The cost of not borrowing…

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Unused Line Fees or Commitment Fees

Everyone understands loans have an interest rate applied to the balance or the amount borrowed.  Not everyone understands business lines of credit generally come with ‘Commitment Fees’ or ‘Unused Line Fees’ applied on the amount of the line of credit not borrowed.  It is generally a relatively low rate compared to the interest rate, and it is basically the fee the bank charges to have the amount of the line of credit available for you to borrow if and when you need it, even though you are not currently using it.  Middle market CFO’s should understand the following 3 points:

(1) They may be negotiable.

(2) When comparing 2 or more loan offers, include the unused line fees in the analysis.  The difference may be substantial enough to tip the scales to one loan versus another.  If so, remember point #1.

(3) When determining the amount of the line of credit, include the unused line fees in the analysis.  While it may be best to have more credit available than you think you will need, understand the cost and factor it into your decision.

Although the reason the banks charge unused line fees is understandable and the cost is relatively small (especially compared to the amount of interest you might be paying on the portion of a term loan you don’t need), unused line fees are often a source of annoyance to many business owners and CFO’s who simply can not get used to the idea of paying the bank a fee on money they are not borrowing.  What types of fees and business expenses are the most annoying to you?

Hedging with Derivatives; Part 2 of 3: Interest Rate Risk

If variable interest rates leave your company exposed, you should consider an interest rate hedging strategy.  The most common method is a ‘vanilla’ interest rate swap which can be used to effectively convert all or part of a variable (LIBOR + X) rate loan into a fixed rate loan, thereby mitigating the risk of fluctuating exchange rates.  Simple example:  You have a $2 million loan that pays a variable interest rate.  You can enter into a swap agreement whereby you will borrow $1 million at a fixed rate and invest it in a security that earns a variable rate.  This will reduce your exposure to fluctuations in the variable LIBOR rate.

Another situation that may necessitate an interest rate hedging strategy is when you are anticipating a significant inflow or outflow of cash to take place in the future, perhaps one year from now.  The viability of the strategy may depend to some degree on the interest rate at that time, and you do not know what that interest rate will be.  By purchasing a Treasury futures contract, you could effectively ‘lock-in’ the interest rate now.  This will take one important variable out of the equation and make it easier to focus on the other aspects of the deal.

As with other types of hedging, remember the purpose of a hedge program is to mitigate risk.

Next up:  Hedging with Derivatives; Part 3 of 3:  Commodity or Product Input Risk

Hedging risk with derivatives

Warren Buffet called derivatives “financial weapons of mass destruction”.  Warren is right, as always, but he also understands their purpose.  Derivatives can be extremely risky investments, but when used properly, they are tools to reduce risk.  It is very important when implementing a hedging strategy to build in sufficient oversight & accountability and follow the policy closely.  This not only protects the interests of the company, for the CFO it is about CYA – covering your ass-ets.  When done right, a hedge strategy is like insurance.  It costs the company money and you hope you never need to use it.  It’s about cutting your losses, not making money. The idea is the cost of the hedge is far less than the potential loss had you not hedged.  CEO’s and owners will sometimes forget this point and question why you spent money on derivatives that expired with no value.  If the strategy was clearly presented to them, they participated in the decision and signed off on it, it will help them remember the blurry uncertainty you were hedging against at the time the strategy was implemented, which can be difficult to see when hindsight is 20-20.

To help you evaluate a company’s use of derivatives for hedging risk, in this 3 part series, we’ll look at the three most common ways to use derivatives for hedging.