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Secret Bank Loans

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Secret Bank Loans Summary

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Author: Dewey Oates
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Estimates Of Equations For Bank Loans And Trade Credit

L Short-term bank loans of maturity under a year. proposition 4 on page 77 considered the interrelationships of cash, securities, and short-term bank loans, and net receivables, inventories, and unanticipated receipts. One set of equations that could be used to analyze these relationships is These three equations do not allow us to explore the relationships among securities, cash, and bank loans. We could, it is true, specify a system of equations that would let us take account of the interrelationships among them. A simpler approach which answers our questions about C, S, and L is to use the method of canonical correlation. We define the variable q where qi & ACt + S2 ASt + & ALt, and where the 's are weights, and the variable r where rt by AIt + b2 A(R - D)t + 3 A(P - N) t, and the b's are weights. The canonical weights are those values of the jS's and Vs which maximize (or give the canonical) correlation between q and r.2fi We expect that the canonical weights of inventories,...

Long Term Syndicated Bank Loans

Most bank loans are for less than a year. They serve as a short-term bridge for the acquisition of inventory and are typically self-liquidating that is, when the firm sells the inventory, the cash is used to repay the bank loan. We talk about the need for short-term bank loans in the next section of the text. Now we focus on long-term bank loans. First, we introduce the concept of commitment. Most bank loans are made with a commitment to a firm. That commitment establishes a line of credit and allows the firm to borrow up to a predetermined limit. Most commitments are in the form of a revolving credit commitment (i.e., a revolver) with a fixed term of up to three years or more. Revolving credit commitments are drawn or undrawn depending on whether the firm has a current need for the funds.

Attracting Investors in the Bank Loan Market

In addition to some of the factors mentioned above, there are two reasons why investors are attracted to the bank loan market. First, bank loans generally have a more senior position within the capital structure of a borrowing corporation. This higher priority of claim on assets affords investors greater protection than high-yield bonds. A recent study by Fitch found that over the period 1997-2000, bank loans had significantly greater recovery rates than high-yield bonds. Bank loans recovered on average 73 of par value while senior unsecured bonds recovered only 35 of par value and subordinated bonds recovered only 17 of par value.' These recovery rates are consistent with a study by Moody's Investor services that found that senior secured bank loans recovered 70.26 of their par value while senior unsecured A second reason for bank loan popularity is that they are less volatile investments. The reason is that bank loans typically have floating coupon rates 7 See Steven O'Shea, Sharon...

The Cost of Bank Loans

Bank loans often extend for several years. Interest payments on these loans are sometimes fixed for the term of the loan but more commonly they are adjusted up or down as the general level of interest rates changes. The interest rate on bank loans of less than a year is almost invariably fixed for the term of the loan. However, you need to be careful when comparing rates on these shorter term bank loans, for the rates may be calculated in different ways. The interest rate on bank loans frequently is quoted as simple interest. For example, if the bank quotes an annual rate of 12 percent on a simple interest loan of 100,000 for 1 month, then at the end of the month you would need to repay 100,000 plus 1 month's interest. This interest is calculated as Unfortunately the NSC's paramilitary outfit cost millions of dollars to run far more than it earned in revenue. Friedrich bridged the gap by borrowing A236 million of debt. The banks were happy to lend because the NSC's debt appeared well...

Bank Loans

Although bank loans remain a major part of the total amount of debt that firms take on, the volume of bank financing has shrunk drastically since the 1960s when loans, along with bonds, made up about half of the corporate debt outstanding Today, bank loans account for about 20 percent of the debt outstanding. Major corporations with good credit ratings have found that commercial paper, a short-term debt security, and nonbank loans from syndicates of wealthy private investors and institutions, such as insurance companies, are less expensive than bank debt as a way to raise funds. Types of Bank Loans Exhibit 2.1 shows the two general types of bank loans lines of credit and loan commitments. Harman, described in the opening vignette, now has a type of loan commitment known as a revolver. To understand the terms of a bank loan you need to have a thorough understanding of the floating interest rates that are generally used for these loans. We turn to this topic next. 2Many features of bank...

Leveraged Bank Loans

The leveraged loan market is typically defined as bank loans that are made to companies that have a credit rating below investment grade, or loans that are priced at LIBOR + 150 basis points or more. Similar to high-yield bonds, bank loans are subject to the risk that the borrower will pay down the loan faster than expected or refinance the loan (call risk) as well as the risk of default, downgrade, and increased credit spread. The corporate bank loan market typically consists of syndicated loans to large and mid-sized corporations. They are floating-rate instruments, often priced in relation to LIBOR. Corporate loans may be either revolving credits (known as revolvers) that are legally committed lines of credit, or term loans that are fully funded commitments with fixed amortization schedules. Term loans tend to be concentrated in the lower credit rated corporations because revolvers usually serve as backstops for commercial paper programs of fiscally sound companies. Term bank loans...

Public and Private Sources of Capital

Private capital comes either in the form of bank loans or as what are known as private placements, which are financial claims exempted from the registration requirements that apply to securities. To qualify for this private placement exemption, the issue must be restricted to a small group of sophisticated investors fewer than 35 in number with minimum income or wealth requirements. Typically, these sophisticated investors include insurance companies and pension funds as well as wealthy individuals. They also include venture capital firms, as noted in Exhibit 1.1.

The Plan Of This Book

The rates of interest here reported are sometimes derived from marketable securities, such as bonds, notes, and treasury bills, and sometimes from nonmarketable loans, such as personal loans, bank loans, mortgages, and deposits. Each type is classified separately. No bourse type of market is reported for any form of credit instruments before medieval times. It is probable that an active exchange of obligations did take place in ancient Athens and Rome, but no quotations have come down to us. The history of the modern money market began in twelfth-century Italy.

Using Financial Statements

Pat was applying for a bank loan to start her new business, Nutrivite, a retail store selling nutritional supplements, vitamins, and herbal remedies. She described her concept to Kim, a loan officer at the bank. Bank loan The left side shows Nutrivite's investment in assets. It classifies the assets into current (which means turning into cash in a year or less) and noncurrent (not turning into cash within a year). The right side shows how the assets are to be financed partly by the bank loan and partly by your equity as the owner. Pat Now I see why it's called a balance sheet. The money invested in assets must equal the financing available its like the two sides of a coin. Also, I see why the assets and liabilities are classified as current and noncur-rent the bank wants to see if the assets turning into cash in a year or less will provide enough cash to repay the one-year bank loan. Well, in a year there should be cash of 104,000. That's enough cash to pay off more than twice the...

Working Capital Management and Short Term Planning

Short-term financial decisions generally involve short-lived assets and liabilities, and usually they are easily reversed. Compare, for example, a 60-day bank loan for 50 million with a 50 million issue of 20-year bonds. The bank loan is clearly a short-term decision. The firm can repay it 2 months later and be right back where it started. A firm might conceivably issue a 20-year bond in January and retire it in March, but it would be extremely inconvenient and expensive to do so. In practice, such a bond issue is a long-term decision, not only because of the bond's 20-year maturity, but because the decision to issue it cannot be reversed on short notice. A financial manager responsible for short-term financial decisions does not have to look far into the future. The decision to take the 60-day bank loan could properly be based on cash-flow forecasts for the next few months only. The bond issue decision will normally reflect forecast cash requirements 5, 10, or more years into the...

