1. © Prentice Hall, 2004 22 Corporate Financial Management 3e Emery Finnerty Stowe Liquidity Management

2. Working Capital Management Working capital = current assets – current liabilities Working capital management refers to choosing the levels and mix of: cash, marketable securities, receivables and inventories. different types of short-term financing.

3. Considerations in Working Capital Management Sales impact Liquidity Relations with stakeholders suppliers customers Short-term financing mix profitability risk considerations

4. Working Capital Management Maturity matching approach Conservative approach Aggressive approach

5. Maturity Matching Approach Hedge risk by matching the maturities of assets and liabilities. Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing. There are no excess funds.

6. Maturity Matching Approach Temporary Current Assets Time $ Permanent Current Assets Fixed Assets Long Term Financing Short Term Financing

7. Conservative Approach Long-term funds are used to finance both permanent as well as some temporary short- term assets. When there are excess funds, they are invested in marketable securities.

8. Conservative Approach Temporary Current Assets Time $ Permanent Current Assets Fixed Assets Marketable securities Long Term Financing Short Term Financing

9. Aggressive Approach Use less long-term and more short-term financing than the conservative approach.

10. Aggressive Approach Temporary Current Assets Time $ Permanent Current Assets Fixed Assets Long Term Financing Short Term Financing

11. Cost and Risk Considerations Yield curve is usually upward sloping. Short-term rates are more volatile than long- term rates. Firm's ability to obtain needed short-term financing.

12. Cash Conversion Cycle The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable.

13. Cash Conversion Cycle Purchase Inventory Sale on Credit Collect Acct. Receivable Payment of Accts. Payable Inventory Conversion Period Cash Conversion Cycle Time Payables Deferral Period Receivables Collection Period

14. Cash Conversion Cycle

15. Inventory Conversion Period The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.

16. Receivables Collection Period The receivables collection period is the average number of days it takes to collect on accounts receivable. Equal to days sales outstanding (DSO)

17. Payables Deferral Period The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same.

18. Cash Conversion Cycle Given the following information about Vision Opticals, compute the firm’s cash conversion cycle. Inventory Accounts Receivable Accounts Payable Wages, Benefits, Payroll Taxes Sales Cost of Sales Selling & Other Expenses $19,000 $21,000 $5,600 $9,000 $227,000 $93,000 $22,000

19. Inventory Conversion Period

20. Receivables Collection Period

21. Payables Deferral Period

22. Cash Conversion Cycle

23. Cash Management How much liquidity (cash plus marketable securities) should the firm have? What should be the relative proportions of cash and marketable securities?

24. Demands for Cash Transactions demand Precautionary demand Speculative demand Compensating balances

25. Short-Term Investment Alternatives U.S. Treasury securities T-bills, T-notes, and T-bonds U.S. federal agency securities Negotiable certificates of deposit Short-term tax-exempt municipals Bankers acceptances Commercial paper Preferred stock & money market preferred stock

26. Other Factors in Cash Management Compensating balance requirements Optimal amount of marketable securities transaction costs maturity risk yield Special tax situations

27. Float Float is the difference between the available (or collected) balance at the bank and the firm’s book or ledger balance. Disbursement float occurs when the firm writes a check but the check has not yet cleared the banking system. Collection float occurs when a check has been deposited but the funds are not yet credited to the firm’s bank account.

28. Float Management Techniques Wire transfers Zero balance accounts (ZBAs) Controlled disbursing Centralized processing of payables Lockboxes

29. Lockbox Systems Discount Music Stores is evaluating a lockbox system which will reduce float by 3 days. The lockbox system costs $15,000 per year. The firm’s daily collections average $150,000, and its opportunity cost of funds is 6% per year. Should the firm utilize this lockbox system?

30. Lockbox Systems Funds freed up due to a reduction in float = (3 days)($150,000 per day) or $450,000. Annual value of float reduction = $450,000(6%) = $27,000. After deducting the $15,000 cost of the lockbox system, the firm nets $12,000 before taxes.

