RE-160 Lecture Notes - Lecture 30: Finance Charge, Title Insurance, Discount Points
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this is an ethical question regarding options ARMs posed by myinsturctor:
Alan recently joined Friendly Investment and Financing Options(FIFO) as a loan officer. FIFO is a national company thatspecializes in mortgage lending. One of Alanâs responsibilities isto increase the amount of mortgages FIFO initiates. In a meeting hehad with the CEO yesterday, Alan was told about a new mortgage thatFIFO intends to market. The new mortgage is called an optionadjustable rate mortgage, or an option ARM for short, and its mostattractive feature is that homeowners can choose to make relativelylow monthly payments at the beginning of the mortgage period.However, the payments increase significantly later in the life ofthe mortgage. In fact, depending on the amount the borrower choosesto pay early (hence, the term âoptionâ), the amounts that must bepaid later could be substantialâas much as four to five times theinitial payments. In many cases, when a homeowner chooses to paythe minimum amount or an amount that he or she can afford, themortgage turns âupside down,â which means that the amount due onthe mortgage grows to an amount that is greater than the value ofthe house.
The primary benefit of option ARMs to borrowers is that suchloans allow those who cannot afford the monthly payments associatedwith conventional mortgages the opportunity to purchase houses. Aborrower with income that is lower than is needed to qualify for aconventional mortgage can borrow using option ARMs, choose anaffordable (lower than conventional) payment in the early years ofthe mrotgage, and then make the higher payments in later years,when their incomes presumably will be higher. Thus, option ARMspermit those who canât afford conventional mortgages to buy housestoday that they otherwise couldnât afford until years into thefuture.
Lenders such as FIFO like selling option ARMs because they canrecognize as current revenues the monthly payments that would berequired if the loans were conventional mortgages, regardless ofthe amounts that the borrowers opt to pay. In other words,companies can âbookâ revenues that will not be collected for a fewyears.
Unlike most people, including many professionals, Alanunderstands the complexities of option ARMs. He knows that manyborrowers who choose such mortgages will lose their houses three tofive years after buying them because the payments increase sosignificantly after the low-payment option period expires thatthese borrowers cannot afford the new monthly payments. And,although they would like to refinance with conventional mortgages,often these homeowners do not have good enough credit. Thisscenario is quite disturbing to Alan. He would like to explain tohis customers in clear terms the possible pitfalls of option ARMs,but the CEO of FIFO has instructed Alan that he should provide onlythe information that is required by law and to follow companypolicy, which states that lending officers should provide basicprinted material, give simple advice, and answer questions thatmight provide negative information only when asked.
Alan has a bad feeling about option ARMs. He knows that they aregreat lending/borrowing tools when used as intended. He is afraid,however, that FIFO is more concerned about booking revenues thanabout the financial wellbeing of its customers (borrowers).
Small business management class.
Please answer the two questions from the article belowplease.
Q1)Which one of the techniques to increase cash inflows is bestillustrated in the article? Explain how you know. ?
Q2)Which one of the techniques to decrease cash outflows is bestillustrated in the article? Explain how you know. ?
The financial crisis on Wall Street is quickly spiraling down tosmall businesses, making it extremely difficult for them to securefrom large banks the credit they need to start and maintain theiroperations.
Some businesses that currently have good relationships withbanks are getting more scrutiny and higher interest rates -- suchas 15% or more. Riskier borrowers are being denied creditaltogether.
Aside from falling back on friends or family -- or charging upyet another credit card -- here's a look at five alternatives forgetting extra cash to run a business in this economy.
-- Peer-to-Peer Lending Sites
Several Web sites now facilitate loans between individuals whodon't know each other. Typically, the prospective borrowers createprofiles that include how much they need to borrow, what the moneywill be used for and some credit history.
Other individuals can browse the loan requests and make offersthat include payment terms and interest rates. Prospective lendersalso get a risk assessment of the borrower generated by the Website based on the borrower's credit history.
