Unit 8
Project Finance and Risk Management
Investments & Short-
Term Financing
Index
Key Ideas 3
8.1. Introduction and Objectives 3
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8.2. Short-Term Investment Strategies and Policies 3
8.3. Short-Term Investment Management 5
8.4. Short-Term Financing 6
8.5. Bibliographical References 9
In Depth 10
Test 11
Key Ideas
8.1. Introduction and Objectives
As we have mentioned in previous units, surplus investment and short-term financing
are key functions in treasury management. Investment management requires a prior
definition of investment policies, that will be aligned with the company’s strategy.
Short-term financing requires prior analysis of the options to find the one that is
closest and most beneficial to the organization.
The learning objectives of this unit are:
Identifying the elements that comprise the company’s investment policy.
Adopt investment decisions under the investment policy.
Differentiating between the various short-term financing options and determining
which one is the most appropriate for each stage of the business activity.
8.2. Short-Term Investment Strategies and Policies
The first step is to determine the company’s investment policy. Once established, the
company may manage investment by itself, if it has the appropriate personnel to
manage investment within the company itself, or assign it to a third party.
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Developing the investment policy requires the company to determine the level of risk
tolerance, always aiming to preserve the initial capital and the liquidity of inversion.
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Unit 8. Key Ideas
The short-term investment policy of a company should include:
Investment objectives, considering the risks and the benefit desired to obtain.
Instruments and types of investment allowed and not allowed.
Minimum ratings of investment agencies.
The maximum investment term of a certain instrument.
The maximum investment term of the portfolio.
The maximum percentages which the portfolio may hold in shares, sectors,
countries, types of assets, etc.
The procedure and guidelines in case of international assets investment.
Internal control methods.
Portfolio monitoring, assessment and reports.
Responsibilities and information required of third parties, fund managers, brokers,
etc.
The investment policy needs to be approved by the Board of Directors or Supervisory
board.
The company that lacks the appropriate personnel to manage its portfolio may
contract an investment banking, a fund manager or a financial advisor. In these cases,
the company will need to consider the manager’s wage, the resources available for
him and his experience.
Companies should clearly communicate their investment policy to the advisor, to
prevent him from making decisions that infringe that policy.
The short-term policies strategies of the company will vary depending on its
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objectives:
A conservative profile will hold investments until they are mature or for the term
established in the investment policy.
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Unit 8. Key Ideas
An aggressive profile will actively manage its portfolio, where there is turnover in
assets sales.
The company may also consider the fiscal consequences of managing its portfolio
and the benefit that investment in certain assets may bring to the organization.
A company that manages its own portfolio may choose to hold investment in few
money market funds, which are liquid and have few risks.
8.3. Short-Term Investment Management
Short-term investment management is a fundamental part of current assets
management. In large-sized companies, this means managing a portfolio with various
types of short-term investment.
Return is the money gained from investment, and it is determined by the time the
investor stops using that capital. In short-term investment, it is shown in an annual
percentage or at a nominal rate, even though the term may be less than a year.
The formulas to calculate short-term investment return are the following:
Annual Return = maintenance term return x days in the year / days to maturity date
Maintenance term return = sum received by maturity date – invested sum /
invested sum
Return may be at risk because of several factors that are to be considered:
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Credit risk: it is the risk that the investor may not be paid at the end of the maturity
term. Normally, investments with a greater return imply a greater risk – that is
why the return is higher -, and this risk may remain unpaid. A way to minimize
credit risk is to check the credit risk that rating agencies assign to the investment,
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Unit 8. Key Ideas
such as Standard & Poor’s, Moody’s Fitch and Dominion. But not every investment
is rated by rating agencies.
Liquidity risk: it is the risk that the investment may not be undone at the desired
moment because there is no buyer (in private investment), or because the term
established for the investment has not finished.
Price or interest risk: it occurs when the interest rate in the market is on the rise,
which may result in a value loss of the initial investment. For example, an
investment in government debt where interest rates are rising, the investment
value will drop as interest grows.
Exchange rate risk: if the company invests in assets in foreign currencies, it should
consider the risks of the variation of exchange rates that may arise from the
purchase moment until the moment when the investment is made, not
considering what it is or the maturity term agreed, because currencies fluctuate
constantly.
8.4. Short-Term Financing
Short-term financing (less than a year) facilitates companies to finance their assets,
for example accounts receivable and inventory. Let’s analyze the various alternatives
which companies have to be financed.
Commercial Credits
It is one of the most used financing methods. The buyer receives the goods or
services, but the payment is not made until a later date. The seller allows the buyer
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to use the sum of money, which, in another context, would be demanded when the
goods are delivered, for other purposes. It is important that both the buyer and the
seller manage the payment term properly because a buyer that has paid in advanced
is no longer using a line of credit without interests (unless there is a discount for early
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Unit 8. Key Ideas
payment); and a seller that provides an excessive payment term, is not managing
flows and surplus properly.
Internal Loans (Intra-Company)
Companies may also be financed internally. For example, in a business group, the
companies of the group may finance each other or may ask the parent company for
financing. The same happens among business units. These are companies that have
developed internal banks (or in-house banks) or internal loans.
This type of loans is documented formally, and the applicable interest rates are the
market’s. The advantage is that the organization holds liquidity and the benefits
stemming from the loans.
Companies which make use of this entity for financing will need to consider the
governing law of each country on this type of financing and its fiscal consequences.
