FM3
UNIT VWorking Capital financing Q1) What is Trade Credit? Write its characteristics.A1) Trade credit is an important external source of working capital financing. It is a short-term credit extended by suppliers of goods and services in the normal course of business, to a buyer in order to enhance sales. Trade credit arises when a supplier of goods or services allows customers to pay for goods and services at a later date. Cash is not immediately paid and deferral of payment represents a source of finance. Features of Trade Credit:The features of trade credit are given below:1.There are no formal legal instruments/acknowledgements of debt.2. It is an internal arrangement between the buyer and seller.3. It is a spontaneous source of financing.4. It is an expensive source of finance, if payment is not made within the discount period. Characteristics of trade credit:1. It is easy and automatic source of short-term finance.2. It reduces the capital requirement.3. It helps the business focus on core activities.4. It does not require any negotiation or formal agreement. Q2) Write the key features and Characteristics of Bank Credit?A2) Bank loans are the easiest source of availing finance. A bank loan is an extension of credit by a bank to a customer or business; it has to be paid along with interest.Features of Bank Loans:Bank loans have the following characteristics:1. It is a short-term source of finance.2. A bank loan may be either secured or unsecured depending upon the circumstances.3. The interest charged by the bank on such a loan may be either fixed or variable.4. If mortgage loan is to be obtained, the borrower has to pay a number of fees such as title searching fees, application fees, inspection fees, etc. Q3) What is Commercial Paper? Note down its advantages.A3) Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities. Maturities on commercial paper typically last several days, and rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.Commercial paper was first introduced over 150 years ago when New York merchants began to sell their short-term obligations to dealers that acted as middlemen in order to free up capital to cover near term obligations. These dealers would thus purchase the notes at a discount from their par value and then pass them on to banks or other investors. The borrower would subsequently repay the investor an amount equal to the par value of the note. Commercial paper is not usually backed by any form of collateral, making it a form of unsecured debt. It differs from asset-backed commercial paper (ABCP), a class of debt instrument backed by assets selected by the issuer. In either case, commercial paper is only issued by firms with high-quality debt ratings. Only these kinds of firms will be able to easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.Because commercial paper is issued by large institutions, the denominations of the commercial paper offerings are substantial, usually $100,000 or more. Other corporations, financial institutions, wealthy individuals, and money market funds are usually buyers of commercial paper. Advantages of Commercial PaperA major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months, or 270 days, making it a very cost-effective means of financing. Although maturities can go as long as 270 days before coming under the purview of the SEC, maturities for commercial paper average about 30 days, rarely reaching that threshold. The proceeds from this type of financing can only be used on current assets, or inventories, and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. Commercial Paper during the Financial CrisisThe commercial paper market played a big role in the financial crisis that began in 2007. As investors began to doubt the financial health and liquidity of firms such as Lehman Brothers, the commercial paper market froze, and firms were no longer able to access easy and affordable funding. Another effect of the commercial paper market freezing was some money market funds - substantial investors in commercial paper - "breaking the buck." This meant that the affected funds had net asset values under $1, reflecting the diminishing value of their outstanding commercial paper issued by firms of suspect financial health. The Commercial Paper Funding Facility (CPFF) was subsequently created by the Federal Reserve Bank of New York on October 27, 2008, as a result of the credit crunch faced by financial intermediaries in the commercial paper market. The Federal Reserve Bank of New York closed the CPFF in February 2010 after it no longer became necessary as the financial sector and broader economy recovered. Q4) What are the Benefits of Certificate of Deposit?A4) It is a risk-free instrument, means your funds are safe with banks. Since FDIC (Federal Deposit Insurance Corporation) insures Certificates Of Deposit, it acts as a guarantee that you won’t lose the principal amountCDs get a higher interest rate than the savings account or the interest-bearing checking account. Since there is a competition among banks for the depositor’s funds, some banks offer better rates than the others. This means you can try different banks to get the highest interest rate. DisadvantagesThe biggest limitation of a Certificate of Deposit is that your money gets stuck until the maturity. Though you can always withdraw it early, you have to bear a small penalty as well. Nowadays, some banks do offer flexibility in the term of the amount that you can withdraw without any penalty. So, do ask your bank if it offers any such facility. Since your money gets stuck, you may lose some profitable investment opportunities. For instance, if during the CD period, the rate of interest rises on the other instruments, you will lose the interest you would have earned. To avoid this, you can go for a no-penalty CD, or something similar that allows you to withdraw amount easily. Even though CDs pay more interest rate than the savings account, sometimes they don’t offer enough to compensate for the inflation rate. In case, the inflation rate is more than the interest rate on CD, you will lose in real term. Q5) How to Choose a CD?A5) Below are the few useful guidelines that could help you to choose the best Certificate of Deposit;The longer the investors are willing to let their funds with the bank, the more interest rate they will get. If you expect an interest rate to rise in the near future, then you should first select the CD with a short-term. Thereafter, after it matures, you can reinvest it at a higher interest rate. If you expect the interest rate to drop in the future, then select a longer tenure for the CD. This will ensure that you get more interest rate even if the rate drops. Tax Treatment of Interest Earned on CDsIf you have a CD, the bank will regularly credit the interest amount at regular intervals, like every quarter or after six months. When a bank credits the interest, the same will show up in your account as interest income. Thus, similar to other interest income, you should also report this as part of your income when you file a tax return. Most people, however, feel that since they can’t actually withdraw the interest on CD when the bank credits them, they should be taxed only at maturity. This is wrong as interest becomes taxable as soon as the bank adds it to your account. Q6) How Does a CD Work?A6) Opening a CD is very similar to opening any standard bank deposit account. The difference is what you’re agreeing to when you sign on the dotted line (even if that signature is now digital). After you’ve shopped around and identified which CD(s) you’ll open, completing the process will lock you into a four things.The interest rate: Locked rates are a positive in that they provide a clear and predictable return on your deposit over a specific time period. The bank cannot later change the rate and therefore reduce your earnings. On the flip side, a fixed return may hurt you if rates later rise substantially and you’ve lost your opportunity to take advantage of higher-paying CDs. The term: This is the length of time you agree to leave your funds deposited to avoid any penalty (e.g., 6-month CD, 1-year CD, 18-month CD, etc.) The term ends on the “maturity date,” when your CD has fully matured and you can withdraw your funds penalty-free. The principal: With the exception of some specialty CDs, this is the amount you agree to deposit when you open the CD. The institution: The bank or credit union where you open your CD will determine aspects of the agreement, such as early withdrawal penalties (EWPs) and whether your CD will be automatically reinvested if you don’t provide other instructions at the time of maturity. Once your CD is established and funded, the bank or credit union will administer it like most other deposit accounts, with either monthly or quarterly statement periods, paper or electronic statements, and usually monthly or quarterly interest payments deposited to your CD balance, where the interest will compound.
0 matching results found