Introduction to Corporate Finance

19: Cash, Payables and Liquidity Management

find only weak evidence that firms draw

on their lines to increase precautionary

cash holdings. Finally, we document

that credit line drawdowns of financially

unconstrained firms reduce the drawing

firms’ stock returns, indicating that

investors infer adverse information about

these firms from credit line drawdowns.

Source: Used with permission. ‘The Real Effects of Credit Line Drawdowns,’ Jose M. Berrospide and Ralf R Meisenzahl, Working Paper, Federal Reserve Board, April 2013.

Bank Overdraft or Line of Credit

A bank overdraft or line of credit is an up-front commitment by a bank to lend to a borrower in the future. For

example, a company may arrange to borrow up to $10,000,000 from a bank at any time during the next

30 months. The company must pay a commitment fee to establish this option to borrow, a fee that might

cost one-quarter per cent (such as $25,000 to establish a $10,000,000 overdraft facility). When a company

borrows through the overdraft, it must also pay interest on the amount borrowed, usually a variable interest

rate of approximately 100 to 200 basis points (one to two percentage points) above the BBSW.

Bank overdrafts are designed for temporary borrowing. A company experiencing slow collections one

month may draw on the line to pay end-of-month payroll, rather than arrange a new, short-term loan. Or a

seasonal company may draw on the overdraft during its slow quarter, planning to pay back the borrowings

plus interest the following quarter. Overdrafts are also used as bridge financing for long-term investing. For

example, a company may initially fund the purchase of a 10-year asset with an overdraft, retiring the line

quickly as longer-term financing is finalised. More generally, overdrafts are a fairly low-cost form of liquidity

insurance, as an alternative to a company needing to accumulate large cash balances. Overdrafts usually

remain open for two to three years, assuming that the company does not violate a loan covenant before then.

The effective borrowing rate (EBR) on a bank overdraft is generally determined as the total amount of

interest and fees paid, divided by the average usable loan amount. This rate is then adjusted for the actual

number of days the loan is outstanding. A demonstration of this calculation follows.

example

We can determine the effective borrowing rate on a one-year overdraft with the following characteristics:

■ CL = credit line, $500,000 total

■ AL = average loan outstanding, $200,000

■ CF = commitment fee, 0.35% (35 basis points) on the unused portion of the overdraft

■ IR = interest rate, 2.5% over LIBOR (assumed to be 5.75%), which equals 8.25%.

If we use a 365-day year and assume that no compensating balances are required, then the calculations

proceed as follows:

()()

=

×+ ×−

×

0.0825 $200,000 0.0035 $500,000 $200,000

$200,000

365

365

$16,500 $1,050

$200,000

365

365

$17,550

$200,000

= 18 .775%

+

×= ×=

The effective borrowing rate of 8.775% is about 50 basis points (0.50%) above the 8.25% interest rate as a

result of the commitment fee paid on the unused portion of the overdraft.

bank overdraft or line of

credit

An up-front commitment by a

bank to lend to a borrower in

the future

effective borrowing rate

(EBR)

Generally determined as the

total amount of interest and

fees paid, divided by the

average usable loan amount