Expanding global money capital

IMF estimates that in 2005 the total value of the stocks, bonds, and bank loans worldwide was about US 165 trillion. The global bond (debt) market's share was close to US 104 trillion - by far the largest component of the global capital markets - accounting for over 63 of the total banking credit in 2008 amounted to about US 23 trillion. In 2005, cross-border money flows (stocks, bonds, real estate, and so on) amounted to about US 6 trillion. The foreign exchange markets have also undergone a phenomenal increase, with about US 3 trillion being traded daily in 2007.

The Firm Structural Set up

To finance these assets, the firm can raise money from two sources. It can raise funds from investors or financial institutions by promising investors a fixed claim (interest payments) on the cash flows generated by the assets, with a limited or no role in the day-to-day running of the business. We categorize this type of financing to be debt. Alternatively, it can offer a residual claim on the cash flows (i.e., investors can get what is left over after the interest payments have been made) and a much greater role in the operation of the business. We term this equity. Note that these definitions are general enough to cover both private firms, where debt may take the form of bank loans, and equity is the owner's own money, as well as publicly traded companies, where the firm may issue bonds (to raise debt) and stock (to raise equity).

P113 Contracts Risk and Uses of Accounting Information

6 Sonny Beam established Solar Supply Corporation earlier in the current year. To obtain resources, he contributed 5,000 of his savings to the company, had the company borrow 8,000 from his mother, sold shares of company stock to friends totaling 10,000, and obtained a 25,000 bank loan. The company is obligated to buy out all investors and repay the two loans within 12 months of the business becoming profitable. Sonny located space in a nearby business park and leased it for monthly rent of 1,000 plus 1 of his company's sales. Several competing manufacturers tried to attract him as a distributor of their products. He signed an exclusive agreement with one that offered its products at 52 off their normal sales prices

P114 Using Information About Risk to Make Decisions

Obbs. 6 Nancy and Mauro are reviewing the information given below for different reasons. Nancy is a bank loan officer who has received a 2-year, 50,000 loan application from both firms. Mauro is an independently wealthy investor who is considering investing 50,000 in a company. The information below is just one part of a complete data set about the companies that both persons are reviewing. The data reveal the profit history of the two firms over the last seven years. The companies are very similar except for the way in which their profits vary over the years. (All dollar amounts are in thousands.)

Petrodollar recycling

Turkey was running a big current-account deficit with the help of foreign bank loans and deposits sent home by migrant workers in western Europe. To attract hard currency, the Turkish central bank had to pay well above the prevailing market interest rates for dollars and D-marks. As the Turkish government lurched from crisis to crisis - the invasion of Cyprus in July 1974, new elections in September and another long delay before the next coalition was formed - it had increasing difficulty attracting foreign currency loans.

The Financing Principle

Every business, no matter how large and complex it is, is ultimately funded with a mix of borrowed money (debt) and owner's funds (equity). With a publicly trade firm, debt may take the form of bonds and equity is usually common stock. In a private business, debt is more likely to be bank loans and an owner's savings represent equity. While we consider the existing mix of debt and equity and its implications for the minimum acceptable hurdle rate as part of the investment principle, we throw open the question of whether the existing mix is the right one in the financing principle section. While there might be regulatory and other real world constraints on the financing mix that a business can use, there is ample room for flexibility within these constraints. We begin this section in chapter 7, by looking at the range of choices that exist for both private businesses and publicly traded firms between debt and equity. We then turn to the

Summary And Analysis Of Ancient Interest Rates

Up to recently in the United States many types of interest rates fluctuated very sluggishly. A 6 tradition lasted for at least two centuries. Usury limits generally lasted unchanged until the 1960's. The rates on bank loans charged by banks far removed from money market centers and from Big Business were relatively stable for long periods. Personal small loan rates rarely changed except with legislation.

Reserves and related items group E

Reserve assets are government-owned assets. They include monetary gold, convertible foreign currencies, deposits, and securities. For most countries, the principal convertible currencies are the US dollar, the British pound, the euro, and the Japanese yen. Credit and loans from the IMF are usually denominated in special drawing rights. Special drawing rights (SDRs), sometimes called paper gold, are rights to draw on the IMF. SDRs can be used as means of international payment. Exceptional financing is financing mobilized by a country's monetary authorities that is not regarded as official reserves. Examples of this account include postponing the repayment of foreign-currency debt and drawing on private bank loans to finance transactions that would otherwise deplete the country's reserve assets.

And Financial Environments

Money markets serve the short-term liquidity needs of investors. The usual line of demarkation is one year money markets include instruments with maturities of less than a year while capital markets involve securities with maturities of more than one year. However, both markets are financial markets with the same economic purpose so the distinction of maturity is somewhat arbitrary. Money markets involve instruments that are impersonal funds flow on the basis of risk and return. A bank loan, for example, is not a money-market instrument even though it might be short term. 22. The major sources are bank loans, bond issues, mortgage debt, and stock issues.

Points To Remember About Financial Statements

Every transaction is an exchange, and both sides of each transaction are recorded. For example, when a company obtains a bank loan, there is an increase in the asset cash that is matched by an increase in a liability entitled Bank Loan. When the loan is repaid, there is a decrease in cash which is matched by a decrease in the Bank Loan liability. After every transaction, the balance sheet stays in balance.

Commercial Bank Services

Corporate financing involves two components. First is the procuring of funds for a bank's customers. This can go beyond traditional bank loans to involve the underwriting of securities. As we shall explain later, legislation in the form of the Glass-Steagall Act at one time limited bank activities in this area. In assisting customers in obtaining funds, banks also provide bankers acceptances, letters of credit, and other types of guarantees for their customers. That is, if a customer has borrowed funds backed by a letter of credit or other guarantee, its lenders can look to the customer's bank to fulfill the obligation. The second area of corporate financing involves advice on such matters as strategies for obtaining funds, corporate restructuring, divestitures, and acquisitions.

Summary and Conclusions

This chapter has provided an introduction to the various sources of debt financing bank loans, leases, commercial paper, and debt securities. A large variety of debt financing is available. In addition, there are many ways to categorize debt instruments by their covenants, options, cash flow pattern, pricing, maturity, and rating.

The Role Of The Financial Manager

To carry on business, corporations need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices others are intangible, such as technical expertise, trademarks, and patents. All of them need to be paid for. To obtain the necessary money, the corporation sells claims on its real assets and on the cash those assets will generate. These claims are called financial assets or securities. For example, if the company borrows money from the bank, the bank gets a written promise that the money will be repaid with interest. Thus the bank trades cash for a financial asset. Financial assets include not only bank loans but also shares of stock, bonds, and a dizzying variety of specialized securities.5 The financial markets in which the firm raises money are likewise international. The stockholders of large corporations are scattered around the globe. Shares are traded around the clock in New York, London, Tokyo, and other financial...

The Basic Accounting Equation

Two aspects of the definition of liabilities need elaboration. First, as with assets, the term probable is used. This is an important part of the definition. Although in some instances, the existence of a liability is virtually certain (as when one arises from obtaining a bank loan), other situations are less clear. For example, consider a firm that has been sued. At the inception of the suit, the outcome may be highly uncertain, but as the litigation proceeds, it may seem more likely (but not certain) that the firm will be forced to pay some amount. Accountants need to exercise judgment in determining the existence of a liability. They do so by assessing whether a potential future sacrifice is probable.

