield.
To illustrate: Determine the effective interest rate on a Php100,000 loan on a add-on basis
at a nominal rate of 12% payable in 12 monthly installments.
1. The approximate annual interest rate is computed as follows:

2 x 12 x 12,000
( 12+1 ) x 100,000

288,000
1,300,000

22.15

2. Effective annual interest rate is obtained as follows:

100,000+12,000
Monthly payment =
12
9,333.33
100,000=9,333.33 x F

F=10.71429
Using the PV of an annuity of P1 table, n = 12, the effective interest rate will fall between 1 to 2
% per period.
To compute for the exact rate, interpolation may be used:
x1 )
( 11.255110.71429
11.255110.5753

Effective Interest Rate per Period=1 +

x1 )
( 0.54081
0.6798

1.795
12

Effective annualinterest rate=( 1+0.01795 ) 1

23.8

o Simple Interest with Compensating Balance

Compensating balance is the minimum account balance that a lending bank

requires the borrower to maintain. Its effect is to raise the effective rate on a loan
because the net withdrawable amount is reduced.
Effective annualrate simple =
CB

Interest
Face ValueCompensating balance

OR
Nominal rate( )
Effective annualrate simple =
1.0Compensating balance ( )
CB
To illustrate, assume that the bank offers to lend the company Php100,000 for 1
year at a 12% simple rate but the company must maintain a compensating balance
equal to 10% of the loan amount. What is the effective annual rate of the loan?
The effective annual interest rate is computed as follows:
Php 12,000
=13.33
Php 100,000Php 10,000
12
=13.33
100 10

OR

o Discount interest with compensating balance

The formula to compute for the effective annual rate if the loan is on a discount
basis is:
Interest
Face valueInterest Compensating balance
OR
Nominal rate()
1.0Nominal Interest RateCompensating balance rate
Illustration:
Assume the same data as in number 4 except, that the loan is a discount loan.
What is the effective annual rate of the loan?
The effective annual interest rate is computed as follows:
Php .12,000
=15.38
Php . 100,000Php 12,000Php .10,000
OR

12
=15.38
100 10 12

Cost of Commercial Paper

To calculate the effective cost of credit, through the issuance of commercial paper, the following formula
may be used:

Days
1
Interest + Issue Costs
maturity
Effective annualrate discount =
x

Face Value of the NotesInterestIssue Costs 360 Days

Example:
The Choeneqck Company uses commercial paper regularly to support its needs for short-term financing.
The firm plans to sell Php. 100 Million in 270-day-maturity paper on which it expects to have to pay
discounted interest at an annual rate of 12 percent per annum. In addition, Choeneqck expects to incur a
cost of approximately Php100,000 in dealer placement fees and other expenses of issuing the paper. What
is the effective cost of credit of Choeneqck?
Solution:
The effective annual cost to Choeneqck can be calculated as follows:

Rate=

Php 9,000,000 + Php .100,000

1
x
Php 100 MillionPhp 100,000Php .9 Million 270
360

13.35

Interest=Php 100 Million x 12 x

Php9 Million

270
360