1. 19- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will Chapter 19 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Short-Term Financial Planning

2. 19- 2 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Links Between Long-Term and Short-Term Financing  Working Capital  Tracing Changes in Cash and Working Capital  Cash Budgeting  A Short-Term Financing Plan  Sources of Short-Term Financing  The Cost of Bank Loans

3. 19- 3 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital  Factors in establishing working capital levels 1.Matching maturities 2.Permanent working capital requirements 3.The advantages of liquidity

4. 19- 4 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Firm’s Cumulative Capital Requirement Lines A, B, and C show alternative amounts of long-term finance. Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for remainder Strategy C: A permanent short-term borrower A B C Year 2Year 1 Dollars Cumulative capital requirement Time

5. 19- 5 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Conversion Cycle - Period between firm’s payment for materials and collection on its sales. Carrying Costs - Costs of maintaining current assets, including opportunity cost of capital. Shortage Costs - Costs incurred from shortages in current assets.

6. 19- 6 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Simple Cycle of operations Cash Finished goods inventory Receivables Raw materials inventory

7. 19- 7 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital  Cash conversion cycle

8. 19- 8 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital

9. 19- 9 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

10. 19- 10 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

11. 19- 11 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

12. 19- 12 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

13. 19- 13 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Working Capital Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle. Cash conversion cycle = (42.2+43.6) – 32.4 = 53.4

14. 19- 14 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Cash & W.C. Example - Dynamic Mattress Company

15. 19- 15 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Cash & W.C. Example - Dynamic Mattress Company Assume dividend = $1 mil R.E.=$11 mil

16. 19- 16 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Cash & W.C. Example - Dynamic Mattress Company

17. 19- 17 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Cash & W.C. Example - Dynamic Mattress Company Dynamic used cash as follows  Paid $1 mil dividend.  Repaid $5 mil short term bank loan  Invested $14 mil  Purchased $5 mil of marketable securities  Accounts receivable expanded by $5 mil

18. 19- 18 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Steps to preparing a cash budget Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus.

19. 19- 19 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted sources of cash AR ending balance = AR beginning balance + sales - collections

20. 19- 20 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Example - Dynamic Mattress Company Dynamic collections on AR

21. 19- 21 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Example - Dynamic Mattress Company Dynamic forecasted uses of cash  Payment of accounts payable  Labor, administration, and other expenses  Capital expenditures  Taxes, interest, and dividend payments

22. 19- 22 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Example - Dynamic Mattress Company Dynamic cash budget

23. 19- 23 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Example - Dynamic Mattress Company Dynamic short term financing requirements

24. 19- 24 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting Forecast Uses of Cash 1.Payments of accounts payable. 2.Labor, administrative, and other expenses. 3.Capital expenditures. 4.Taxes, interest, and dividend payments.

25. 19- 25 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved A Short Term Financing Plan Example - Dynamic Mattress Company Dynamic forecasted deferrable expenses

26. 19- 26 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved A Short Term Financing Plan Example - Dynamic Mattress Company- Financing Plan

27. 19- 27 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Sources of Short Term Financing  Line of Credit  Agreement by a bank that a company may borrow at any time up to an established limit.  Bank loans  Secured loans  Inventory financing  Commercial paper

28. 19- 28 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Bank Loans Simple Interest Example: A bank quotes 6% annual interest on a $100,000 loan. What is the monthly simple interest?

29. 19- 29 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Bank Loans Effective annual rate Example: A bank quotes 6% annual interest on a $100,000 loan, compounded monthly. What is the effective annual rate?

30. 19- 30 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Bank Loans Discount Interest Effective annual rate on a discount loan

31. 19- 31 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Example: A company can receive a 6% discount loan on $100,000. What is the annual interest rate assuming annual payments? What is the effective annual interest rate given monthly payments? Cost of Bank Loans

32. 19- 32 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Bank Loans Compensating Balance Effective annual rate on a compensating balance loan

33. 19- 33 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Bank Loans Example: A company can receive a 6% discount loan on $100,000, but must maintain a $20,000 compensating balance. What is the annual interest rate assuming annual payments? What is the effective annual interest rate given monthly payments?

34. 19- 34 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Web Resources