Name: SHAMS-UL-ISLAM

ROLL NO: BBA/2k23/241

Subject: PRINCIPLES OF
BUSINESS FINANCE

Department: INSTITUTE OF
BUSINESS ADMINISTRATION

Submitted to: MAAM MARIA

AIJAZ SHEIKH
 Chap # 01
Short term Financing
Topics:
 Spontaneous Financing
 Negotiated financing
 Factoring Accounts Receivable
Spontaneous Financing
Spontaneous financing refers to the automatic or involuntary
generation of funds by a business or individual, often as a result of
normal business operation.
There are two types of spontaneous financing
1. Accounts payable (Trade credit from suppliers)
2. Accrued expense
Trade credit: trade credit refers to the credit granted from one
business to another.
Examples of trade credit
 Open Accounts: The seller ships goods to the buyer with an
invoice specifying goods shipped, total amount due and terms
of the sale
 Notes payable: the buyer signs a note that an evidences a debt
to the seller
 Trade acceptance: the seller draws a draft on the buyer that the
orders the buyer to pay the draft at some future time period.
(draft_ A signed, written order by which the first party (drawer)
instruct a second party (drawee) to pay a specified amount of
money to a third party (payee). The drawer and payee are often
one and same.
Terms of sale:
 COD and CBD – No trade credit: The buyer pays cash on
delivery or cash before delivery. This reduces the seller’s risk
under COD to the buyer refusing the shipment or eliminates it
completely for CBD.
 Net period – No cash Discount: when credit is extended, the
seller specifies the period of time allowed for payment. “Net
30” implies full payment in 30 days from the invoice date
 Net period- cash discount: when credit is extended, the seller
specifies the period of time allowed for payment and offers a
cash discount if paid in early part of the period. “2/10, net 30”
implies full payment within 30 days from the invoice date less a
2% discount if paid within 10 days
 Seasonal dating: credit terms that encourage the buyer of
seasonal products to take delivery before the peak sales period
and to defer until and after the peak sales period.
Trade credit as means of financing: what happens to account
payable if firm purchase 1000 rupees/ day at “net 30”
1000 * 30 days= 30,000 Account balance
What happen to account payable if a firm purchase 1500
rupees/ day at “net 30”
1500 * 30 days= 45,000 account balance. A 15,000increase
from operations
Cost to forgo a discount:
What is the approximate annual cost to forgo the cash discount
of “2/10, net 30” after first ten days?
Approximate annual interest cost=
[% discount/ (100%- % discount)] *[ 365 days/ (payment date-
discount period)]
Cost of forgo a discount means we have given a discount for
ten days to pay certain amount otherwise pay full amount in
net period and we not taken discount for example “2/10, net
30”
 Approximate interest cost= [ 2%/100%-2%] * 365/ 30 days – 10
days)
[2/98] * [ 365/20] = 37.2%

