b6005 lecture 11 trade credit and shortem loan handout

B6005Financial Management

Lecture 11

Current Liability Management

2B6005 Dr. Siri Chutikamoltham

Asset L&E

Current Assets

Current Liabilities

Fixed Assets

LT Liabilities

Balance Sheet

3B6005 Dr. Siri Chutikamoltham

Learning Objectives

Understand working capital financing policy

Understand benefits and costs of major current liabilities

Understand the trade-offs of long term and short term debt

Calculate costs of trade credits

Calculate costs of different types of loans

4B6005 Dr. Siri Chutikamoltham

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.

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Years

$

Perm NOWC

Fixed Assets

Temp. NOWC

Lower dashed line, more aggressive.

} S-TLoans

L-T Fin:Stock &Bonds,

Moderate Financing Policy

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Conservative Financing Policy

Fixed Assets

Years

$

Perm NOWCL-T capital:Stock &LT Bonds

Marketable Securities

Zero S-Tdebt

7B6005 Dr. Siri Chutikamoltham

Short-Term Liabilities

Accounts payable (trade credit)

Short-term bank loans

Accruals

Commercial paper

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Accruals

Major Accruals: wage accruals, tax accruals, customer deposits.

Is there a cost to accruals?

Accruals are free in that no explicit interest is charged.

Can firms control accruals?

Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

9B6005 Dr. Siri Chutikamoltham

Commercial Paper (CP)

Short term notes issued by large, strong companies.

A cheap source of fund for issuers.

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.

10B6005 Dr. Siri Chutikamoltham

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 for small firms.

Trade credit is spontaneous and relatively easy to get, but the cost can be high.

11B6005 Dr. Siri Chutikamoltham

Terms of Sales Trade credit terms of 1/10, net 30 means:

Customers will get a discount of 1% if the account is paid within 10 days; otherwise the account must be paid in full within 30 days.

From the supplier’s perspective:

sales = $100

Sales of the goods or service = $99

Finance charge = $1

Payables amount for the first 10 days = free trade credit.

The amount owed from Day 11th to 30th = costly trade credit.

12B6005 Dr. Siri Chutikamoltham

Cost of Trade Credit to Customer Annualized opportunity cost of forgoing the discount = a/(1-a)

x 365/(c-b)

a = discount percentage

b = discount period

c = credit period

Ex. 1/10, net 30

a = 1, b = 10, c = 30

Note: Can use 360 or 365 days when annualize.

The typical discount ranges from 0.5% to 10%.

Discount period is generally 10 days.

Credit period ranges from 30 –90 days.

13B6005 Dr. Siri Chutikamoltham

Example: Annualized Nominal Cost of Credit

Terms 1/10, net 30

Annualized nominal cost of foregoing the discount

= 1%/(1-1%) x 365/(30-10)

= 0.01/(1-0.01) x 365/(20)

= 18.09%

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Pop QuizWhat is the annualized cost of foregoing the

discount if the credit terms are 2/10, net 30?

15B6005 Dr. Siri Chutikamoltham

Back to SKI SKI buys equipments in the amount of $506,985 per year,

net of discount, on terms of 1/10, net 30, but routinely pays on Day 40 (stretching its AR!!).

Find free and costly trade credit.

Net daily purchases = $506,985/365 = $1,389.

Annual gross purchase = $506,985/(1-0.01)

= $512,106

Difference = 512,106 – 506,985 = $5,121.

16B6005 Dr. Siri Chutikamoltham

Gross/Net Purchase Breakdown

Company buys goods worth $506,985. That’s the net cash price.

They must pay $5,121 more if they don’t take discounts.

Think of the extra $5,121 as a financing cost similar to the interest on a loan.

Should SKI take the discount?

17B6005 Dr. Siri Chutikamoltham

Payables amount if don’t take discount: Payables = $1,389(40) = $55,560.

Total trade credit = $55,560 Free trade credit = 13,890 Costly trade credit = $41,670

Free and Costly Trade Credit

Payables amount if take discount: Payables = $1,389(10) = $13,890.

18B6005 Dr. Siri Chutikamoltham

Annualized Nominal Cost of Costly Trade Credit

But the $5,121 is paid several times during the year, not at year-end, so EAR rate is higher than the nominal rate.

Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so:rNom = $5,121 / $41,670 = 12.29%

19B6005 Dr. Siri Chutikamoltham

Nominal Cost Formula 1/10, net 30 but pays on 40th day

SKI pays a nominal trade credit cost of 1.01% for 12.167 times per year.

rNom = Discount %

1 - Discount %

×365 days

Days

Taken

Discount

Period-

20B6005 Dr. Siri Chutikamoltham

Effective Annual Rate, 1/10, net 30, but pays on the 40th day

Periodic rate = 0.01/0.99 = 1.01%.

Periods/year = 365/(40 – 10)

= 12.1667.

EAR = (1 + Periodic rate)n – 1.0

= (1.0101)12.1667 – 1.0

= 13.01%.

21B6005 Dr. Siri Chutikamoltham

What should be the EAR for SKI if they do not stretch the terms 1/10, net 30?

rNOM = 20.13%

22B6005 Dr. Siri Chutikamoltham

Short-term vs Long-term Bank LoanPROS

1. Lower Cost

2. Quickly

3. Repay w/o penalty

CONS

Roll Over (may not be able to)

Riskier due to volatility of ST interest rates

23B6005 Dr. Siri Chutikamoltham

Compare Costs of Loans

A bank is willing to lend SKI $100,000 for 1 year at an 8 percent nominal rate. Which loan should SKI take?

1.Simple annual interest, 1 year.

2.Simple interest, paid monthly.

3.Discount interest.

4.Installment loan, add-on, 12 months.

24B6005 Dr. Siri Chutikamoltham

How should SKI evaluate the loans?

The nominal rate is 8%

Compare effective cost of the loan and choose the lowest cost alternatives

Because the loans have different terms, we must make comparison base on EAR

25B6005 Dr. Siri Chutikamoltham

1. Simple Annual Interest, 1-Year Loan

“Simple interest” means the interest rate is compounded only once a year, and there is no discount or add-on.

Interest = 0.08($100,000) = $8,000

KNOM = EAR = 8,000/100,000 = 8%

For a simple interest loan of one year, kNom = EAR.

26B6005 Dr. Siri Chutikamoltham

2. Simple Interest, Paid Monthly

EAR = (1 + periodic rate)^#times – 1.0 = 8.3%

Periodic Rate = 8% / 12 = 0.67%

EAR = (1+0.67%)^12 – 1 = 8.3%

27B6005 Dr. Siri Chutikamoltham

3. An 8% Discount Interest Loan, calculate interest only once per year

Interest deductible = 0.08($100,000) = $8,000.Usable funds = $100,000 - $8,000 = $92,000.

N I/YR PV PMT FV

1 92 0 -100

8.6957% Nominal rate? EAR = ?

0 1i = ?

92,000 -100,000

28B6005 Dr. Siri Chutikamoltham

Discount Interest (Cont)IF SKI needs $100,000 usable fund, how

much is the face amount of loan ?

Face Amt. Of Loan =

= = $108,696.

Amount needed 1 - %Nominal interest rate

$ 100,0000.92

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4. Add-on Loan1-Year Installment Loan of $100,000, 8%

“Add-On”

Interest = 0.08($100,000) = $8,000.

Face amount of loan = $100,000 + $8,000 = $108,000, after the interest is added on.

Monthly payment = $108,000/12 = $9,000.

(More...)

30B6005 Dr. Siri Chutikamoltham

Cost of Add-on Loan

To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below:

-9,000100,000

0 1 12i=?

-9,000 -9,000

Months2

...

31B6005 Dr. Siri Chutikamoltham

N I/YR PV PMT FV

12 100000 -9000

1.2043% = rate per month

0

Annualized kNom = (1.2043%)(12) = 14.45%.Since loan amortization (of interest and principle) happens 12 times a year, there is a compounding. Must find EAR.EAR = (1.012043)^12 – 1 = 15.45%

32B6005 Dr. Siri Chutikamoltham

Summary

Major sources of short term financing

Suppliers’ credits ( payables)

Short term loans

Goal: shorter cash conversion cycle = more suppliers’ credit, if only cheaper than other financing.

Must evaluate costs of different types of credits, based on EAR