Factoring
It consists in selling the accounts receivable (invoices) to a financial entity, either a
bank or a financial establishment. The buying entity, or factor, acquires the accounts
receivable of the company at a discount.
Factoring can either be with or without “recourse,” which is the right to claim. In
factoring with recourse, the factor is entitled to return the invoices that he had been
unable to collect and receive the paid sum for purchasing the invoices. In factoring
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without recourse, the buyer runs the risks stemming from the operation.
The important aspect of factoring is that the factor acquires the accounts receivable
with the credit rating of the seller, only considering the risks brought on by the
bearers of receivable invoices.
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Unit 8. Key Ideas
Bank Loan
Bank loans are a mainstream source of financing for companies. These types of loans
may be structured with or without collateral or guarantees by the company.
When a company asks for a great sum on loan, the bank entity may decide to invite
other bank entities to loan. This is known as syndicated loan.
A line of credit is a sum of money that a financial entity provides to a company for a
certain time. The organization does not receive the entire sum at the beginning of
the operation. It will receive it according to the needs at different moments. This type
of loans is tailor-made, and the bank entity will set the terms of use and payment that
it considers appropriate.
The lines of credit may also be structured with or without guarantees and the bank
entity may agree or not to provide them.
The differences between loans and lines of credit are:
In a loan, the total sum is provided at the beginning of the operation. On the other
hand, in a line of credit, the needed amount is provided when necessary.
In loans there are interests to pay from the moment the capital is provided,
whereas, in lines of credit, the interests will be paid when the necessary capital is
available.
The line of credit may be renewed several times after it is due, whereas the loan
shall be redeemed within the term agreed upon.
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The term in a line of credit is shorter than in a loan.
The interest rates tend to be higher in lines of credit than in loans
The users of lines of credit are usually self-employed individuals and small and
medium-sized companies that need to cover their liquidity needs at certain
moments.
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Unit 8. Key Ideas
Revolving Credit
The revolving credit agreement is a line of credit to which a bank entity commits, for
a certain term, usually several years.
Commercial Paper Issuance
Commercial paper issuance (corporate debt) requires a credit rating agency to be
involved, and the rating to be high, aiming to attract potential buyers. Sometimes,
the issuing has a guarantee given by the bank entity, in case of default of the issuer.
In this case, the credit rating used during the debt offer is the bank’s credit.
The costs related to the issuing of this type of debt are high and include those
regarding the rating agency, the bank’s guarantee and those associated to the
financial intermediary for its placement in markets.
This is the reason why companies accumulate debt when they need high financing
sums, in which the financing rate may be attractive.
Asset-Based Lending (Inventory or Accounts Receivable)
Bank entities and financing establishments offer loans whose collaterals are the
accounts receivable or the inventory.
8.5. Bibliographical References
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Masson, D. & Krawczyk, M. (2012). Essentials of Treasury Management. AFP.
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Unit 8. Key Ideas
In Depth
What is an Investment Policy Statement (IPS)?
Corporate Finance Institute. (n. d.). What is an Investment Policy Statement (IPS)?
[Link]
investing/investment-policy-statement-ips/
Article about the components of an investment policy statement.
Investment Policy Statement
Morgan Stanley. (2016). Rethinking Your Investment Policy Statement. Global Liquidity
Solutions.
[Link]
tment_Policy_Statement.pdf
Recommendation for corporate treasurers on liquidity management, cash
segmentation and investment.
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Project Finance and Risk Management
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Unit 8. In Depth
Test
1. Which of the following items of information are not necessary to be included in a
company’s short-term investment policy?
A. The number of employees.
B. The maximum investment term.
C. An asset’s minimum rating by a rating agency.
D. The investment objectives.
2. Which of the following is not part of a short-term investment strategy?
A. Fiscal consequences.
B. Turnover frequency of the assets
C. The name of the person in charge of managing investment.
D. Risk and liquidity rate.
3. Return may be in danger due to:
A. The possibility that the investor may not be paid at the end of the maturity term.
B. The possibility of rising interest rates.
C. The possibility of fluctuation of the currency in foreign currency investment.
D. All of the above.
4. Which of the following is not a short-term financing option?
A. Leasing.
B. Factoring.
C. Internal Loans.
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D. Bank Loans.
Project Finance and Risk Management
Unit 8. Test 11
5. The financing method in which the financial entity provides a sum of money to a
company for a certain time is called:
A. Factoring.
B. Bank Loan.
C. Line of credit.
D. Commercial paper.
6. In revolving credits, the bank entity agrees to:
A. Provide a line of credit for several years.
B. Ensure its issuing.
C. Buy the invoices.
D. Provides funding in exchange for the company’s inventory as a collateral of the
loan.
7. In a commercial credit:
A. The bank agrees to provide the company a certain sum of money for a certain
time.
B. The buyer acquires the goods or services but does not pay until a later date.
C. The buying entity obtains the accounts receivable at a discount.
D. The company obtains financing asking the parent company for a loan.
8. In internal loans:
A. They are formally documented and the interest rates applicable are market
rates.
B. There is a right to claim.
C. Collateral may be demanded.
D. There are fees for using the loan.
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Project Finance and Risk Management
Unit 8. Test 12
9. Paper issuing does not necessarily require:
A. The involvement of a credit rating agency.
B. The use of financial intermediaries.
C. The bank’s guarantee.
D. High credit rating.
10. The “recourse” right is present in:
A. Factoring.
B. Revolving credit.
C. Commercial credit.
D. Line of credit.
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Project Finance and Risk Management
Unit 8. Test 13