Untitled-29

(^356) Financial Management
Transaction Basis
When a firm borrows only occasionally, for specific purposes that may differ from time
to time, it will generally negotiate each loan with the bank as a separate transaction.
Bill Discounting
Under this a borrower can obtain the bank credit through the bankís purchase of (or
discount of) its bills. The amount covered under this agreement is covered within the
overall working capital limits. Before purchasing or discounting the bills the bank satisfies
itself with the creditworthiness of the drawer. In practice, the banks hold the bills as
security against the credit it gives to the company.
Cost of Bank Credit
Interest rates on bank loans to business are determined through negotiation between
borrower and lender. The rate charged tends to vary directly with the credit quality, or
the credit-worthiness, of the borrower. The largest, soundest companies possessing the
highest credit quality are able to borrow at the prime rate, the lowest rate charged on
business loans at any point in time.
The prime rate is the one at which the nationís largest banks lend to their biggest and
best business-borrowing customers. It is the connecting link between a commercial
bankís loan rates and short- term, open-market money rates. The prime rate measures,
in effect, the opportunity cost to banks of lending rather than investing in short-term,
open market instruments. Since the latter are virtually risk less, it follows that prime-
rate borrowers must possess credit qualities of the very highest order to qualify for the
lowest bank loan rate.
This rate is usually used for the working capital financing, while for extending short-
term credit (especially in commercial paper) this rate is almost never used as the
benchmark and banks frequently lend below this rate.
Example: M&M Beverage Company has a Rs 300,000 line of credit which requires a
compensating balance equal to 10 per cent of the loan amount. The rate paid on the
loan is 12 per cent per annum, Rs 200,000 is borrowed for a six-month period, and the
firm does not, at present, have a deposit with the lending bank. The cost of the loan
includes the interest expense and, in addition, the opportunity cost of maintaining an idle
2 Although technically incorrect, the same answer could have been obtained by assuming a total loan of Rs
200,000 of which only 90 per cent of Rs 180,000 was available for use by the firm; that is,
13.33 per cent
18/360
1
Rs 180,000
RATE = Rs^ 12,000¥ =
Interest is now calculated on the Rs 200,000 loan amount (Rs 12,000 = Rs 200,000 ◊ .12 ◊ Ω).
.