Some "peer-to-peer" lending sites include LendingClub.com,Prosper.com, RaiseCapital.com and Zopa.com.
On Prosper.com, for instance, 25% of borrowers are individualsrunning or looking to start businesses, says Chief Executive ChrisLarsen. The site facilitates loans between individuals from $1,000to $25,000, and interest rates on those loans right now range from6% for those with the strongest credit ratings to about 30%.
Prosper, which has 800,000 registered users, is seeing moreentrepreneurs with good credit scores signing up. "We're certainlyseeing a steady increase of the quality of borrower coming to oursite," Mr. Larsen says. About 55% of the loans being funded are forborrowers with credit scores above 720, he adds, while only about5% are for those categorized as "subprime" borrowers.
-- Community Banks, Credit Unions
While big banks are being battered by all the financial turmoilon Wall Street, many local banks and credit unions are far morestable.
In fact, community banks continue to expand, although some havesuffered losses on securities issued by troubled mortgage giantsFannie Mae and Freddie Mac, says Camden Fine, chief executive ofthe Independent Community Bankers of America, an industryassociation in Washington.
Still, he says, even the community banks are more hesitant tolend to companies that lack rock-solid balance sheets.
-- Factoring, Asset-Based Loans
Though certainly not a cheap route to capital, some banks andnon- bank financing companies offer financing that is backed by abusiness's assets or accounts receivable.
So-called factoring, where a lender might, say, outright give aborrower 80 cents on the dollar for the company's accountsreceivable, can be a good option for businesses like manufacturersthat are owed a lot of money by customers and that have no betterlending option right now, says Raphael Amit, an entrepreneurshipprofessor at the University of Pennsylvania's Wharton School.
Interest rates on such financing can sometimes run 15% orhigher, so it's best to only resort to this approach when there'sno lower-cost option.
So-called asset-based loans -- loans in which assets such asinventory, equipment or real estate are used as collateral -- canbe good options for companies with lots of assets. But again, ratestend to run much higher than on traditional bank loans. The loanamounts are often capped at a percentage of the assessed value ofthe assets, such as 65%.
Also, even loans backed by assets can be difficult to get forcompanies with less-than-stellar credit ratings. Mark Sunshine,president of First Capital, a West Palm Beach, Fla., financecompany, says he's seeing more demand for loans based on accountsreceivable or assets, but isn't necessarily doing much morebusiness. "There's a reason local banks won't lend them money," hesays of riskier small companies. He says he's sticking to companieswith lots of assets to use as collateral.
-- Negotiating With Customers or Suppliers
Another smart strategy for helping cash flow -- perhaps even ifyou do have access to loans -- is striking better payment termswith customers and suppliers, Prof. Amit says. Especially whenbusiness relationships are strong and long-lasting, many companiesare willing to help each other out in tough economies.
A business that usually gives customers 30 to 60 days to pay thebills, for instance, might require customers to pay upon receipt ofgoods. A supplier, on the other hand, might be willing to extendlengthier payment terms to a business customer if it feels thecustomer is trustworthy and vital to its own business. Somesuppliers also will lend money to their longstanding, most valuedcustomers.
-- Changing Behaviors
Hard times call for small businesses to be nimble andentrepreneurial. Many businesses are using the tough economy toscrutinize their business practices and find creative ways tocreate better cash flow.
Some turn to leasing instead of buying equipment they need.
Others are identifying areas of the business that will tend tobe more lucrative in today's economy and shifting their resourcesin those directions.
Case 13â6: Butler Lumber Company*
After a rapid growth in its business during recent years, the Butler Lumber Company in the spring of 2011 anticipated a further substantial increase in sales. Despite good profits, the company had experienced a shortage of cash and had found it necessary to increase its borrowing from the Suburban National Bank to $247,000 in the spring of 2011. The maximum loan that Suburban National would make to any one borrower was $250,000, and Butler had been able to stay within this limit only by relying very heavily on trade credit. In addition, Suburban was now asking that Butler secure the loan with its real property. Mark Butler, sole owner and president of the Butler Lumber Company, was therefore looking elsewhere for a new banking relationship where he would be able to negotiate a larger and unsecured loan.