From Danwei to the Modern Enterprise System

The focus during this first period of reforms starting in 1978 was on reintroducing markets and incentives within the domain of direct state ownership and control. Market forces started to operate alongside plans and administrative orders through a dual pricing system. In addition, the government allowed new structures such as collectives and private enterprises to develop and compete with state enterprises. Various types of performance contracts created a link between market success and compensation. Some rudimentary forms of penalties associated with failing the market test began to emerge bank loans started to replace budget grants, a bankruptcy system was established for SOEs, and for the first time enterprises could fire workers.

Standard financial analysis plan

Let us analyse this sentence in more depth. A company will be able to remain viable and ultimately survive only if it manages to find customers ready to buy its goods or services in the long term at a price that enables it to post a sufficient operating profit. This forms the base for everything else. Consequently, it is important to look first at the structure of the company's earnings. But the company needs to make capital expenditures to start operations acquire equipment, buildings, patents, subsidiaries, etc. (which are fixed assets) and set aside amounts to cover working capital. Fixed assets and working capital jointly form its capital employed. Naturally, these outlays will have to be financed either through equity or bank loans and other borrowings.

Safety and performance

Most businesses initially and often throughout their entire existence confine their financial strategy to bank loans, either long-term or short-term, viewing the other financing methods as either too complex or too risky. In many respects the reverse is true. Almost every finance source other than banks will to a greater or lesser extent share some of the risks of doing business with the recipient of the funds.

Past Transactions and Other Economic Events

Creditors The lending decision involves two issues whether or not credit should be extended, and the specification of a loan's terms. For example, consider a bank loan officer evaluating a loan application. The officer must make decisions about the amount of the loan (if any), interest rate, payment schedule, and collateral. Because repayment of the loan and interest will rest on the applicant's ability to generate cash, lenders need to estimate a firm's future cash flows and the uncertainty surrounding those flows. Although investors generally take a long-term view of a firm's cash generating ability, creditors are concerned about this ability only during the loan period.

Summary Restructuring Yields High Value Increase Potential Companies Simply Have to Go After It

The survey revealed that restructuring processes offer very high value increase potentials, which are attractive for return-driven investors in Germany also. If companies can convince investors that they can and will realize these value gains, they will be in a position to procure new equity capital as an alternative to conventional bank loans, even in times of crisis. For enterprises battling liquidity problems this type of outside capital sourcing is particularly advantageous, given that their liquidity is not further compromised by interest and repayments. the outside capital of crisis-ridden corporations.14 Nevertheless, given that the volume of corporate bonds does play a comparatively minor role in Germany and the transfer of bank loans is not easily possible, it is safe to assume that a far greater percentage of these investments will flow into the equity capital of companies in crisis. Newer loan contracts do, however, allow banks the option to resell their credit commitments....

P32 Ethics and Accounting Measurement

Obb. 1 Hardy Rock is proprietor of a jewelry store. In January, he applied for a bank loan and was asked to submit an income statement for the past year, ending in December. Near the end of the prior year, Hardy had purchased merchandise for resale that cost him 60,000. He still owed 45,000 for this merchandise at year end. Half of the merchandise was sold during the Christmas holidays for 75,000. Customers owed Hardy 50,000 for these purchases at year end. Hardy included these transactions as part of his financial statements as follows

Development Obstacles Imposed by Unwarranted Prudential Regulation

Supervision and regulation have important implications for the effectiveness of intermediation and access to financial services, in addition to their roles in fostering stability. Entry regulation and uneven supervisory practices across different groups of financial institutions (either by type or ownership) can hamper competitiveness and, thus, effectiveness. Different regulatory and supervisory standards across different financial institutions that offer similar products and compete directly with each other can negatively affect competitiveness. Heavy regulation of branch openings (as already mentioned) or other delivery channels can limit access to financial services. For example, prudential policies should avoid undue reliance on tools that are likely to disadvantage small and new firms (such as excessive mandatory collateralization requirements for bank loans). Supervision and regulation also impose transaction costs on financial institutions and, ultimately, on the users. The...

Bank And Market Centered Governance

In the 1990s, as the Japanese economy collapsed, the pendulum swung the other way.6 Kang and Stulz (1998) show that, far from being the promoters of rational investment, Japanese banks perpetrate soft budget constraints, over-lending to declining firms that require radical reorganization. And according to Weinstein and Yafeh (1998) and Morck and Nakamura (1999), Japanese banks, instead of facilitating governance, collude with enterprise managers to deter external threats to their control and to collect rents on bank loans. In the recent assessments by Edwards and Fischer (1994) and Hellwig (1999), German banks are likewise downgraded to ineffective providers of governance. Market-based systems, in contrast, rode the American stock market bubble of the 1990s into the stratosphere of wide support and adulation.

The relationship between banks and companies

Commercial banking is an extremely competitive activity. After taking into account the cost of risk, profit margins are very thin. Bank loans are somewhat standard products, so it is relatively easy for customers to play one bank off against another to obtain more favourable terms.

Banking Issues in the 21st Century

Rybczynski (1997) argued that financial systems evolve through time, passing through three phases. Phase one is bank oriented, where most external finance is raised through bank loans, which in turn is funded through savings. Banks are the most important financial intermediaries in the financial system, and interest income is the main source of revenue. Phase two is market oriented. Households and institutional investors begin to hold more securities and equity, and non-bank financial institutions may offer near-bank products, such as money market accounts. Banks themselves reduce their dependence on the traditional intermediary function, increasing their off-balance sheet activities, including proprietary trading, underwriting and asset management. The market or securitised phase is established when the financial markets are the source of external finance for both the financial and non-financial sectors. Corporate bank loans are largely replaced by corporate bonds and commercial...

Distressed Capital The Future of Corporate Financing in Germany

Financial investors in Germany have been operating in the German market as distressed capital investors for several years. They offer companies an alternative form of corporate financing. What does distressed capital mean Distressed capital refers to all purchases of titles in and claims to distressed companies. Private equity companies specializing in distressed companies buy company equity. In contrast, distressed debt investors generally purchase loans, bonds or uncertificated claims. In this case, distressed debt refers to non-performing bank loans - corporate or real estate loans - extended to customers. According to various analyses, the German market potential for distressed debt is estimated at EUR 100-320 billion. In 2003, the transaction volume amounted to EUR 3 billion. In 2005, a volume of EUR 20 billion is expected. However, these volumes generated by past transactions were mainly the result of portfolio trades. Portfolio trades are sales of entire portfolios of...

Constraints to the Exercise of Governance by Creditor Banks In the

Even in transformed small and medium enterprises, ownership transfer often occurs in ways that impede enterprises' access to bank loans and other forms of financing in the future, thereby limiting the role banks and other financiers can play in the corporate governance of these enterprises. For instance, the valuation process often excludes land use rights or severely undervalues them so that insiders can acquire controlling stakes more easily. This reduces the borrowing capacity of transformed enterprises. Preferential treatment of insiders in the form of huge discounts on the purchase price of shares or deferred payments for shares might make attracting outside investors more difficult in the future. This could affect enterprises' long-term prospects, and the state is likely to continue to perform some of the monitoring functions that banks and outside investors would normally do. In this context addressing deficiencies in the credit security and insolvency regime becomes especially...

