Textbook Notes (368,252)
Canada (161,740)
Finance (362)
FIN 502 (69)
Joan Lobo (33)
Chapter 12

CFIN502- Chapter 12- Credit and Debt Management.docx

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FIN 502
Joan Lobo

CFIN502- Chapter 12- Credit and Debt Management DEBT CAPACITY  Why we use debit o No cash available—credit must be used if the product is to be purchased o Borrowing allows the income stream to match the desired consumption stream o If credit is used properly it can serve a very valuable function o Concerned about people who become over indebted through careless and impulsive use of credit  Debt capacity o Over indebtedness—natural questions  How much debt can a person take on?  Is there an optimal level of debt that a person can take on?  Who are the factors that affect this optimal level of debt?  How can someone manage his or her credit and debt effectively? o Debit capacity Borrowers—amount of debt that he or she can reasonably except to be able to repay under the terms of the loan agreement  Given current and expected and future financial situations o Determinant of someone’s debt capacity—that persons expected future net cash flow, or their ability to generate sufficient cash flow, after living expenses and required capital outlays to pay interest and principal of all loans to maturity o Lender is interceded in both the borrowers short run and long run ability to pay interest and principal  Liquidity and solvency o Liquidity- ability of a family to meet its debt service payments in the short run o Solvency- long run ability of the family to pay its debts  Assets VD cash Flows o Lender is concerned about liquidity and solvency of the borrower o Borrows two sources of cash to pay off loan  Employment income  Sale of assets o Important factor that affect debt capacity—expected net assets or net worth and your expected net cash flow each year o Higher net assets and net cash flow—higher the debt capacity  Risk o How likely the cash flow is to fail to provide for all debt services charges o Comes from variability of cash flows form one period to another  During the time when cash flow id low that the person would have problems meeting their debt obligations o Biggest variation come from changes in earning streams o Causes that affect changes in earnings; loss of employment, pay cut, death of a breadwinner, disability or poor heath, failure of a small business, withdrawal from work for pregnancy o Cause that decrease an assets value; deprecation, negative changes in economy, increase interest rates, disasters, closing of major factory in a small town, obsolescence of ones professional skills  How much debt can you afford? o No theory that determines precise value of debt capacity o No method to determine a family’s optimal level of consumer debt o Amount of debt family can assume depends on spending objectives and family’s risk tolerance o Useful tool for assessing debt capacity—budget of income and expenditure o Budget for the entire period of the loan. The budgeting process will cover both liquidity and solvency aspects of your debt o Add proposed debt payments to the expenses in the budget—see id it still balances  Include all additional expenses or revenues caused by whatever the borrowed money is spent on  Debt service ratios o Commonly quick-scoring method for loan applications  1 CFIN502- Chapter 12- Credit and Debt Management  o Two benchmarks  GDS ration of not over 30%  TDS ratio of not over 40% o Budgeting process is still superior to these ratios for the following reasons  Ratios do not allow for risk  Ratios are based on gross income—do not allow for the effect of taxes  Benchmarks are normally applicable for average incomes only  Ratios do not give information about the short run liquidity and long run solvency that a budget would give  Matching assets and debt o Matching principle in finance—one should match the expected economic life of an asset to the term if maturity of the financing o Assets with long expected economic lives should be financed by long term debt CONSUMER CREDIT  People that borrow money to purchase consumer goods and services—making god use of consumer credit for financing from one form or another  EG; personal loans, auto loans, credit cards, home equity  Where individuals borrows money to purchase consumer assets or services  Consumer loans and time value o Consumer loan is almost invariably repayable in equal monthly installments of blending principal and interest o Compounded and payable monthly o Loan rate quoted as APR or as an EAR—depending on applicable legislation  Personal credit management o Gain knowledge in order to be successful in managing your debt and credit;  How do you get credit?  How do you build up and maintain positive credit habits?  How do you maintain a good credit record?  Hoe do you spend the money that you have to borrow?  How do you get credit o Lenders target their loans towards specific risk classes of borrowers o Banks, trusts companies, and credit unions—specialized in lower risk loans o Finance companies and loan companies that are tied to specific sellers normally specialize in slightly higher credit risk loans o Small finance companies, pawnshops, loan sharks who specialize in high credit risk—high interest risk loans o Borrower—you wan to pay as low an interest rate as possible on a loan  Credit shoring o Lenders use a predetermined scoring system to make credit decisions o Point are added or deducted for various characteristics elicited by the application form o Each characteristic will be given a score based on some credit standard o If you score high—you will get the credit or loan o Evidence of deception will remain in your file and become part of your credit history for a long time  Your credit file o Every major city in Canada has a credit bureau o Credit reporting agency do not evaluate your credit shore  They record all relevant information in your file and make the information available to credit bureau members o Single factor that affects your future borrowing—credit report o Unfavorable credit report—jeopardize your future credit and loan application ALLOWABLE RATE OF INTEREST  Maximum allowable rate of interest for lender to charge is regulated in Canada in the criminal code  Placement of provision against ‘usury’—the changing of high interest rates 2 CFIN502- Chapter 12- Credit and Debt Management o Lender who charges too much may be charged with a criminal offence, and the penalty can include a jail sentence o Such charges are rare and as we will see in the section on alternative credit markets they are not presently encored  Criminal of interest; two definitions are important o Criminal rate- effective annual rate of interest calculated in accordance with generally accepted actuarial practices and principles that exceeds 60% on credit advances under an agreement or arrangement o Interest- aggregate of all charges and expenses form of fee, fine, penalty, commission or other similar charge or expense or in any other form paid or payable for the advancing of credit under an agreement or arrangement  By or behave of the person to whom the credit is or is to be advanced  Irrespective of the person to whom any such charges and expenses are or are to be paid or payable  Does not include any repayment of credit advanced or any insurance charge, official fee, overdraft charge, required deposit balance or, in the case of a mortgage transaction, any amount required to be paid on account of property taxes COMMON TYPES OF CREDIT AND LOANS  Open account credit and credit cards o Form of credit extended to the consumer in advance of any transactions o Good idea if you pay the full amount of the account balance before the due date— don’t have to pay interest charges o Charge high interest rates on balances no
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