Butler had recently been introduced by a friend to George Dodge, an officer of a much larger bank, the Northrop National Bank. The two men had tentatively discussed the possibility that the Northrop Bank might extend a line of credit to Butler Lumber up to a maximum amount of $465,000. Butler thought that a loan of this size would more than meet his foreseeable needs, but he was eager for the flexibility that a line of credit of this size would provide. After this discussion, Dodge had arranged for the credit department of the Northrop National Bank to investigate Mark Butler and his company.
The Butler Lumber Company had been founded in 2001 as a partnership by Mark Butler and his brother-in-law, Henry Stark. In 2008 Butler bought out Starkâs interest for $105,000 and incorporated the business. Stark had taken a note for $105,000, to be paid off in 2009; to give Butler time to arrange for the financing necessary to make the payment of $105,000 to him. The major portion of the funds needed for this payment was raised by a loan of $70,000, negotiated in late 2008. This loan was secured by land and buildings, carried an interest rate of 11%, and was repayable in quarterly installments at the rate of $7,000 a year over the next 10 years.
The business was located in a growing suburb of a large city in the Pacific Northwest. The company owned land with access to a railroad siding, and two large storage buildings had been erected on this land. The companyâs operations were limited to the retail distribution of lumber products in the local area. Typical products included plywood, moldings, and sash and door products. Quantity discounts and credit terms of net 30 days on open account were usually offered to customers.
Sales volume had been built up largely on the basis of successful price competition, made possible by careful control of operating expenses and by quantity purchases of materials at substantial discounts. Much of the moldings and sash and door products, which constituted significant items of sales, were used for repair work. About 55% of total sales were made in the six months from April through September. No sales representatives were employed, orders being taken exclusively over the telephone. Annual sales of $1,697,000 in 2008, $2,013,000 in 2009, and $2,694,000 in 2010 yielded after-tax profits of $31,000 in 2008, $34,000 in 2009, and $44,000 in 2010.1 Operating statements for
theyears2008â2010andfor thethreemonthsendingMarch31,2011,aregiveninExhibit1.EXHIBIT 1: Operating Statements for Years Ending December 31,411 2008â2010, and for First Quarter 2011 (thousands of dollars)
a ln the first quarter of 2010 sales were $698,000 and net income was $7,000.
b Operating expenses include a cash salary for Mr. Butler of $75,000 in 2008, $85,000 in 2009, $95,000 in 2010, and $22,000 in the first quarter of 2011. Mr. Butler also received some of the perquisites commonly taken by owners of privately held businesses.
Mark Butler was an energetic man, 39 years of age, who worked long hours on the job. He was helped by an assistant who, in the words of the investigator of the Northrop National Bank, âhas been doing and can do about everything that Butler does in the organization.â Other employees numbered 10 in early 2011, 5 of whom worked in the yard and drove trucks and 5 of whom assisted in the office and in sales
As part of its customary investigation of prospective borrowers, the Northrop National Bank sent inquiries concerning Mark Butler to a number of firms that had business dealings with him. The manager of one of his large suppliers, the Barker Company, wrote in answer:
The conservative operation of his business appeals to us. He has not wasted his money in disproportionate plant investment. His operating expenses are as low as they could possibly be. He has personal control over every feature of his business, and he possesses sound judgment and a willingness to work harder than anyone I have ever known. This, with a good personality, gives him a good turnover; and from my personal experience in watching him work, I know that he keeps close check on his own credits.
All the other trade letters received by the bank bore out this opinion.
In addition to owning the lumber business, which was his major source of income, Butler held jointly with his wife an equity in their home. The house had cost $72,000 to build in 1989 and was mortgaged for $38,000. He also held a $70,000 life insurance policy, payable to his wife. She owned independently a half interest in a house worth about $55,000. Otherwise, they had no sizeable personal investments.