S-T-R-E-T-C-H-I-N-G Accounts Payables: Postponing payment

beyond the end of the net period is known as stretching
accounts payable or leaning on the trade.
Possible costs of stretching accounts payable
 Cost of the cash discount (if any forgone)
 Late payment penalties or interest
 Deterioration in credit rating
Advantages of trade credit
Compare costs of forgoing a possible cash discount against the
advantages of trade credit.
 Convenience and availability of trade credit
 Greater flexibility as a means of financing.
Accrued Expenses: Amounts owed but not yet paid for wages, taxes,
interest and dividends. The accrued expenses account is a short-term
liability
 Wages: Benefits accrue via no direct cash costs, but costs can
develop by reduced employee morale and efficiency.
 Taxes: benefits accrue until the due date, but costs of penalties
and interest beyond the due date reduce the benefits.
Negotiated financing: Negotiated financing is type of short term
financing in which lender negotiated with the borrower’s in
lending of money there are two types of negotiated financing that
is
1. Money market credit
o Commercial paper
o Bankers’ acceptance
 2. Unsecured loan
o Line of credit
o Revolving credit
o Transaction loan
1. Money market credit:
o Commercial paper: is a short term, unsecured promissory
notes, generally issued by large corporation
Commercial paper market is composed of of the dealer
and direct placement markets.
Commercial paper is cheaper than short term business
loan from commercial paper and dealers required a line of
credit to ensure that commercial paper is paid off.
There is some commercial paper of bank supported in
which a bank provides a letter of credit (a promise from
third part usually a bank for payment in the event that
certain conditions are met. It is frequently used as
guaranteeing the payment of obligations), for a fee
guaranteeing the investor the company obligations are
paid, bank supported commercial paper are best for less
known firms to access lower costs of funds.
o Bankers acceptance: banker acceptance is promisary
trade notes for which the bank promise to pay the holder
the face value at the maturity. It facilitate the foreign
trade, shipment of certain marketable goods, liquid
market provide rates similar to the commercial paper
rates
2. Unsecured loan: Unsecured loan is that type of loan in which
money borrowed is not backed by pledge of specific assets
There are three types of unsecured loan:
o Line of credit: it is also called credit line. It is an informal
arrangement between bank and customer specifying
maximum amount of money bank will permit to owe at
 any one time, basically one-year limit is reviewed prior to
determine if conditions nessiciate changes. Credit line is
based on the assessment of the bank of the
creditworthiness of the borrower and the need of credit
and sometime cleanup provision is set in which the banks
ask the creditor not to owe or a period of time.
o Revolving credit Agreement: unlike the credit line it is a
formal commitment between bank and customer to
extent up credit to some maximum amount for a specified
period. Firm receive revolving credit by paying
commitment fees (fee charged by the lender for agreeing
to hold credit available) from the unused portion of the
maximum amount
o Transaction loan: a loan agreement that meet the short
term funds available for the needs of the firm for a single
or specified purpose. Each request is handeld as a
separate transaction by the bank. The project loan
determination is based on the cash flow ability of the
borrower. The loan is paid at the completion of the
project by the firm from resulting cash flow.
Accounts-Receivable-Backed loans
It is the one of the most liquid asset accounts and the loan
evaluation are based on the quality and size means not all individual
accounts are accepted may reject on aging and small size accounts
may reject as being too costly (per dollar of loan) to handle by
institution. There are two types of accounts receivable types of loan
3. Non notification: firm customer are not notified that their
accounts have been pledged to the lender. The firm forwards
all payments from pledged accounts to the lender
 4. Notification: firm customer are notified that their accounts
have been pledged to the lender and remittances are made
directly to lendeing institution
Inventory Baked loans
These are relatively liquid assets accounts and loans evaluation
based on the :
 Marketability
 Perishability
 Price stability
 Difficulty and expense of selling fpr loan
 Cash flow ability
There are five types of inventory loans
1. Floating loan: A general loan against a group of assets, such as
inventory or receivables, without the assets being specifically
identified.
2. Chattel Mortgage: A loan on specifically identified personal
property (assets other than real estate) backing a loan
3. Trust Receipt: A security device acknowledging that the
borrower holds specifically identified inventory and proceeds
from its sale in trust for the lender
4. Terminal warehouse receipt: A receipt for the deposit of goods
in a public warehouse that a lender holds as collateral for a
loan.
5. Field warehouse Receipt: A receipt for goods segregated and
stored on the borrower’s premises (but under the control of an
independent warehousing company) that a lender holds as
collateral for a loan.
Factoring Accounts Receivable
Factoring: the selling of receivables to a financial institution the
factor is known as the factoring, Factor is often a subsidiary of a bank
holding company it maintains a credit department and performs
credit checks on accounts it allows firms to eliminate credit
department and associated costs factoring contracts are usually for
one year but renewable.
Factoring costs: Factor receives a commission on the face value of
that receivables (typically <1% but as much as 3%). And cash
payment is usually made on the actual or average due date of the
receivables. If the factor advances money to the firm, then the firm
must pay interest on the advance. Total cost of factoring is
composed of factoring fee plus interest charge on any cash advance.
It is although expensive but provide substantial flexibility
Chapter # 02
Role of financial markets
Financial system: financial system is the collection of market,
institution, laws, regulation and techniques and etc through which