Openness and Transparency as Success Factors

In this environment it was no wonder that German and French companies hesitated to expose themselves too much to the ''rude'' global capital markets. Also, the private investor preferred to put money in a bank's savings accounts with low interest yields rather than risky corporate stocks. On the other hand, it was nearly impossible for start-up companies to raise venture capital banks were not willing to finance these new businesses with bank loans. The consequence was that the German and French economies,

Collateralised Mortgage Obligations

Other CDOs include collateralised bond obligations (CBOs), consisting of collateralised bonds and collateralised loan obligations (CLOs), which involve collateralised pools of corporate loans or other credit facilities. After being pooled and turned into a security, they are split into different investment classes or security tranches. The bank loans used as collateral for CLOs are typically at investment grade level, whereas the CBOs are usually a mix of investment grade and sub-investment grade, but collateralised by higher yielding securities. CLOs originated in the 1990s and consist of a pool of investment grade revolving term loans, standby letters of credit and even derivatives. Unlike the original ABS MBS, the components of the pool can be quite diversified, and the originator remains the owner of the underlying portfolio.

Interpreting Cash Flow Statement

Cash flow from operating activities Cash flow from investing activities Purchase of Musicbox, Ltd. Purchase of property and equipment Total from investing activities Cash flow from financing activities Proceeds from issuance of stock Proceeds from short-term bank loans Payment of dividends Total from financing activities

Legal and Contractual Requirements

Some organizations are required to budget. Local police departments, for example, cannot ignore budgeting even if it seems too much trouble, and the National Park Service would soon be out of funds if its management decided not to submit a budget this year. Some firms commit themselves to budgeting requirements when signing loan agreements or other operating agreements. For example, a bank may require a firm to submit an annual operating budget and monthly cash budgets throughout the life of a bank loan.

Estimate Cash Flows on an Incremental Basis

For example, in 1971 Lockheed sought a federal guarantee for a bank loan to continue development of the TriStar airplane. Lockheed and its supporters argued it would be foolish to abandon a project on which nearly 1 billion had already been spent. Some of Lockheed's critics countered that it would be equally foolish to continue with a project that offered no prospect of a satisfactory return on that 1 billion. Both groups were guilty of the sunk-cost fallacy the 1 billion was irrecoverable and, therefore, irrelevant.1

Lessons learned as of 2003

1 This case study is based on the prospectus for the project bonds, the offering memorandum for the syndicated bank loan, credit rating agency press releases, articles in the financial press, and interviews with Thomas E. Lake, then Vice President, Project Finance, Energy Natural Resources Infrastructure, Dresdner Kleinwort Benson, New York and D West Griffin, Vice President, Finance - Latin America, InterGen Energy.

Budgeted Statement of Cash Flows Indirect Method 4255

The statement of cash flows consists of three sections, net cash flows from operations, net cash flows from investing activities, and net cash flows from financing activities. Net cash flows from operations are equal to net income plus depreciation expense plus or minus changes in current assets (other than cash) and current liabilities (other than bank loans). Increases (decreases) in current assets are treated as cash outflows (inflows), and increases (decreases) in current liabilities are treated as cash inflows (outflows). Net cash flows from financing activities consist of changes in borrowed funds (short and long term), changes in other long-term liabilities, changes in common stock, and dividends paid. The only financing activities in this example are increases (decreases) in bank loans outstanding. The bank line of credit is the buffer that keeps assets equal to liabilities and stockholders' equity. As assets grow with increases in inventories and accounts receivable, bank...

Financial systems and the match with corporate governance

We mentioned in Chapter 1 that the first attempts to categorise financial and corporate governance systems had put the emphasis on finance, by distinguishing between bank-based and stock-exchange-based systems. All the systems we have categorised as insider-dominated - the stakeholder-capitalist, state-led capitalist and family-state capitalist categories - were alleged to be bank-based, presumably because they clearly were not stock exchange based. In fact banks and stock exchanges are not the only sources of finance (see Tables 3.12(a) and 3.12(b) later). The main sources of external finance can indeed be divided into 'stock exchange' equity shares and fixed-interest securities, and 'bank' bank loans and overdrafts. However, external equity finance going into most firms is not raised on the stock exchange, but from the personal resources of the managers, their families and friends (there is also private equity, as we shall see). Loans for many firms come from similar sources....

Scope And Method Of The Study

We will also be concerned with variations in the other current accounts of firms, and in particular with short-term bank loans and net receivables. Though some of our results relate to long-run behavior of large corporations, the study is oriented toward explaining short-run fluctuations in these accounts.

Interest With Compensating Balances

Bank loans often require the firm to maintain some amount of money on balance at the bank. This is called a compensating balance. For example, a firm might have to maintain a balance of 20 percent of the amount of the loan. In other words, if the firm borrows 100,000, it gets to use only 80,000, because 20,000 (20 percent of 100,000) must be left on deposit in the bank.

Financial systems the evidence

The aggregate data for the 1980s (Table 3.12(a), for seven of our economies, and Table 3.12(b) for nine of them) and the 1970s and 1980s (Table 3.12(c), for four of them) confirm some of the contrasts we have drawn. The US and the UK are more than 60 per cent dependent on retentions and shares in both periods, and have ratios of debt to total equity below 2, as does Switzerland. Two of the three 'stakeholder' economies, Sweden and Japan, were less than 50 per cent dependent on retentions and shares for net financing in the 1980s. Sweden and Japan both got more than 30 per cent of their net financing from bank loans, as did Japan in 1970-1989. Both had high debt equity ratios, Sweden's more than three times that of any of the shareholder economies. The big surprise is Germany. The German figures for the 1980s are less disaggregated than the others but they still indicate a striking deviation from the stakeholder pattern retentions plus shares contribute more than even in the US and UK....

Financial Leverage Ratios

If a company can achieve an after-tax return on investment of 25 percent on a project that will reach fruition in three years, whether the cost of the money needed for that project is 9.0 percent or 9.5 percent is not going to change the decision to invest in the project as long as the loan has a maturity of more than three years. If the financing is a one-year bank loan, the company will not have the cash to repay it and may be forced to cut back the project and reduce expenses at exactly the wrong time (if it is unable to refinance the loan). So, while the cost of funds is important, you should focus on the repayment schedule, as well.

O 116 Long Term Capital Flows to Developing Countries

Figure 11.5(a) shows that long-term capital flows to developing countries have declined since 1998, mainly due to the Asian financial crisis of 1997-8 and the recent slowdown of the global economy. New long-term flows totaled 261 billion in 2002, 83 billion below the peak in 1997. Sharp declines in private capital market flows in recent years - bank loans, bonds, and portfolio equity flows account for nearly all of this decline. As a result, the share of emerging markets in global capital market financing fell to 3 percent in 2002, compared to 6.4 percent in 1998 and 11 percent in 1997. Figure 11.5(b) shows that even foreign direct investment (FDI), which tends to be more resilient than capital market flows, has slowly but steadily declined since 1999.