The bank gave particular attention to the debt position and current ratio of the business. It noted the ready market for the companyâs products at all times and the fact that sales prospects were favorable. The bankâs investigator reported: âSales are expected to reach $3.6 million in 2011 and may exceed this level if prices of lumber should rise substantially in the near future.â On the other hand, it was recognized that continuation of the current general economic downturn might slow down the rate of increase in sales. Butler Lumberâs sales, however, were protected to a considerable degree from
fluctuationsinnewhousingconstructionbecauseoftherelativelyhighproportionofitsrepairbusiness.Projectionsbeyond2011weredifficulttomake,buttheprospectsappearedgoodfora continued growth in the volume of Butler Lumberâs business over the foreseeable future.
The bank also noted the rapid increase in Butler Lumberâs accounts and notes payable in the recent past, especially in the spring of 2011. The usual terms of purchase in the trade provided for a discount of 2% for payments made within 10 days of the invoice date. Accounts were due in 30 days at the invoice price, but suppliers ordinarily did not object if payments lagged somewhat behind the due date. During the last two years, Butler had taken very few purchase discounts because of the shortage of funds arising from his purchase of Starkâs interest in the business and the additional investments in working capital associated with the companyâs increasing sales volume. Trade credit was seriously extended in the spring of 2011 as Butler strove to hold his bank borrowing within the $250,000 ceiling imposed by the Suburban National Bank. Balance sheets at December 31, 2008â2010 and March 31, 2011, are presented in Exhibit 2.
The tentative discussions between George Dodge and Mark Butler had been about a revolving, secured 90-day note not to exceed $465,000. The specific details of the loan had not been worked out, but Dodge had explained that the agreement would involve the standard covenants applying to such a loan. He cited as illustrative provisions the requirement that restrictions on additional borrowing would be imposed, that net working capital would have to be maintained at an agreed level, that additional investments in fixed assets could be made only with prior approval of the bank, and that limitations would be placed on withdrawals of funds from the business by Butler. Interest would be set on a floating-rate basis at 2 percentage points above the prime rate (the rate paid by the bankâs most creditworthy customers). Dodge indicated that the initial rate to be paid would be about 10.5% under conditions in effect in early 2011. Both men also understood that Butler would sever his relationship with the Suburban National Bank if he entered into a loan agreement with the Northrop
NationalBank.412 Questions 413
What has been the companyâs financial strategy? Why does Mr. Butler have to borrow so much money to support this seemingly profitable business? Has he been managing his companyâs cash flow wisely?
Sales in 2006 and 2007 amounted to $728,000 and $1,103,000, respectively; profit data for these years are not comparable with those of 2008 and later years because of the shift from a partnership to a corporate form of organization. As a corporation, Butler was taxed at the rate of 15% on its first $50,000 of income, 25% on the next $25,000 of income, and 34% on all additional income above $75,000.
This statement is not necessarily consistent with the profit maximization assumption often made in economics. The techniques in this chapter are equally applicable under a profit maximization assumption, however, so there is no point in arguing here whether the profit maximization assumption is valid and useful. Discussion of this point is deferred until Chapter 26.
As described later, net income may be subject to an adjustment for interest expense when calculating ROI.
In this context, the companies are using net assets to mean assets less current liabilities, whereas the formal accounting meaning is assets minus all liabilities.
Diagrams analogous to Illustration 13â1 can be drawn to show return on invested capital or return on assets, as alternative ROI measures.
Major newspapers such as The Wall Street journal print firmsâ P/E ratios along with the firmâs daily stock quotations. These data are also available in many sites on the Internet.
Financial analysts often exclude one-time items from income when calculating profitability ratios. In addition to extraordinary items, one-time items often include restructuring changes, inventory writedowns, asset impairments, contingency losses and gains, and gains and losses on asset dispositions.
A companyâs implied growth rate is often used in dividend and net income-based equity valuation models to normalize dividend and net income growth for future periods beyond five years.