Presentation on theme: "CHAPTER 16 Financing Current Assets"— Presentation transcript:
1 CHAPTER 16 Financing Current Assets Working capital financing policiesA/P (trade credit)Commercial paperS-T bank loans
2 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.
3 Moderate financing policy YearsLower dashed line would be more aggressive.$Perm C.A.Fixed AssetsTemp. C.A.S-TLoansL-T Fin:Stock,Bonds,Spon. C.L.
5 Short-term credit Any debt scheduled for repayment within one year. Major sources of short-term creditAccounts payable (trade credit)Bank loansCommercial loansAccrualsFrom the firm’s perspective, S-T credit is more risky than L-T debt.Always a required payment around the corner.May have trouble rolling over loans.
6 Advantages and disadvantages of using short-term financing SpeedFlexibilityLower cost than long-term debtDisadvantagesFluctuating interest expenseFirm may be at risk of default as a result of temporary economic conditions
7 Accrued liabilitiesContinually 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.
8 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.
9 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
10 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.
11 Breaking down trade credit Payables level, if the firm takes discountsPayables = $8, (10) = $82,192Payables level, if the firm takes no discountsPayables = $8, (40) = $328,767Credit breakdownTotal trade credit $328,767Free trade credit - 82,192Costly trade credit $246,575
12 Nominal cost of costly trade credit The firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit:kNOM = $30,303 / $246,575= = 12.29%The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.
15 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.
16 Bank loansThe firm can borrow $100,000 for 1 year at an 8% nominal rate.Interest may be set under one of the following scenarios:Simple annual interestDiscount interestDiscount interest with 10% compensating balanceInstallment loan, add-on, 12 months
17 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.
18 Simple annual interest “Simple interest” means no discount or add-on.Interest = 0.08($100,000) = $8,000kNOM = EAR = $8,000 / $100,000 = 8.0%For a 1-year simple interest loan, kNOM = EAR
20 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)= $100,000 / 0.92 = $108,696
21 Discount interest loan with a 10% compensating balance Effective cost = $9,756 / $100,000 = 9.756%
22 Add-on interest on a 12-month installment loan Face amount = $100,000 + $8,000 = $108,000Monthly payment = $108,000/12 = $9,000Avg loan outstanding = $100,000/2 = $50,000Approximate cost = $8,000/$50,000 = 16.0%To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000. This constitutes an annuity.
23 Installment loan From the calculator output below, we have: kNOM = 12 ( )= = 14.45%EAR = ( )12 – 1 = 15.45%12100-9INPUTSNI/YRPVPMTFVOUTPUT1.2043
24 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.
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