International Banking Issues and Country Risk Analysis

Source of funds since the early 2000s. Bank loans, however, are still the dominant source of funds for most developing countries, because their capital markets are underdeveloped. Thus, international banks must reduce the impact of country risk through systematic assessment and management.

Inflationary Biases in Interest Costs

Most firms raise some of their capital by issuing fixed-income assets such as bonds and bank loans. This borrowing leverages the firm's assets since any profits above and beyond the debt service go to the stockholders. In an inflationary environment, nominal interest costs rise, even if real interest costs remain unchanged. But corporate profits are calculated by deducting nominal interest costs, which overstates the real interest costs to the firm. Hence, reported corporate profits are depressed compared to true economic profits.

Net Reduction in Long Term Debt

This item is not unlike the bank loans items in the way it flows through the report. Additional borrowings increase cash repayments reduce cash. The separate classification and different labels simply reflect the fact that long-term debt is shown on a different line on the balance sheet, so it is typically shown on a separate line in the statement of cash flow, to help the reader associate the two statements when reading the company's financial report. In this particular month, the company made a 1,000 payment on its long-term debt and did not borrow any more money in this category, so the net change is a reduction of 1,000. We can't be perfectly certain of this from the short format in our example, but logic tells us that a net change in cash of so small an amount was unlikely to include anything other than a monthly payment. A quick look at the balance sheets for this month and the month before (March 2003 in our example) would confirm our notion that no new debt was incurred.

The international debt crisis of the 1980s

Several developments in the 1970s turned banks into the predominant suppliers of funds to those developing countries that do not produce oil and to Eastern-bloc nations. First, there were growth and investment opportunities in these countries, because economies began to open and to rise in the second half of the 1960s. Second, the 1973-4 oil shock, when higher oil prices and the subsequent world recession skyrocketed the current-account deficit of the borrowing nations, accelerated bank loans to these countries. Third, many developing countries began to incur large balance-of-payments deficits during the early 1980s, because the worldwide recession of 1979-82 compelled industrial countries to reduce their imports from developing countries. Fourth, observers argue that capital flight, prompted by political and economic uncertainty, caused the debt crisis. The World Bank estimates that capital flight from Latin American debtor countries to industrial countries exceeded 70 billion...

The Asian Financial Crisis and the International Monetary Fund IMF

The IMF and the principal governments lent a total of 119 billion to Indonesia, Korea, and Thailand so that they could pay the interest on the existing bank loans or repay the principal. Extending new credit helped the Asian banks to avoid default, but money went to the foreign banks. International bank loans were in dollars, yen, and other hard currencies. Instead of taking large losses like the holders of currency, stocks, and bonds, the international banks collected their loans with relatively small losses. And in exchange for extending repayment, the banks collected fees for renegotiating the loans. They demanded government guarantees of the loans they made to banks, financial institutions, and private companies. Allen Metzer believes that this policy is the fourth mistake, because it may invite a larger financial crisis in the future.

Tranches as Hedging Vehicles

As discussed at the beginning of this chapter, bank loan managers and insurance companies can also use tranche hedges to optimize their return on regulatory capital. Under the current banking regulations, which do not link regulatory capital based on the riskiness of exposures (e.g., all corporate loans and bonds have an 8 percent risk charge irrespective of maturity and default probability), the incentive has been for banks to buy protection on low risk and low yield exposures. These are cheaper to hedge and offer the same capital relief as more risky exposures. However, the new regulatory framework (Basel II) is about to change this (see the last section of this chapter).

Introduction to Leveraged Buyouts

Leveraged buyouts are a way to take a company with publicly traded stock private, or a way to put a company in the hands of the current management (sometimes referred to management buyouts or MBOs). LBOs use the assets or cash flows of the company to secure debt financing either in bonds issued by the corporation or bank loans, to purchase the outstanding equity of the company. In either case, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

Short-term Planning. Paymore Products Places Orders For Goods Equal To 75 Percent Of Its Sales Forecast In The Next

Short-term financial planning is concerned with the management of the firm's short-term, or current, assets and liabilities. The most important current assets are cash, marketable securities, inventory, and accounts receivable. The most important current liabilities are bank loans and accounts payable. The difference between current assets and current liabilities is called net working capital. f. The firm issues 1 million of long-term debt and uses the proceeds to repay a short-term bank loan. 9. Compensating Balances. The stated bank loan rate is 8 percent, but the loan requires a compensating balance of 10 percent on which no interest is earned. What is the effective interest rate on the loan What happens to the effective rate if the compensating balance is doubled to 20 percent 11. Discount Loan. A discount bank loan has a quoted annual rate of 6 percent. 12. Compensating Balances. A bank loan has a quoted annual rate of 6 percent. However, the borrower must maintain a balance of...

Asian Companies Turn to Capital Markets for Funds

Traditionally, capital markets have been the main source of funds for US and British companies, while banks have been the main source of funds for Asian companies. However, Asia appears to be growing less dependent on bank loans for funding as companies have increasingly turned to the stock and bond markets to raise money. Primary figures for 1999, for example, suggest a decided shift in the way Asian companies and governments obtain financing in the wake of the Asian financial crisis. The volume of new bonds for Asia-Pacific issuers rose to 98.1 billion in 1999 as of December 16, 1999, from 70.9 billion in 1998. The 1999 total is much less than 1997's 111.5 billion, but surpassed for a second straight year the amount that Asian companies raised through syndicated bank loans. The big bond issues in 1999 from outside Japan included a 1 billion deal for Korea Development Bank, a 1 billion deal for Malaysia, and a 1.6 billion deal for Thailand's Ministry of Finance. Source. More Asian...

Theoretical Example Of A Leveraged Buyout

This company was purchased from RCA for 81 million with all but 1 million financed by bank loans and real estate leasebacks. When Gibson Greetings went public, the 50 equity interest owned by the LBO firm was worth about 140 million, equal to a compound annual rate of return of over 200 .

Germany how stakeholder structures developed

Much as in the United States, the German corporate governance system at the beginning of the twentieth century consisted of family capitalism supplemented, so to speak, by a small number of large firms that had expanded with the help of bank loans and or bank-sponsored share issues. As Jeidels (1905) showed, Germany's dual board system of corporate control, unique at that point, had been developed largely to give the big banks good arrangements for oversight. It was not until the 1970s that bank influence in German industry began to wane. The banks survived the Crash in good shape indeed this and other recessions rather tightened their grip, as insolvent firms conceded share stakes to them in return for loan forgiveness. But the balance between bank and family power was not a zero-sum game a family that wanted to maintain control of a fast-expanding firm might well prefer bank loans and even a bank share stake to exposure to the dangers of external equity capital via the stock...

Theory Of The Loan Offer Function

Robinson has emphasized the importance of avoiding default risks The arithmetic of lending and loan interest is impressive. The average rate of return on member bank loans in 1948 was 3.8 per cent. About two-thirds of this amount was absorbed in expenses leaving only slightly more than 1 per cent for losses on loans and profits for stock-holders. An average loss ratio of 1 2 of 1 per cent would have meant that the profit rate was halved it disappeared if average losses went to 1 per cent of outstanding loans. Robinson, op. cit., p. 102.

