1. Ch. 16: Working-Capital Management and Short-Term Financing

4. Working-Capital Management n Current Assets –cash, marketable securities, inventory, accounts receivable n Long-Term Assets –equipment, buildings, land n Which earn higher rates of return? n Which help avoid risk of illiquidity?

5. Working-Capital Management n Current Assets –cash, marketable securities, inventory, accounts receivable n Long-Term Assets –equipment, buildings, land n Risk-Return Trade-off: Current assets earn low returns, but help reduce the risk of illiquidity. Current assets earn low returns, but help reduce the risk of illiquidity.

6. Working-Capital Management n Current Liabilities –short-term notes, accrued expenses, accounts payable n Long-Term Debt and Equity –bonds, preferred stock, common stock n Which are more expensive for the firm? n Which help avoid risk of illiquidity?

7. Working-Capital Management n Current Liabilities –short-term notes, accrued expenses, accounts payable n Long-Term Debt and Equity –bonds, preferred stock, common stock n Risk-Return Trade-off: Current liabilities are less expensive, but increase the risk of illiquidity. Current liabilities are less expensive, but increase the risk of illiquidity.

8. Balance Sheet Current Assets Current Liabilities Current Assets Current Liabilities Fixed Assets Long-Term Debt Fixed Assets Long-Term Debt Preferred Stock Preferred Stock Common Stock Common Stock To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

9. Balance Sheet Current Assets Current Liabilities Current Assets Current Liabilities Fixed Assets Long-Term Debt Fixed Assets Long-Term Debt Preferred Stock Preferred Stock Common Stock Common Stock Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!

10. Balance Sheet Current Assets Current Liabilities Current Assets Current Liabilities Fixed Assets Long-Term Debt Fixed Assets Long-Term Debt Preferred Stock Preferred Stock Common Stock Common Stock Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!

11. The Hedging Principle n Permanent Assets (those held > 1 year) –should be financed with permanent and spontaneous sources of financing n Temporary Assets (those held < 1 year) –should be financed with temporary sources of financing

12. Balance Sheet Temporary Current Assets

13. Balance Sheet Temporary Temporary Current Assets Short-term financing

14. Balance Sheet Temporary Temporary Current Assets Short-term financing Permanent Fixed Assets

15. Balance Sheet Temporary Temporary Current Assets Short-term financing Permanent Permanent Fixed Assets Financing and Spontaneous Spontaneous Financing Financing

16. The Hedging Principle n Permanent Financing –intermediate-term loans, long-term debt, preferred stock, common stock n Spontaneous Financing –accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes) n Short-term financing –unsecured bank loans, commercial paper, loans secured by A/R or inventory

17. Cost of Short-Term Credit Interest = principal x rate x time ex: borrow $10,000 at 8.5% for 9 months Interest = $10,000 x.085 x 3/4 year = $637.50 = $637.50

18. Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR)

19. APR = x Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR) interest 1 interest 1 principal time principal time

20. APR = x Cost of Short-Term Credit interest 1 interest 1 principal time principal time

21. APR = x Cost of Short-Term Credit interest 1 interest 1 principal time principal time example: If you pay $637.50 in interest on $10,000 principal for 9 months:

22. APR = x Cost of Short-Term Credit interest 1 interest 1 principal time principal time example: If you pay $637.50 in interest on $10,000 principal for 9 months: APR = 637.50/10,000 x 1/.75 =.085 = 8.5% APR = 8.5% APR

23. Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

24. APY = ( 1 + ) - 1 Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: i m i m m

25. APY = ( 1 + ) - 1 Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: i m i m m i = the nominal rate of interest m = the # of compounding periods per year

26. Cost of Short-Term Credit What is the (APY) of a 9% loan with monthly payments? APY = ( 1 + (.09 / 12 ) 12 -1 ).0938 = 9.38% = 9.38%

27. Sources of Short-term Credit n Unsecured

28. Sources of Short-term Credit n Unsecured –accrued wages and taxes

29. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit

30. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit –bank credit

31. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit –bank credit –commercial paper

32. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit –bank credit –commercial paper n Secured

33. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit –bank credit –commercial paper n Secured –accounts receivable loans

34. Sources of Short-term Credit n Unsecured –accrued wages and taxes –trade credit –bank credit –commercial paper n Secured –accounts receivable loans –inventory loans