Slide Financial Management - Chapter 16 pps

CHAPTER 16 Financing Current Assets „ Working capital financing policies „ A/P trade credit „ Commercial paper... Working capital financing policies„ Moderate – Match the maturity of th

CHAPTER 16

Financing Current Assets

„ Working capital financing

policies

„ A/P (trade credit)

„ Commercial paper

Working capital financing policies

„ Moderate – Match the maturity of the assets with the maturity of the

financing.

„ Aggressive – Use short-term financing

to finance permanent assets.

„ Conservative – Use permanent capital for permanent assets and temporary assets.

Moderate financing policy

L-T Fin:

Stock, Bonds, Spon C.L.

Conservative financing policy

L-T Fin:

Stock, Bonds, Spon C.L.

Short-term credit

„ Any debt scheduled for repayment within one year

„ Major sources of short-term credit

„ Accounts payable (trade credit)

„ Bank loans

„ Commercial loans

„ Accruals

„ From the firm’s perspective, S-T credit is

more risky than L-T debt

„ Always a required payment around the corner.

Advantages and disadvantages of

using short-term financing

„ Fluctuating interest expense

„ Firm may be at risk of default as a result of temporary economic conditions

Accrued liabilities

„ Continually recurring short-term

liabilities, such as accrued wages or

taxes.

„ Is there a cost to accrued liabilities?

„ They are free in the sense that no

explicit interest is charged

„ However, firms have little control over

the level of accrued liabilities

What is trade credit?

„ Trade credit is credit furnished by a firm’s suppliers

„ Trade credit is often the largest source of short-term credit, especially for small

firms

„ Spontaneous, easy to get, but cost can

be high

The cost of trade credit

„ A firm buys $3,000,000 net ($3,030,303

gross) on terms of 1/10, net 30

„ The firm can forego discounts and pay on Day 40, without penalty

Net daily purchases = $3,000,000 / 365

= $8,219.18

Breaking down net and gross

„ Think of the extra $30,303 as a financing

cost similar to the interest on a loan

„ Want to compare that cost with the cost of

a bank loan

Breaking down trade credit

„ Payables level, if the firm takes discounts

„ Payables = $8,219.18 (10) = $82,192

„ Payables level, if the firm takes no discounts

„ Payables = $8,219.18 (40) = $328,767

„ Credit breakdown

Total trade credit $328,767

Free trade credit - 82,192

Costly trade credit $246,575

Nominal cost of costly trade credit

„ The firm loses 0.01($3,030,303)

Nominal trade credit cost formula

12.29%

0.1229

10 - 40

365 99

1

period Disc.

taken Days

-days

365

% Discount -

Effective cost of trade credit

„ Periodic rate = 0.01 / 0.99 = 1.01%

„ Periods/year = 365 / (40-10) = 12.1667

„ Effective cost of trade credit

„ EAR = (1 + periodic rate) n – 1

= (1.0101) 12.1667 – 1 = 13.01%

Commercial paper (CP)

„ Short-term notes issued by large, strong

companies B&B couldn’t issue CP it’s

too small

„ CP trades in the market at rates just

above T-bill rate

„ CP is bought with surplus cash by banks

and other companies, then held as a

marketable security for liquidity purposes

Bank loans

„ The firm can borrow $100,000 for 1

year at an 8% nominal rate.

„ Interest may be set under one of the

Must use the appropriate EARs to

evaluate the alternative loan terms

„ Nominal (quoted) rate = 8% in all cases

„ We want to compare loan cost rates and

choose lowest cost loan

„ We must make comparison on EAR =

Equivalent (or Effective) Annual Rate basis

Simple annual interest

„ “Simple interest” means no discount or

Raising necessary funds with a

discount interest loan

„ Under the current scenario, $100,000 is borrowed but $8,000 is forfeited

because it is a discount interest loan.

„ Only $92,000 is available to the firm.

„ If $100,000 of funds are required, then the amount of the loan should be:

Amt borrowed = Amt needed / (1 – discount)

Discount interest loan with a

10% compensating balance

$121,951 0.1

0.08 -

-1

$100,000

balance comp.

discount -

-1

needed

Amount borrowed

Add-on interest on a 12-month installment loan

What is a secured loan?

„ In a secured loan, the borrower pledges

assets as collateral for the loan

„ For short-term loans, the most commonly pledged assets are receivables and

inventories

„ Securities are great collateral, but

generally not available