Dynamic Mattresss Shortterm Plan

Bank loan 10. Of bank loan Bank loan aFrom Table 19-7, bottom line. A negative cash requirement implies positive cash flow from operations. bThe interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start of the quarter. Thus the interest due in the second quarter is .02 x 40 million .8 million. cThe interest cost of the stretched payables is 5 percent of the amount of payment deferred. For example, in the third quarter, 5 percent of the 15.8 million stretched in the second quarter is about .8 million. aFrom Table 19-7, bottom line. A negative cash requirement implies positive cash flow from operations. bThe interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start of the quarter. Thus the interest due in the second quarter is .02 x 40 million .8 million. cThe interest cost of the stretched payables is 5 percent of the amount of payment deferred. For example, in the...

Japan how stakeholder understandings developed

As in Germany, the recovery depended heavily on bank lending, both by the ex-zaibatsu banks, mostly within their groups, and by the 'city banks', which lent mostly to small and medium enterprises in their areas.2 What was different was that there was no corporate governance structure through which banks could - or at any rate, did - exercise influence systematically (Hanazaki and Horiuchi 1999). Nonetheless, 'Japanese banks monitor more actively than other countries' (Corbett 1987 45) and this was the more true during the period of very high borrowing up to the 1970s. There would be a dramatic change if the borrowing firm got into difficulty. At that point the 'main' bank at least would start to act like a major shareholder. For the duration of the emergency, the bank would put in one of its employees as a (full-time) top manager of the firm - if the size of the firm, the size of the loan, or the 'social importance' of the firm was big enough to justify the trouble. It would then act...

Mezzanine Financing to Bridge a Gap in the Capital Structure

Mezzanine debt is used to fill the gap between senior debt represented by bank loans, mortgages and senior bonds, and equity. Consequently, mezzanine debt is junior, or subordinated, to the debt of the bank loans, and is typically the last component of debt to be retired.

Options For Shortterm Financing

With these two options, the short-term financing strategy is obvious use the lower cost bank loan first. Stretch payables only if you can't borrow enough from the bank. 2. Interest on bank loanb 5. Bank loan 10. Of bank loan aFrom Table 2.7, bottom line. A negative cash requirement implies positive cash flow from operations. b The interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start of the quarter. Thus the interest due in the second quarter is .02 x 40 million .8 million. c The interest cost of the stretched payables is 5 percent of the amount of payment deferred. For example, in the third quarter, 5 percent of the 15.8 million stretched in the second quarter is about .8 million. aFrom Table 2.7, bottom line. A negative cash requirement implies positive cash flow from operations. b The interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start of the quarter. Thus the interest due in...

Interpreting Financial Statements Long Term Liabilities

9-51 Hansel, Inc., is an international company specializing in debt collection with a range of complementary credit management services. It is headquartered in Amsterdam and aims to maintain and enhance its position as Europe's leading force in debt collection. Its 1999 financial statements list bank loans of 17,000,000 ( pounds sterling) with the following related note BANK LOANS

Integration of European Retail Banking Markets A Review of the Literature

A few works analyze financial convergence by using financial accounts data. For example, analyzing a long period from 1980 to 2000, Byrne and Davis (2002) find evidence of a-convergence, toward a more market-oriented financial system, for the balance sheet structures of UK, France, Germany, and Italy. Examining components of financial assets and liabilities in euro-area countries, Hartmann et al. (2003) find that the dispersion of currency, deposits, and loans increased between 1995 and 2001, while bond investment and financing became more uniform. Using flow of funds statistics of seven European countries, for the years 1972-1996, Murinde et al. (2004) find convergence of equity issues and internal firm finance but not of bank loans.

External Financing and Growth

By 1974 Grant's debt-equity ratio had reached 1.8. This figure was high, but not alarmingly so. The problem was that rapid expansion combined with recession had begun to eat into profits. Almost all the operating cash flows in 1974 were used to service the company's debt. Yet the company insisted on maintaining the dividend on its common stock. Effectively, it was borrowing to pay the dividend. By the next year, W.T. Grant could no longer service its mountain of debt and had to seek postponement of payments on a 600 million bank loan.

Vulture Investors and Hedge Fund Managers

Distressed debt investors are often referred to as vulture investors, or just vultures because they pick the bones of underperforming companies. They buy the debt of troubled companies including subordinated debt, junk bonds, bank loans, and obligations to suppliers. Their investment plan is to buy the distressed debt at a fraction of its face value and then seek improvement of the company.

Measuring Capital Structure

The figures shown in Table 11.1 are taken from Big Oil's annual accounts and are therefore book values. Sometimes the differences between book values and market values are negligible. For example, consider the 200 million that Big Oil owes the bank. The interest rate on bank loans is usually linked to the general level of interest rates. Thus if interest rates rise, the rate charged on Big Oil's loan also rises to maintain the loan's value. As long as Big Oil is reasonably sure to repay the loan, the loan is worth close to 200 million. Most financial managers most of the time are willing to accept the book value of bank debt as a fair approximation of its market value.

Distressed Debt and Bankruptcy

Classification of Claims Under the bankruptcy code, a reorganization plan may place a claim in a particular class only if such claim is substantially similar to the other claims in that class. For instance, all issues of subordinated debt by a company would constitute one class of creditors under a bankruptcy plan. Similarly, all secured bank loans (usually the most senior of creditor claims) are usually grouped together as one class of creditors. Finally, at the bottom of the pile is common equity, the last class of claimants in a bankruptcy. Absolute Priority A plan of reorganization must follow the rule of priority with respect to its security holders. Senior secured debtholders, typically bank loans, must be satisfied first. The company's bondholders come next. These may be split between senior and subordinated bondholders. The company's shareholders get whatever remains. As the company pie is split up it is usually the case that senior secured debt is made whole and that...

They do not affect project NPV

Unfortunately, managers often are influenced by sunk costs. For example, in 1971 Lockheed sought a federal guarantee for a bank loan to continue development of the Tristar airplane. Lockheed and its supporters argued that it would be foolish to abandon a project on which nearly 1 billion had already been spent. This was a poor argument, however, because the 1 billion was sunk. The relevant questions were how much more needed to be invested and whether the finished product warranted the incremental investment.

Risks of Distressed Debt Investing

As a consequence, Iridium could not meet the interest payments on 800 million of senior bank debt. Still, in May 1999, distressed debt investors jumped to buy Iridium's 14 subordinated notes for 26 cents on the dollar when it appeared that Iridium would be able to restructure its senior bank loans. However, the restructuring failed, and with over 3 billion in debt Iridium filed for Chapter 11 bankruptcy in August 1999.

