Chapter 15 Working Capital Management 495With this background, we can de! ne two types of trade credit: free and costly:- Free trade credit is the trade credit that is obtained without a cost, and it con-
sists of all trade credit that is available without giving up discounts. In PCC’s
case, when it buys on terms of 2/10, net 30, the! rst 10 days of purchases, or
$19,600, are free. - Costly trade credit is any trade credit over and above the free trade credit. For
PCC, the additional 20 days, or $39,200, are not free because getting additional
credit means giving up the discount.
Firms should always use the free component, but they should use the costly com-
ponent only if they cannot obtain funds at a lower cost from another source.^18Free Trade Credit
Credit received during the
discount period.Free Trade Credit
Credit received during the
discount period.Costly Trade Credit
Credit taken in excess of
free trade credit, whose
cost is equal to the
discount lost.Costly Trade Credit
Credit taken in excess of
free trade credit, whose
cost is equal to the
discount lost.(^18) Note that the cost of trade credit can be reduced by paying late. If PCC could get away with paying in 60 days
rather than the speci! ed 30 days, the e# ective credit period would become 60 # 10 " 50 days, the number of
times the discount would be lost would fall to 365/50 " 7.3, and the nominal cost would drop from 37.2% to
2.04% $ 7.3 " 14.9%. This is called stretching accounts payable, and it damages the! rm’s reputation and can
cause problems later.
(^19) Sometimes the note will also specify that the! rm must maintain a compensating balance equal to 10% to 20%
of the face amount of the loan. This balance generally has the e# ect of increasing the e# ective cost of the loan.
Compensating balances are much less common today than they were a few years ago.
SEL
F^ TEST What is trade credit?
What is the di! erence between free trade credit and costly trade credit?
What is the formula for " nding the nominal annual cost of trade credit?
Does the nominal cost of trade credit understate the e! ective cost? Explain.
15-10 BANK LOANS
The key features of bank loans, another important source of short-term! nancing
for businesses and individuals, are discussed in this section.
15-10a Promissory Note
The terms of a bank loan are spelled out in a promissory note. Here are some key
features of most promissory notes:^19
- Amount. The amount borrowed is indicated.
- Maturity. Although banks do make longer-term loans, the bulk of their lending is
on a short-term basis—about two-thirds of all bank loans mature in a year or
less. Long-term loans always have a speci! c maturity date, while a short-term
loan may or may not have a speci! ed maturity. For example, a loan may
mature in 30 days, 90 days, 6 months, or 1 year; or it may call for payment “on
demand,” in which case the loan can remain outstanding as long as the bor-
rower wants to continue using the funds and the bank agrees. Bank loans to
businesses are frequently written as 90-day notes, so the loan must be repaid
or renewed at the end of 90 days. It is often expected that the loan will be
renewed; but if the borrower’s! nancial position deteriorates, the bank can
refuse to renew it. This can lead to bankruptcy. Because banks usually don’t
Promissory Note
A document specifying the
terms and conditions of a
loan, including the
amount, interest rate, and
repayment schedule.Promissory Note
A document specifying the
terms and conditions of a
loan, including the
amount, interest rate, and
repayment schedule.