bonds, stocks and other securities are traded, interest rates are
determined, providing information about finance and other activities
and financial services are produced and delivered.
There are six parts of financial system that are
 Money: it is an important part of financial system from which
these are paid for purchases and store wealth
 Financial instrument: financial instrument is to transfer
resources from those who have excess to those who need
funds and to transfer risk to one best equipped to bear it
 Financial markets: financial markets are the places where
financial instruments are traded
 Financial institution: are those firms, organization who provide
access to the financial market, provide related information and
provide financial services
  Regulating agencies: they provide oversight to the financial
system
 Central bank: to monitor financial institution and stabilize
economy
Financial markets
It is market where financial assets (bonds, shares) are traded, it
facilitates the flow of funds, allowing financing and investing.
Financial markets transfer funds from those who have excess funds
to those who need funds. Participants of financial market include
Households, Firms, Government agencies The ones providing funds
to financial markets are called Surplus Units-(households)
Participants who use financial markets to obtain funds are
called Deficit Units
Security: A certificate that represents a claim on the issuer. They
work by issue (sell) securities to surplus units in order to obtain funds
There are two types of security that are
1. Debt security
2. Equity security
1. Debt security: debt security by its name representing debt (also
called credit, or borrowed funds) incurred by the issuer. Deficit
units that issue the debt securities are borrowers. The surplus
units that purchase debt securities are creditors.
2. Equity security: Equity securities (also called stocks) represent
equity or ownership in the firm. Some businesses prefer to issue
equity securities rather than debt securities when they need funds
but might not be financially capable of making the periodic
interest payment required for debt securities.
Role of financial markets
Role of financial marketing involves
Accommodating corporate finance needs is a key role of financial
markets is to accommodate corporate finance activity in simple
terms it serves as a mechanism where by corporation (acting as
deficit units) can obtain funds from (acting as surplus units) and
another is the accommodating investment needs is an another role
of financial market in which it accommodating surplus units who
want to invest in either debt or equity securities
Primary versus secondary markets
Primary markets are the places where new securities are traded and
secondary markets are the places where existing securities are
traded, it facilitates the trading of existing securities, provide
liquidity, provide continuous information, and make it easy for firms
to raise funds
Securities traded in financial markets:
Money markets: money market facilitate the short-term debt
securities by deficit units to surplus units. The securities that are
trade in this market is referred to as money market which have
maturity of usually one year or less. Common types of money market
securities include: treasury bills, commercial paper, negotiable
certificates of deposits.
Capital market: these are the markets facilitate long-term debt
security by deficit units to surplus units. The securities that are
traded in this market is refer to as capital market securities are
commonly issued to finance the purchase of capital assets like
property, machinery, equipment etc.
Three common types of capital markets:
1. Bonds: bonds are the long-term debt securities issued by the
treasury, government agencies and corporations to finance
operations. They provide a return to investor in the form of
interest payments (coupon payment). Since bonds represent
 debt, they specify the amount, timing of interest and the
principal payment to investors who purchase them. At
maturity, investor holdings the debt securities are paid the
principal
2. Mortgages: are long-term debt securities created to finance
purchase of real estate. Lender assess the likelihood of
repayment by using various criteria, such as borrower’s income
level relative to the value at home. They prime mortgages to
borrower who qualify based on these criteria.
Derivative securities
Derivative securities are financial contracts whose value is
determined from the value of underling assets (debt securities,
equity securities). Many derivative securities enable investor to
engage in speculation and management.
Derivatives allow investor to speculate movements in the value
of underlying assets.
valuation of Securities
The valuation of a Securities is measured as the
present value of its expected cash flows, discounted at
a rate that reflects the uncertainty surrounding the
cash flows
Impact of Information on Valuation
Investors can attempt to estimate the future cash flows that
they will receive by obtaining information that may influence a
stock’s future cash flows. When investors receive new
information about a security that clearly indicates the
likelihood of higher cash flows or less uncertainty, they revise
their valuations of that security upward. When investors
receive unfavorable information, they reduce the expected
cash flows or increase the discount rate used in valuation. The
valuations of the security are revised downward, which result
in shifts in the demand and supply conditions in the secondary
market and a decline in the equilibrium price. In an efficient
market, securities are rationally priced. If a security is clearly
undervalued based on public information some investors will
capitalize on the discrepancy by purchasing that security. This
strong demand for the security will push the security’s price
higher until the discrepancy no longer exists. The investors who
recognized the discrepancy will be rewarded with higher
returns on their investment. Their actions to capitalize on
valuation discrepancies typically push security prices toward
their proper price levels, based on the information
that is available.
Impact of the Internet on Valuation
The Internet has improved the valuation of securities in several
ways Prices of securities are quoted online and can be obtained
at any given moment by investors. For some securities