Europe Without Germany

Just like in Germany, bank loans take rank two at 44 . Ranks 3 through 5 go to working capital measures and sale and leaseback. Capital market financing and shareholder loans are not included among the Top 5. In the medium-term, it is however safe to expect things to change, as is evident in Germany right now, given that the funding sources that are currently being utilized are limited, and the role of banks has begun to change radically throughout Europe. The changes caused by the provisions of Basel II and the currently still high risk positions at banks will further complicate the granting of outside capital financing by the banks. Alternative forms of financing, such as mezzanine capital will be utilized more extensively in the future. The increasing acquisition of companies by private

Step 2 Forecast the Income Statement

Forecast Interest Expense How should we forecast the interest charges The actual net interest expense is the sum of the firm's daily interest charges less its daily interest income, if any, from short-term investments. Most companies have a variety of different debt obligations with different fixed interest rates and or floating interest rates. For example, bonds issued in different years generally have different fixed rates, while most bank loans have rates that vary with interest rates in the economy. Given this situation, it is impossible to forecast the exact interest expense for the upcoming year, so we make two simplifying assumptions. As noted above, interest on bank loans is calculated daily, based on the amount of debt at the beginning of the day, while bond interest depends on the amount of bonds outstanding. If all of the debt remained constant all during the year, the correct balance to use when forecasting the annual interest expense would be the amount of debt at the...

Estimation Of The Loan Offer Function With Canonical Correlation

This section reports attempts to estimate a commercial bank loan offer function with canonical correlation.84 Substitution between terms of lending is explicitly considered when this technique is employed. One measure of the degree to which substitutability exists among terms of lending is the amount by which the canonical correlation exceeds the largest multiple correlation of the previous partial offer functions. Unfortunately, no probability statement can be made about whether the difference between these two correlations is significantly greater than zero.85

Ownership of the Corporation

These rights are split up and reallocated as soon as the company borrows money. If it takes out a bank loan, it enters into a contract with the bank promising to pay interest and eventually repay the principal. The bank gets a privileged, but limited, right to cash flows the residual cash-flow rights are left to the stockholder.

Late 19801989 A Financial Bubble Grows and Bursts

Banks and securities firms were enthusiastic supporters of zaitech behaviour. Some corporate loan business was being lost to the bond markets, but banks benefited from disintermediation through fee based ''commissioned'' underwriting. The rise in the stock market increased the value of their cross-shareholdings in keiretsu member firms. Lending patterns also changed. Hoshi and Kashyap (1999) report a dramatic increase in loans to small business and the real estate sector through the 1980s. The proportion of bank loans to property firms doubled between the early 1980s and early 1990s.

Project and Firm Duration

One of the most common choices firms face is whether to make the coupon rate on bonds (and the interest rate on bank loans) a fixed rate or a floating rate, pegged to an index rate such as the LIBOR. In making this decision, we once again examine the characteristics of the projects being financed with the debt. In particular, we argue that

Debt Comes in Many Forms

The financial manager is faced with an almost bewildering choice of debt securities. For example, look at Table 14.5, which shows the many ways that H.J. Heinz has borrowed money. Heinz has also entered into a number of other arrangements that are not shown on the balance sheet. For example, it has arranged lines of credit that allow it to take out further short-term bank loans. Also it has entered into a swap that converts its fixed-rate sterling notes into floating-rate debt. simply needs to finance a temporary increase in inventories ahead of the Christmas season, then it may make sense to take out a short-term bank loan. But suppose that the cash is needed to pay for expansion of an oil refinery. Refinery facilities can operate more or less continuously for 18Figure 14.3 does not include shorter-term debt such as bank loans. Almost all short-term debt issued by corporations is held by financial institutions. Bank loans Most bank loans and some bonds offer a variable, or floating,...

Strategies for Managing the Cash Conversion Cycle

Some firms establish a target cash conversion cycle and then monitor and manage the actual cash conversion cycle toward the targeted value. A positive cash conversion cycle, as we saw for MAX Company in the earlier example, means the firm must use negotiated liabilities (such as bank loans) to support its operating assets. Negotiated liabilities carry an explicit cost, so the firm benefits by minimizing their use in supporting operating assets. Simply stated, the goal is to minimize the length of the cash conversion cycle, which minimizes negotiated liabilities. This goal can be realized through use of the following strategies

Financial Statement Impact Earnings Per Share

10-70 Philip Morris was the founder and chairman of Lollipops, Inc. until his death in 1998. The company's performance had been sharply declining during the 1990s. Because Morris owned the majority of the shares in the company, he was very concerned about the resultant decline in the share prices and market value of Lollipops. To protect his investments, he secretly funneled 300,000,000 from other companies that he owned into purchases of additional Lollipops shares. These new shares were used by the other companies as collateral for bank loans, for financing the purchase of the shares, and for supporting the operations of the other companies. After his death, this series of stock purchases and bank loans was revealed in the financial press, and Lollipops' shares plummeted in value

Which Financing Policy Is Best

Most firms attempt to match the maturities of assets and liabilities. They finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent refinancing and is inherently risky because short-term interest rates are more volatile than longer-term rates.

Financial Institutions

Notice that banks promise their checking account customers instant access to their money and at the same time make long-term loans to companies and individuals. Since there is no marketplace in which bank loans are regularly bought and sold, most of the loans that banks make are illiquid. This mismatch between the liquidity of the bank's liabilities (the deposits) and most of its assets (the loans) is possible only because the number of depositors is sufficiently large so b. Interest on many bank loans is based on a_of interest.

Step 3 Forecast the Balance Sheet

Fifth, many firms use short-term bank loans, shown on the balance sheet as notes payable, as a financial shock absorber. When extra funding is needed, they draw down their lines of credit, thus increasing notes payable, until their short-term debt has risen to an unacceptably high level, at which point they arrange long-term financing. When they secure the long-term financing, they pay off some of their short-term debt to bring it down to an acceptable level. We will explain how to forecast the final level of notes payable shortly, but initially we assume that MicroDrive will simply maintain its current level of notes payable.

Examples of Private Equity Interval Funds

Initially, many interval funds were used for less liquid investments such as bank loans and other less marketable debt obligations. However, with the surge in private equity investing in the latter part of the 1990s, it was not long before the advantages of interval funds became apparent to private equity. In fact, many recent interval funds have been introduced for private equity investing. Consider the following examples.

Sources of Short Term Financing

Bank loans Most bank loans have durations of only a few months. For example, Dynamic may need a loan to cover a seasonal increase in inventories, and the loan is then repaid as the goods are sold. However, banks also make term loans, which last for several years. These term loans sometimes involve huge sums of money, and in this case they may be parceled out among a syndicate of banks. For example, when Eurotunnel needed to arrange more than 10 billion of borrowing to construct the tunnel between Britain and France, a syndicate of more than 200 international banks combined to provide the cash.

Unsecured Sources of Short Term Loans

Businesses obtain unsecured short-term loans from two major sources, banks and sales of commercial paper. Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are negotiated and result from actions taken by the firm's financial manager. Bank loans are more popular, because they are available to firms of all sizes commercial paper tends to be available only to large firms. In addition, firms can use international loans to finance international transactions.

Temporary Cash Surpluses

A firm such as Toys 51 Us may buy marketable securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course, bank loans are another short-term financing device. The use of bank loans and marketable securities to meet temporary financing needs is illustrated in Figure 20.6. In this case, the firm is following a compromise working capital policy in the sense we discussed in the previous chapter.

The Short Term Financial Plan

The most common way to finance a temporary cash deficit is to arrange a short-term unsecured bank loan. Firms that use short-term bank loans usually ask their bank for either a noncommitted or a committed line of credit. A noncommitted line is an informal arrangement that allows firms to borrow up to a previously specified limit without going through the normal paperwork. The interest rate on the line of credit is usually set equal to the bank's prime lending rate plus an additional percentage. Most of the time, banks will also require that compensating balances be kept at the bank by the firm. For example, a firm might be required to keep an amount equal to 5 percent on the line of credit.

