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Discounting &Factoring
(A Presentation of Banking & Financial Markets )
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Discounting
Discounting simply means, multiplying
an amount by a discount rate & then
subtracting from principal to computeits present value (the 'discounted value').
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Bill of exchange can be discounted before its
maturity date.
It is basically a three-party negotiable instrument in
which; The first party, the drawer, presents an order for the
payment of a sum certain on a second party, the drawee,
for payment to a third party, the payee, on demand or at
a fixed future date.
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What if the payee needs the payment before thematurity date???
The bill can be presented for discounting to the bank
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Three major things to notice when the bill is
being presented for discounting;
The signature as well as credit limit of the banksborrowers have been verified.
The original tenor of the bill does not exceed 120
days ifBill Discounting Facility is to be availed of.
The payment instructions and maturity date areclearly mentioned on the bill.
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Discount Rate:
The rate at which the bill is discounted i.e. the rate
at which the present value of the bill is calculated.
Tenor (Discount period):
The period between the date of discounting and the
future due date that is written on the bill.
Discount fee: A fee is charged for discounting the bill. It varies
from bank to bank. And its not higher as well.
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Example;
A person XYZ comes to the bank and wants to
discount his Bill ofExchange of Rs. 500, 000/- on
June 1, 2009-. The maturity date ofBill ofExchange
is August 15, 2009.
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The bank decides to purchase it at a discount rate of 10%.
Total number of days= 75 days
DiscountAmount= 500,000*10%*75/365= 10274
The person XYZ will get 500,000 10274 = 489726
This shows bank has purchased the bill at the price of 489726
And after 75 days the bank will make profit of 10274.
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Bill ofExchange has the advantage of reselling
many times before the maturity date.
Every time it is sell a stamp ofEndorsement (Asignature used to legally transfer a negotiable
instrument) is placed for the prove on the bill.
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Continuing with theexample:
For example the bank sells this bill to another bank
ABC when there were 50 days to maturity. The bill
was discounted by bankABC at the rate of 9%
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The tenor = 50 days
Discount rate = 9%
Discount amount = 500,000 * 9% * 50/365
= 6164
The bank gets = 500,000 6164
= 493836
Profit that bank gets = 493836 489726
= 4110
The purchasing price for the bankABC = 493836
After 50 days the BankABC will get the profit of 6164.
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Advantages
To Banks:
S
afety of Funds. (signed by the parties. Its a promisethat they will get their amount back)
Profitability. (by re-investing it/utilizing it)
The buyer of the bill expects to make a profit by purchasing
the bill at a discount to its face value & then either receiving
full payment at maturity or reselling the bill before maturity. No change in the face value of the bill.
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Advantages
To the payee who comes for discounting
G
etting immediate cash Normally lower discount rates
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Factoring
The selling or transferring of accounts
receivable to a third party in order to gain
funds that are immediately available. The purchase is made at a discount from the
account's value.
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Three parties are involved in it;
Factor
A company sells its receivables to another company,
which is called a factor.
Selling Company (Customer)
Buyer ( debtor )
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For Example;
A company ABC sells its machinery to XYZ and
creates an invoice. The Company ABC needs the
cash, so it will go the bank and will sell its invoices
(Accounts Receivables) at a discount to get
immediate cash.
Bank Factor
Company ABC Seller
XYZ Debtor
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Types of factoring
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Example:
ACompany XYZ has sold the invoices of amount Rs.
500,000/-. The selling company goes to the bank to
discount its invoices that are receivable in 2
months. In contract it is decided to pay 85% of the
invoices in advance.
Payment made by factoring company = 500,000*.85
= 425,000
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Assume that after 2 months the bank collected only400,000 of invoices
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With RecourseWithout Recourse
The bank will have the loss of:= 425,000 400,000
= 25,000
Plus all the interest & charges.
The factor is at risk
The Selling Company (Customer)will itself pay the bank the
remaining payment which is not
collected:
= 425,000 400,000
= 25,000
Plus all the interest & charges.
The factor is not at risk
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Advantages of Factoring (to Selling
company):
Get money quickly Avoid thehassle of collecting baddebt
Under the agreement of without recourse
Borrow money, secured by your debt
Smooth your cash flow
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Disadvantages:
Higher cost of factoring
the fact that sellers clients have to deal with thefactoring companies
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Similarity
Discounting & factoring both provides the
ready & immediate cash (finance) rather than
waiting for the maturity date.
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Differences
FactoringDiscounting
Discounting is done for:
Bills ofExchange under L/Cs.BankersAcceptance.
Promissory Notes
Factoring is done for:
Receivables receipts/ invoices.
Discounting of bills can be donemany times before reaching the
maturity date.
In factoring the accountsreceivables once purchased
can not be resell.
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Differences
FactoringDiscounting
In case of discounting the bank
dont have to bear the risk of
repayment.
In case of factoring without
recourse the bank have to bear
the risk of the collection of
receivables.
Discounting charges are muchlower.
Factoring charges are higher as
the factor is also maintainingthe sales ledger of the
company plus bearing the risk
of repayment.
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Differences
FactoringDiscounting
Companys profile/performancedoes not matter a lot.
Companys profile/ performance
is considered highly. Only those
companies which have good
profitable profiles are selected.
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THANK YOU
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