investors can track the actual sequence of transactions Because
much more information about the firms that issue securities is
available online securities can be priced more accurately,
Furthermore, orders to buy or sell many types of securities can
be submitted online which expedites the adjustment in security
prices to new information.
Uncertainly Surrounding Valuation of Securities
Even if markets are efficient the valuation of a firm’s security is
subject to much uncertainty because investors have limited
information available to value that security
Role of Depository Institution
They are popular financial institutions for the following
reasons. They offer deposit accounts that can accommodate
the amount and liquidity characteristics desired by most
surplus units. They repackage funds received from deposits to
provide loans of the size maturity desired by deficit units. They
accept the risk on loans provided. They have more expertise
than individual surplus units in evaluation the creditworthiness
of deficit units 30. They diversify loans among numerous deficit
units and therefore can absorb defaulted loans better than
individual surplus units could consider the flow of funds from
surplus units to deficit units. If depository institutions did not
exist Each surplus unit would have to identity a deficit unit
desiring to borrow the precise amount of funds available for
the precise time period in which funds would be available each
surplus unit would have to perform the credit evaluation and
incur the risk of default.
Commercial Banks
Commercial banks are the most dominant depository
institution. They serve surplus units by offering a wide variety
of deposit accounts and they transfer deposited funds to deficit
units by providing direct loans or purchasing debt securities.
Commercial banks serve both the private and public sectors
their deposit and lending services are utilized by household’s
business and government agencies. The federal funds market
facilitates the flow of funds between depository institutions
(including banks A bank that has excess funds can lend to a
bank with deficient funds market facilitates the flow of funds
from bank that have excess funds to banks that are in need of
funds.
Savings Institutions
Savings institution which are sometimes referred to as thrift
institutions are another type of depository institution saving
and loan associations S&Ls and saving banks. Whereas
commercial banks concentrate on commercial business loans
savings institutions concentrate on residential mortgage loans.
Credit Unions
Credit unions differ from commercial banks and savings
institutions in firstly they are nonprofit and second they restrict
their business to the credit union members who share a
common bond such as a common employee or union Like
saving institution they are sometimes classified as: Thrift
institutions in order to distinguish them from commercial bank
because of the common bond characteristic credit unions tend
to be much smaller than other depository institutions.
Role of No Depository Financial Institutions
No depository institutions generate funds from sources other
than deposits but also play a major role in financial
intermediation. Finance Companies Most finance companies
obtain funds by issuing securities and then lend the fund to
individuals and small businesses The functions of finance of
finance companies and depository institutions overlap although
each type of institution concentrates on particular segment of
the financial markets.
Mutual Funds
Mutual funds sell shares to surplus units and use the funds
received to purchase a portfolio of securities, they are the
dominant non depository financial institution when measured
in total assets Some mutual funds concentrate their investment
in capital market securities such as stocks or bonds Others
known as money market mutual funds concentrate in money
market securities. Typically, mutual funds purchase securities in
minimum denominations that are larger than the savings of an
individual surplus unit by purchasing shares of mutual funds
and they are known as money market mutual funds.
Securities Firms
Securities provide a wide variety of functions in financial
markets some securities firms act as a broker executing
securities transactions between two parties The broker fee for
executing a transaction is reflected in the difference or (spread)
between bid quote and ask quote. The mark-up as percentage
of the transaction amount will likely be higher for less common
transactions since more time is needed to match up buyers and
sellers. The mark-up for small amount transaction is also
higher in order to adequately compensate the broker.
Securities firms often underwrite the securities. They may sell
securities for a client at a guaranteed price or the best price.
Securities firms often act as
Dealers: making a market in specific securities by maintaining
an inventory of securities, although a broker’s income is mostly
based on the markup the dealer’s income is influenced by the
performance of the security portfolio maintained. some dealers
also provide brokerage services and therefore earn income
from both types of activities. Some securities firms offer
advisory services on mergers and other forms of corporate
restructuring. In addition to helping a company plan its
restructuring, the securities firm also executes the change in
the client capital structure by placing the securities issued by
the company. The securities firms that offer these services are
commonly referred to as investment banks
Insurance Companies
They invest the funds received in the form of premiums until
the funds are needed to cover insurance claims. Insurance
companies commonly investment these funds in stocks or
bonds issued by corporations or in bonds issued by
government, in this way they finance the needs of deficit units
and thus serve as important financial intermediaries. Their
overall performance is linked to the performance of the stocks
and bonds in which they invest.
Pension Funds
The pension funds mange the money until the individuals
withdraw the funds from their retirement accounts the money
that is contributed to individual retirement accounts is
commonly invested by the pension funds in stocks and bonds
issued by corporations or in bonds issued by the government.
Thus pension funds are important financial intermediaries that
finance the needs of deficit units