Implications For Investors

Cash flow CDOs, which currently are the most prevalent CDO structures, rely on the cash flow generated from the pool of assets to service the issued debt. This chapter focuses on cash flow CDO income notes. A CDO is created when a special purpose vehicle (SPV) is established to acquire a pool of high yield corporate bonds, bank loans, or other debt obligations (see Exhibit 25.2). To fund the acquisition of the debt obligations, the SPV issues rated and unrated liabilities. Since the majority of the these liabilities are highly rated, the CDO can raise most of its capital cheaply in the investment-grade market and invest it more profitably in other markets including the high yield market.

Cash Flow Cdo Income Notes

CDO income notes are typically unrated and represent the most subordinated part of the CDO capital structure.1 These notes will receive the residual interest cash flow remaining after payment of fees, rated note holder coupon, and the satisfaction of any asset maintenance tests. Factors that will impact the residual interest cash flow include the level and timing of defaults, the level and timing of recoveries, and the movement of interest rates. Income notes returns are generated by capturing the spread differential between the yield on the pool of fixed income assets (the majority of which are high yield bonds and bank loans) and the lower borrowing cost of the investment-grade and the non-investment-grade debt issued by the SPV. This positive spread relationship can produce risk-adjusted returns to income note holders in the range of 15 to 20 .

Introduction to Credit Derivatives

Credit derivatives, therefore, appeal to financial managers who invest in high-yield bonds, bank loans, or other credit dependent assets. The possibility of default is a significant risk for asset managers, and one that can be effectively hedged by shifting the credit exposure. Before we can discuss credit derivatives we must first review the underlying risk which these new financial instruments transfer and hedge. We begin this chapter with a discussion of credit risk. We then review the credit risks inherent in three important financial markets high-yield bonds, leveraged bank loans, and sovereign debt. Each of these markets is especially attuned to the nature and amount of credit risk undertaken with each investment. Finally, we provide several examples of how credit derivatives may be used in these markets.

Traditional Methods of Managing Credit Risk

Credit risk has been traditionally managed by underwriting standards, diversification, and asset sales.1 Consider a bank that is analyzing a corporate client for a bank loan. The bank will first consider the company's financial position, its revenue growth, earnings potential, interest coverage, and operating leverage. Next the bank will consider the corporation's balance sheet, its ratio of debt to equity and short-term liabilities to long-term liabilities. Then the bank will review the industry in which the company operates. It will consider competitive pressures, consolidation, new products, and growth prospects. The bank will then set a limit on the amount it will loan and will consider the loan amount against the bank's total limit for the industry in which the company operates.

Forecasting Rather than Planning

Financial plan The generic label for any kind of estimate of the future in financial terms.As such, budgets, forecasts, and projections are all financial plans.Aside from the generic usage, this term is most often used in a long-term business plan to identify the financial effects of all the activities discussed in the plan. So, in Chapter 9 we referred to the dollars-and-cents representation of our long-range plan as a financial plan.The resulting definition an integrated, multiyear plan of income, expenses, cash flow, and balance sheet changes. Projection Estimate that is less detailed than a financial plan and usually covers a shorter period of time, typically prepared to demonstrate expected financial results over a few months or a year, perhaps for a special purpose such as a bank loan or to test the continuing validity of a budget or long-range plan. It may not include an integrated balance sheet, but it will almost always include a P& L projection or a cash flow projection,...

Exhibit 4 Ratio of Downgrades to Upgrades for Corporate Bonds

Credit risk is not all one sided, improved credit quality will lead to higher bond prices. For example, in 2000, 261 billion of corporate bonds were upgraded. In addition to credit upgrades, there are other events that have a positive impact on high-yield bonds. Mergers and acquisitions generally lead to either a credit upgrade as a weaker company is acquired by a stronger company, or the bonds are redeemed as part of a change of control provision in the bond indenture. For example, in 2000, Standard & Poor's found that mergers and acquisitions had a positive effect on credit ratings with the ratio of upgrades to downgrades as a result of M& A activity equal to 1.17 to 1.5 Last, as the leveraged loan market has grown, companies have found it advantageous to redeem outstanding high-yield bonds and replace them with cheaper bank loans. Bond redemptions also provide a positive credit event for high-yield bondholders.

The financial handicaps of the private sector

Individuals with more than eight employees in pursuing profit-oriented business (siying qiye). Private businesses remained restricted mainly to service and low-tech, labour intensive industries such as retailing, catering, wholesaling, transportation, and construction (Tsang 1994). In late 1997, the fifteenth Party Congress announced that the private economy was an important component of the socialist market economy and could take any of the classical forms sole ownership, partnership or limited liability. Private business was encouraged to take over small and medium-sized SOEs, to invest in the infrastructure field, to engage in import and export business and to get access to bank loans. And who was the formal system lending to State-owned banks dominate the Chinese financial system and, as of 2000, held more than 60 per cent of the country's banking assets (Saussure et al. 2001) - much more than that, ten years previously. They prefer to lend to (central) state-owned firms, and...

The Growth of the Leveraged Loan Market

This growth has been fueled by several factors. First, over the past several years, the bank loan market and the high-yield bond market have begun to converge. This is due partly to the relaxing of commercial banking regulations which has allowed many banks to increase their product offerings, including high-yield bonds. Contemporaneously, investment banks and brokerage firms have established loan trading and syndication desks to compete with those of commercial banks.

The pecking order hypothesis revisited the choice between financing methods

Overall, the results paint a very mixed picture about whether the pecking order hypothesis is validated or not. The positive (significant) and negative (insignificant) estimates on the unlevered Z-score and interest expense variables respectively suggest that firms in good financial health (i.e. less risky firms) are more likely to issue equities or bonds rather than private debt. Yet the positive sign of the parameter on the debt variable is suggestive that riskier firms are more likely to issue equities or bonds the variance of earnings variable has the wrong sign but is not statistically significant. Almost all of the asymmetric information variables have statistically insignificant parameters. The only exceptions are that firms having venture backing are more likely to seek capital market financing of either type, as are non-financial firms. Finally, larger firms are more likely to issue bonds (but not equity). Thus the authors conclude that the results 'do not indicate that firms...

How the governance flaws of stateowned firms affect managerial behaviour

The Anam case illustrates a number of points rather well. First, technological catch-up takes time. There was nothing much to show for Anam's efforts for more than a decade. (Clearly it could be quicker with a chaebol's access to finance - but still, as we saw in Chapter 6, not very quick.) Second, the key investments in learning required more effort than money - and the money was spent in a rather low-visibility way. We can see that the typical Chinese state-owned enterprise would have avoided Anam's strategy like the plague. Happily (as it would have seemed to SOE managers at the time) there were alternatives available. Unlike Anam, they had access to large amounts of money from state-owned banks. For SOEs, bank loans are or used to be very cheap - in the early 1990s, typically 1 per cent interest from a state-owned bank (Oi 1995) in early 2004 interest rates were 4-7 per cent on loans, but as little as 2 per cent on discounted bills (www.bank-of-china.com). They could spend this...