SHORT TERM FINANCIAL MANAGEMENT FINAL EXAM STUDY GUIDE 1 Know the following the 3 main sources of firm financing how the effective interest rate on a bank line of credit is calculated interest cost commitment fee compensating balance requirement plus loan covenants that have to be satisfied the main short term investment alternatives for a firm e g sweep accounts commercial paper treasury securities and how the discount yield is computed applies to treasury securities commercial paper corporate bonds etc Main sources of firm financing totaling 3 570B and 81 of corporate financing Commercial paper accounting for 126B 2 9 Bank loans accounting for 746B 16 9 Corporate bonds accounting for 2 698B 61 2 Bank line of credit the main short term investment for a firm The effective interest rate on a bank line of credit takes the following into account 1 Banks require firms to hold a DDA compensating balance e g 20 of any borrowed amount may be held idle This being the main point 2 Banks charge a loan commitment fee on the value of the unused line e g 25BP on unused loan amount minor element 3 Banks charge interest on the value of the loan made the value the firm can use the idle compensating balance 4 Banks impose loan covenants that need to be met before the line of credit can be used e g if leverage x then no funds 5 Banks require that the entire borrowed amount be returned for a few weeks each year to make sure that S T loan is really used for S T purposes not L T use which would carry a higher rate Example of the line can ever be actually used by the firm Bank line of credit 100 000 Interest rate on used line 10 Commitment fee on unused portion 25BP Basis Points 0025 Compensating balance 20 of the loan so only 80 of the value Stated interest rate 10 A firm borrows 60 000 of its 100 000 bank line of credit Interest expense 10 60 000 6 000 yr Commitment fee 0025 100 000 60 000 0025 40 000 100 yr unused line Total 6 100 Out of pocket costs Usable balance Compensating balance 20 60 000 12 000 held idle at bank Main short term investment alternatives Sweep accounts Discount yield instruments pay bank fees for this service o Firm s excess collected DDA funds swept into interest earning investments overnight o o Treasury bills o Commercial paper o Banker s acceptances o Firm buys government securities from a bank to earn interest This gives the bank an overnight loan Bank buys back the securities the next day Around 10 of firm S T investments are REPOs Repurchase agreements European euro Japanese yen Jan 2010 per 1 1 661 1 00 cost of 1 per 1 6020 1 00 cost of 1 2 Know how spot and forward exchange rates work Be able to determine if an exchange rate has appreciated or depreciated and what this means for a country s price of imports seen at home and price of exports seen overseas Spot exchange rates are today s exchange rates UK pound Example Forward exchange rates are exchange rates in the future 1 week to 10 years Expected appreciation Expected depreciation Spot St 1 661 Spot St 1 661 Forward 6 mo Ft 180 1 59 1 cost of 1 falls by 1 661 1 59 4 3 1 661 appreciates so pay fewer to get 1 sells at a discount Ft 180 1 70 1 cost of 1 rises by 1 70 1 661 2 3 1 661 depreciates so pay more to get 1 sells at a premium One spot rate is the inverse of the other 1 1 661 6020 1 6020 1 661 PFX Rise in Demand for Exports Appreciation depreciation 1 70 1 661 1 59 appreciation depreciation 1 70 1 661 1 59 appreciation SFX DX new DX DFX DM SFX DX new DM DFX DM X M Value FX PFX Rise in Demand for Imports Depreciation SFX due to DX when sell more SFX due to DX when sell fewer X M Value FX Answer 4 00 x SF 50 M 200 M for US firm Boeing jets or when US receives less investment from the UK exports fall and depreciates DFX due to DM when buy fewer Italian shoes or when US invests less in the UK Boeing jets or when US receives more investment from the UK exports rise and appreciates DFX due to DM when buy more Italian shoes or when US invests more in the UK Example Illustration of exchange rates A US firm has sold 200 million in exports to another firm in Switzerland The current spot rate is 4 00 SF 1 1 Swiss Franc so the Swiss firm has contractually agreed to pay the US firm SF 50 million in 90 days Thus the US firm has an A R of SF 50 million The US firm does not hedge this A R and thus faces FX risk A What is the dollar value received by the US firm if the exchange rate is 4 00 SF 1 B What will be the dollar value received by the US firm if the dollar depreciates by 1 in 90 days when the Swiss firm pays up C What will be the dollar value received by the US firm if the Swiss Franc depreciates by 5 in 90 days D What is the value of Swiss Francs paid by the Swiss firm if the appreciates by 2 3 Be able to use a supply and demand graph to show how a flexible exchange rate is determined and how these supply demand curves are related to the demand for imports and the demand for exports Know the two main components of a country s balance of payments current account and capital account and why a net capital inflow into a country e g a foreign investment in a domestic firm is like an export of a product See graphs above for first part of answer supply and demand graphs Fixed versus floating Answer 5 depreciation of SF changes exchange rate from 4 00 SF 1 to 4 00 SF 1 05 so 4 00 SF 1 05 x SF 50 M 3 81 x SF 50 M 190 M A 5 SF depreciation 5 appreciation so new exchange rate is 3 81 SF 1 Answer 1 dollar depreciation changes exchange rate from 4 00 SF 1 to 4 04 SF 1 so 4 04 x SF 50 M 202 M received by US firm Answer still SF 50 M which was contracted SF amount US has FX risk not Swiss Only major currencies float while other currencies are managed in some way to limit the effects of supply demand on their exchange rate Chinese Yuan S E Asia currencies India Brazil etc Spot rates Today s demand and supply of FX determine today s spot exchange rate between countries Current Account includes Trade Balance Balance of Payments Merchandise trade Services Income transfers Direct investment Portfolio investment Capital Account …