31. Short-Term Financing Trade Credit Secured and Unsecured Bank Loans Commercial Paper

32. Cost of Trade Credit Discount Music Stores buys its inventory on “3/10, net 30” terms. What is the cost of not taking the discount? 01030 +$970,000 –$1,000,000 Suppose DMS buys $1,000,000 worth of inventory; if they forgo the 3% discount to pay on day 30 they are borrowing $970,000 for 20 days and paying $30,000 interest:

33. Cost of Trade Credit: APY vs. APR

34. Cost of Trade Credit: APR 01030 +$970,000–$1,000,000

35. Cost of Trade Credit: APY 01030 +$970,000–$1,000,000

36. Effective Use of Trade Credit Advantages: Readily available Informal Flexible Stretching payments Disadvantages High cost of discounts foregone Stretching of payments can hurt reputation

37. Bank Loans Short-term unsecured loans Transaction loan Line of credit Revolving credit agreement Term loans Bullet maturity Balloon payment

38. Cost of Bank Loans Prime rate + “spread” LIBOR + “spread” Compensating balances

39. Compensating Balance Requirements Let P = amount of loan f = loan term r = interest rate on loan B = incremental cash balance as a result of compensating balance requirements y = interest earned (if any) on compensating balances Interest charges = rPf Interest received = yBf

40. Compensating Balance Requirements

41. Custom Controls is considering a 1-year loan of $150,000 at an interest rate of 14%. Due to compensating balance requirements, Custom Controls will have to maintain a deposit balance of $20,000 which it would not have otherwise maintained at the lending bank. The deposit will earn 6% per year. What is the APR of this loan?

42. Compensating Balance Requirements Without the 6% yield on the compensating balance, the APR = 16.15% = 15.23%

43. Discount Loans The interest charge is deducted in advance for discount loans. Let r = interest rate on the loan f = the term of the loan P = the principal amount The APR of a discount loan is given by:

44. A Comparison of Single Payment Loans Ole Tools Inc. needs to borrow $5,000 for 6 months. Four single payment loan alternatives are available as shown below. In each case, the interest rate is 15% per year. Compute the APR and APY of each alternative. LoanInterest PaymentCompensating Balance A B C D in arrears in advance No Yes (10%) No Yes (10%)

45. A Comparison of Single Payment Loans Interest charge on the loan is $5,000× (.15) ×(0.5 years) or $375. For loans A & B, this amount is added to the repayment at loan maturity. For discount loans (loans C & D), this amount is deducted from the loan amount at loan initiation. Compensating balances (for loans B & D), is $5,000×0.10 = $500.

46. A Comparison of Single Payment Loans A B C D $5,000 $4,500 $4,625 $4,125 ($5,375) ($4,875) ($5,000) ($4,500) LoanCF 0 1 APR

47. A Comparison of Single Payment Loans A B C D $5,000 $4,500 $4,625 $4,125 ($5,375) ($4,875) ($5,000) ($4,500) LoanCF 0 1 APR 15.00% 16.67% 16.22% 18.18% APY 15.56% 17.36% 16.87% 19.01%

48. Discounted Installment Loans Sheridan Systems borrows $12,000 for 3 months at 15%. The interest is paid in advance, and Sheridan will pay the loan in 3 monthly installments of $3,000 at the end of the first two months and $6,000 at the end of the third month. Compute the APY and APR of this loan.

49. Discounted Installment Loans The interest cost of this loan is ($12,000)(15%)(3/12 years) or $450. Since the interest is deducted in advance, Sheridan will get $12,000 - $450 or $11,550 at loan initiation.

50. Discounted Installment Loans 013 –$6,000 2 –$3,000 +$11,550 –$3,000

51. Commercial Paper Commercial paper is a negotiable business IOU note. It is sold by the largest, most creditworthy firms on a discount basis. Maturity is set to less than 270 days. Registration with the SEC is not required. 40% of commercial paper is sold through dealers. Commission of about 0.125% on an annualized basis.

52. Factors Affecting the Short-Term Financing Mix Cost of each source of funds / incl’g options Desired level of current assets Seasonal component of current assets Extent of maturity-matching Flotation costs Restricted access to long-term capital Bankruptcy costs Firm's choice of risk level