Introduction to Finance

salvagesale.com.
21
Hilary Rosenberg, “Mining the Balance Sheet,” 
CFO
,
 
(May 2001), pp. 103–108; Robert S. MacDonald, “Technology 
Tools Used in the Equipment Appraisal Process,” 
The Secured Lender
,
 
(August 2001), p. 8.
22
The movie, “It’s a Wonderful Life” is shown several times on television during the Christmas holiday season. If 
you’ve seen this movie, you may recall the scene where a distraught George Bailey goes to his banker nemesis, Henry 
Potter, to ask for a loan as the Bailey Building and Loan is short of cash. Potter asks Bailey what security he can off er 
on a loan and George pulls out a life insurance policy from his pocket—but Potter scoff s when he learns of its the low 
cash value (he calls it “equity” in the movie).

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Applying Finance To...
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16.7
The Cost of Short-Term Financing
For most asset-based and unsecured loans, a simple method can be used to combine the 
interest expenses and fees to determine the true interest cost of a short-term loan. Fortunately, 
we discussed this earlier in this chapter when we examined commercial paper. Here, we break 
it into steps and present an example.
First, determine the amount to be borrowed. Discounted loans or bank loans with com-
pensating balances will need to use equations 16-2 and 16-3 to determine the amount.
Second, determine the interest expense on the borrowed funds. This is the interest rate 
multiplied by the amount borrowed.
Third, determine the fees and other expenses associated with using the fi nancing source. We 
know, for example, that factors charge a service fee, inventory loans may carry warehouse charges, 
and pledged loans usually carry extra fees because of the extra analysis done by the lender.
Fourth, estimate the net proceeds. This may be the same as the amount borrowed, but in 
the case of discounted loans (such as commercial paper) the net proceeds will be less than the 
amount borrowed.
Fifth, to estimate the fi nancing cost, divide the sum of the interest expenses and fees 
(steps 2 and 3) by the net proceeds (step 4). Annualize this rate, if necessary.
Here’s an example. Fluoridated Manufacturing (FM) is considering short-term fi nancing 
choices. A factor is willing to advance 80 percent of its receivables and charge it a 2 percent 
fee as compensation for analyzing the receivables and determining which it will purchase. FM 
estimates it will pay 12 percent APR to receive cash an average of 45 days earlier. The current 
receivables balance is $10,000.
Let’s do the analysis step-by-step:
1.
Determine the amount to be received. With receivables of $10,000 and an advance rate of 
80 percent, FM w
ill receive $10,000 × 0.80 = $8,000.
2.
Determine the interest expense. With a 12 percent APR, the daily interest charge is 
0.12/365. Factoring allows FM to receive its funds an average of 45 days sooner, so the 
interest expense is $8,000 × (0.12/365) × 45 = $118.36.
3.
Determine the fees and other expenses. The factor’s fee is 2 percent for basing a loan on a 
receivables balance of $10,000. The fees are 0.02 × $10,000 = $200.
4.
Estimate the net proceeds. There is no discounting, so the net proceeds will be $8,000. We 
assume FM will pay the fees out of pocket. The net proceeds will be smaller if the $200 in 
fees is deducted by the factor from the loan amount.
5.
The fi nancing cost is $118.36 + $200 = $318.36, with net proceeds of $8,000. The 
percentage cost is $318.36/$8,000 = 0.0398, or 3.98 percent for 45 days of fi nancing. The 
annualized rate is (1 + 0.0398)
365/45
– 1 = 0.3724, or 37.24 percent.
The above process should help determine the fi nancing cost of almost any lending 
arrangement, whether by a bank, commercial fi nance company, factor, or other short-term 
fi nance source.