Treasurers need to manage portfolios of borrowings and investments, and evaluate the potential benefits of changing the mix. Deals we need to assess include:
- Borrowing
- Selling investments
- Blends of both
WHY BORROW
We might consider borrowing to take advantage of an early settlement discount. If the value of the discount is more than our cost of borrowing, this will give a net saving.
LET’S EXPLORE AN EXAMPLE
Discount offer
Your company is due to pay a supplier’s invoice for £3m in 90 days’ time. You have been offered a flat discount of 0.50% to pay 90 days in advance, today. You do not have enough funds available to make this payment today. However, you do have sufficient available credit lines at Libor plus 40 basis points per annum.
Current £ market rate: 90-day Libor 0.60% per annum.
Calculate which of the following choices is the least expensive:
I. Decline the discount and settle the invoice in 90 days’ time.
II. Accept the discount, funded by borrowing.
START SIMPLE
It’s usually best to look at the simplest choice first. This provides a sound base for comparing more complex alternatives. Here, our simplest choice is to decline the discount, and pay the invoice in full in 90 days’ time. Our future cash outflow will be the full £3m.
DISCOUNT SAVING
Alternatively, we can accept the discount of 0.50% (0.005), for paying early. This discount is ‘flat’, which means the time period is ignored in the calculation. The discount is: 0.005 x 3,000,000 = £15,000
The discounted invoice amount, payable today, is: 3,000,000 – 15,000 = £2,985,000
This is the amount we need to borrow for 90 days.
COUNT THE COST
The market Libor rate is 0.60% per annum, but we have to pay Libor plus 40 basis points (0.40%). Our corporate borrowing cost is: 0.60% + 0.40% = 1% per annum.
Ninety-day £ Libor is quoted as a simple rate, on an ACT/365 fixed basis. This means borrowing for 90 days will cost 1% x 90 / 365.
The interest charge on borrowing £2,985,000 will be:
2,985,000 x 0.01 x 90 / 365 = £7,360
IS THAT BETTER?
After 90 days, we repay: 2,985,000 + 7,360 = £2,992,360
This is less than the full £3m. Our net saving is the discount, offset by the interest cost of funding early settlement: 15,000 – 7,360 = £7,640
We enjoy a net saving, because the annual equivalent value of the discount exceeds our annual equivalent cost of borrowing.
ANOTHER INGREDIENT
Another cash management choice we might consider is to reduce our borrowings by selling certain investments. If the interest savings exceed the investment income given up, we enjoy another net saving.
Let’s extend our earlier example to add this ingredient to the mix.
Sell investment, cut borrowings
We have already identified an opportunity to generate net savings of approximately £7,640 for our company, by borrowing £2,985,000 for 90 days at a rate of 1% per annum.
We also hold a one-year certificate of deposit (CD) investment, face value £2m, paying 1.25% interest per annum, with 90 days left to maturity.
Current £ market rate: 90-day CD of a similar credit quality: 0.50% per annum.
Calculate the potential cash flow improvement from selling the CD to reduce the amount of the borrowing.
START SIMPLER
To calculate the potential benefit, we need to compare our choices.
Again, we start with the simpler one. This is to hold the CD to its maturity.
The CD repays its face value of £2m at maturity, plus total interest of 1.25%. Our cash inflow from the CD on day 90 will be: 2,000,000 x 1.0125 = £2,025,000
We’d also need to repay the borrowing of £2,985,000, plus the interest of £7,360 we calculated earlier, a total payment of £2,992,360.
TIME FOR A TABLE
Often, the best way to keep everything clear is to use a table. Our choices can be column headings. We’ll compare (1) borrowing all of the funds, with (2) selling the CD and borrowing a smaller net amount.
|
(£000) |
(1) Borrow all |
(2) Sell CD |
|
Repay borrowing |
(2,992) |
? |
|
CD proceeds |
2,025 |
- |
|
Net cash outflow |
(967) |
? |
If we sell our CD now, we reduce our borrowing needs, in exchange for giving up the CD proceeds at maturity. We’ve already got several useful figures, a structure and two question marks at this stage.
IT LOOKS SENSIBLE
In a table, the ingredients and results start looking manageable and sensible. We owe £3m, offset by an asset of about £2m, so our net cash outflow is going to be around £1m in each case.
SELLING THE CD
The relevant 90-day CD yield is 0.50% (0.005). The sale price today, discounting the maturity value of £2,025,000, is: 2,025,000 / (1 + (0.005 x 90 / 365) ) = £2,022,506
These proceeds part-fund the discounted invoice amount of £2,985,000, so now we only need to borrow 2,985,000 –2,022,506 = £962,494.
Our interest cost falls to: 962,494 x 0.01 x 90 / 365 = £2,373
Our net cash outflow at day 90 is now simply the repayment of this smaller borrowing, plus the interest: 962,494 + 2,373 = £964,867
ALL DONE
Completing our table, we see that choice 2 is the least expensive, a combination of borrowing and selling the CD.
|
(£000) |
(1) Borrow all |
(2) Sell CD |
|
Repay borrowing |
(2,992) |
(965) |
|
CD proceeds |
2,025 |
- |
|
Net cash outflow |
(967) |
(965) |
IT STILL MAKES SENSE
We’re best off in this last case, because we save interest at a rate of 1% per annum. This ‘cost of carry’ saving is greater than the 0.50% per annum investment return that we give up.
THE BLEND WAS BEST
In this particular scenario, the blended solution had the lowest cash cost. It won’t always, of course. That’s why we need to know how to evaluate our choices with confidence.
____________________
Author: Doug Williamson
Source: The Treasurer magazine