Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is the short-term, self-liquidating loan. These loans are intended merely to carry the firm through seasonal peaks in financing needs that are due primarily to buildups of inventory and accounts receivable. As the firm converts inventories and receivables into cash, the funds needed to retire these loans are generated. In other words, the use to which the borrowed money is put provides the mechanism through which the loan is repaid, hence the term self-liquidating.
short-term, self-liquidating loan
An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid.
Banks lend unsecured, short-term funds in three basic ways: through single-payment notes, through lines of credit, and through revolving credit agreements. Before we look at these types of loans, we consider loan interest rates.
Loan Interest Rates
The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often 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. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent.
prime rate of interest (prime rate)
The lowest rate of interest charged by leading banks on business loans to their most important business borrowers.
Fixed- and Floating-Rate Loans Loans can have either fixed or floating interest rates. On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a 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. 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. Most short-term business loans are floating-rate loans.
A loan with a rate of interest that is determined at a set increment above the prime rate and remains unvarying until maturity.
A loan with a rate of interest initially set at an increment above the prime rate and allowed to “float,” or vary, above prime as the prime rate varies until maturity.
Method of Computing Interest Once the nominal (or stated) annual rate is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to
Most bank loans to businesses require the interest payment at maturity.
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
Loan on which interest is paid in advance by being deducted from the amount borrowed.
Paying interest in advance raises the effective annual rate above the stated annual rate.
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
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
In this case, at the end of the year Wooster writes a check to the lender for $10,000, having “paid” the $1,000 in interest up front by borrowing just $9,000. Paying interest in advance thus makes the effective annual rate (11.1%) greater than the stated annual rate (10.0%).
A single-payment note can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.
A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period.
Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank 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 % above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at % (6% prime rate + % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × (, × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000).
Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate, or EAR, by using Equation 5.10. Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1:
The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.
Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000).
Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:
Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.
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