Business finance ch 16 financing current assets

CHAPTER 16Financing 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.

Short-term credit

 Any debt scheduled for repayment

within one year

 Major sources of short-term credit

 From the firm’s perspective, S-T credit

is more risky than L-T debt

corner.

Advantages and disadvantages

of using short-term financing

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 expenditures

 Firm buys goods worth $3,000,000

That’s the cash price

 They must pay $30,303 more if they

don’t take discounts

 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

Total trade credit $328,767

Free trade credit - 82,192

Costly trade credit $246,575

Nominal cost of costly trade

 The $30,303 is paid throughout the

year, so the effective cost of costly

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 following scenarios:

compensating balance

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

Raising necessary funds with

a discount interest loan

is borrowed but $8,000 is forfeited

because it is a discount interest loan.

then the amount of the loan should

be:

Discount interest loan with a 10% compensating balance

$121,951 0.1

0.08 -

-1

$100,000

balance comp.

discount -

-1

needed

Amount borrowed

an annuity.

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