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Chapter 12.docx

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FIN 502
Joan Lobo

Chapter 12: Credit and Debt Management Debt Capacity Why use credit? - When you borrow, lender giving you credit/trust against your future earnings - Use to buy s/t now - Borrowing allows income stream to match desired consumption - Can acquire assets sooner and in larger amts - Over-in-debtness through circumstances beyond control = loss of unemployment, reduction of income - Right way to take adv of credit = free loan grace period, detailed record keeping, - Wrong way to take adv of credit = build up large debt bal and pay over 18% non-tax-deductible interest Debt capacity - Questions to ask: o How much debt can individual take? o Is there an optimal level of debt that indiv can take? o What are the factors that affect this optimal level of debt? o How can s/o manage credit and debt effectively? - Debt capacity – amt of debt can reasonably expect to be able to repay under terms of loan agreements given current and expected future fin situations (A,L, CF, income, exp) - Looks at what borrower has today and what borrower will have in future - Determinant of debt capacity = expected future net C/ ability to generate CF after living exp and capital outlays to pay interest and principal - Lender – interested in borrowers S-T and L-T ability to pay interest and principle Liquidity and Solvency - Liquidity - ability of family to meet debt service pmt in S-R - Solvency – L-R ability of family to pay its debts Assets vs. Cash Flow - 2 sources of cash to pay off loan: 1. CF 2. Asset sale - Higher expected net assets and net CF = higher debt capacity Risk - future uncertain → assess risk of future CF and future asset val - how likely CF is to fail to provide for all debt service charge - f/ variability of CF → CF low = problem meeting debt obligations - variability of CF f/: o ∆ in earning streams  loss of employment  pay cut  death of breadwinner  disability/ poor health  failure of small bus/  w/drawl f/ work b/c pregnancy o ∆ in asset val → dep; ∆ mutual funds → L-R appreciate, S-R up/down  dep f/ wear/tear  -ve ∆ in ecn  ↑ interest rate  obsolescence of one's professional skills → ↓ val of human capital - variability in CF and asset val ↓ → use insurance How much debt can you afford? - liquidity, solvency, risk affect borrowers debt capacity - depend on spending obj/habits (comfort zone) and family's risk tolerance/risk preference (debt level) - budget income and exp → cover liquidity and solvency aspects of debt - surplus = can afford loan Debt service ratios - consumer credit and debt f/ banks, credit cards, fin comp - Gross Debt Service (GDS) - not over 30% o - Total Debt Service (TDS) - not over 40% o - budgeting process better than ratios - Disadv: o ratios don't allow for risk o ratio based on gross income → not allow for effect of taxes → after tax income a lot higher o applicable for average incomes only (($40,000- $60,000) o not give info on S-R liquidity and L-R solvency that budget would give - Adv: o easy to calc o fin institutions use them o assess debt capacity → prep budget for entire loan period and calc ratio to see if w/in current benchmark → indication how much can borrow Matching Assets and Debts - matching principle in finance - match expected ecn life f asset to term of maturity in fin - asset w/ long expected ecn lives (real estate) - fin by L-T debt - life of asset (yrs) = fin loan period (yrs) → life of home (25 yrs) = pay off loan in (25 yrs) / amortize Consumer Credit Consumer credit - borrow $ to purch consumer good/asset/service ex: personal loans, auto loans, credit cards, home equity loans → not borrowing $ to invest = investment loan Consumer loans and time value - loan rate quoted in EAR = monthly compounding, and payable monthly = norm - loan rate quoted in APR = not allow monthly compounding - PV = purch price I% = [(# pmt per yr *√1 + effective annual interest rate) - 1][100%] = [(12 monthly pmt)*√1 + 0.1122) -1][100%] n = # pmts PMT = ? Personal credit management 1. how do you get credit? 2. how do you build up and maintain +ve credit habits? 3. how do you maintain a good credit record? 4. how do you spend the $ that you have to borrow? How do you get credit? - credit f/ banks, trust companies, credit unions → specialize in low risk loans - fin comp and loan comp tied to sellers (Ford, Canadian Tire) → specialize in higher credit risk loans = high interest rate loans - borrower → want pay low interest rate Credit scoring - characteristic given score based on credit std → high score = get credit/loan - tell truth Your credit file - credit reporting agency - credit file o record all relevant info in your file and make info avail to credit bureau members - group inclu banks, insurance comp, other lenders and issuers of credit - unfavourable credit report jeopardize future credit and loan applications - rights you have for credit file(except Alberta and New Brunswick: o can ask any credit bureau to give complete, accurate copy of file o can req re-verification by credit bureau if info incorrect o can ask missing data added to file o can know exactly why refused credit Allowable rate of interest charging unreasonably high interest rate = criminal offence = jail Criminal code: criminal rate of interest - "criminal rate" - 60% is supposed to be an effective annual rate,effective annual rate of interest cal in accordance w/ GAAP and principles that exceeds 60% on credit advanced under an agreement/arrangement - "interest" - fixed fees/service charges levied by natural gas utility on ppl who paid their bills late were interest charges under Act o not exceed 60% on annual basis even though fees small in $ and reasonable Common types of credit and loans Open account credit and credit cards - Open account credit - most common type of credit o form of credit extended to consumer in advance of transactions o good idea if you pay full amt of account bal b4 the due date → don't have to pay interest charges = get free loan o charge high rate of interest on bal not paid in full on due date = most exp debt - avoid credit card fin What kinds of cred
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