Presentation on theme: "CHAPTER 16 Financing Current Assets"— Presentation transcript:
1CHAPTER 16 Financing Current Assets Working capital financing policiesA/P (trade credit)Commercial paperS-T bank loans
2Working 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.
3Moderate 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.
5Short-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.
6Advantages 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
7Accrued 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.
8What 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.
9The 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
10Breaking 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.
11Breaking 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
12Nominal 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.
15Commercial 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.
16Bank 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
17Must 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.
18Simple 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
20Raising 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
21Discount interest loan with a 10% compensating balance Effective cost = $9,756 / $100,000 = 9.756%
22Add-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.
23Installment loan From the calculator output below, we have: kNOM = 12 ( )= = 14.45%EAR = ( )12 – 1 = 15.45%12100-9INPUTSNI/YRPVPMTFVOUTPUT1.2043
24What 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.