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Copyright 2002 Harcourt, Inc. All rights reserved.

Working Capital Financing Policies

Maturity Matching : Matches thematurity of the assets with the

maturity of the financing.Aggressive : Uses short-term(temporary) capital to finance somepermanent assets.Conservative : Uses long-term(permanent) capital to finance sometemporary assets.

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

What are permanent assets?

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

Maturity Matching Financing Policy

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Years

$

Perm C.A.

Fixed Assets

Temp. C.A.

More aggressive the lower the dashed line.

S-TLoans

L-T Fin:Stock,Bonds,Spon. C.L.

Aggressive Financing Policy

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Conservative Financing Policy

Fixed Assets

Years

$

Perm C.A.L-T Fin:Stock,Bonds,Spon. C.L.

Marketable SecuritiesZero S-Tdebt

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The choice of working capital policy isa classic risk/return tradeoff.

The aggressive policy promises thehighest return but carries the greatestrisk.The conservative policy has the leastrisk but also the lowest expectedreturn.The moderate (maturity matching)policy falls between the two extremes.

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What is short-term credit?

What are the major sources?

Short-term credit : Debt requiringrepayment within one year.

Major sources :Accruals

Accounts payable (trade credit)Commercial paper Bank loans

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Short-term debt is riskier thanlong-term debt for the borrower.

Short-term rates may rise .

May have trouble rolling debt over .Advantages of short-term debt.

Typically lower cost .

Can get funds relatively quickly withlow transactions costs.

Can repay without penalty .

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Is there a cost to accruals?

Do firms have much control over amount of accruals?

Accruals are free in the sense thatno explicit interest is charged.

However, firms have little control

over accrual levels, which areinfluenced more by industrycustom, economic factors, and taxlaws than by managerial actions.

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What is trade credit?

Trade credit is credit furnished by afirms suppliers .

Trade credit is often the largestsource of short-term credit for smallfirms.

Trade credit is spontaneous andrelatively easy to get , but the costcan be high .

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B&B buys $3,030,303 gross, or $3,000,000 net, on terms of 1/10, net30. However, the firm pays on Day 40.

How much free and costly trade creditare they getting?

What is the cost of the costly tradecredit?

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Payables level if discount is taken:Payables = $8,333 (10) = $83,333 .

Credit Breakdown:Total trade credit = $333,333Free trade credit = 83,333Costly trade credit = $250,000

Payables level if dont take discount:Payables = $8,333 (40) = $333,333 .

Net daily purchases = $3,000,000/360= $8,333 .

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Nominal Cost of Costly Trade Credit

But the $30,303 in lost discounts ispaid all during the year, not just atyear-end, so the EAR is higher.

Firm loses 0.01($3,030,303) = $30,303of discounts to obtain $250,000 inextra trade credit, so

k Nom = = =$30,

$250,. .303

0000 1212 12 12% .

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Nominal Cost Formula, 1/10, net 40

Pays 1.01% 12 times per year.

kNom = x

= x = 0.0101 x 12

= 0.1212 = 12.12% .

Discount %1 - Discount %

360Days taken - Discount period

199 36030

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Effective Annual Rate, 1/10, net 40

Periodic rate = 0.01/0.99 = 1.01% .

Periods/year = 360/(40 - 10) = 12 .

EAR = (1 + Periodic rate)n

- 1.0= (1.0101) 12 - 1.0 = 12.82% .

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Commercial Paper (CP)

CP are short term notes issued bylarge, strong companies. B&B could

not issue CP; the company is toosmall.CP trades in the market at rates justabove the T-bill rate.CP is bought by banks and other companies, then held as marketablesecurities for liquidity purposes.

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A bank is willing to lend B&B $100,000

for 1 year at an 8 percent nominal rate.What is the EAR under the followingfive loans?

1. Simple annual interest, 1 year.2. Simple interest, paid monthly.3. Discount interest.4. Discount interest with 10 percent

compensating balance.5. Installment loan, add-on, 12 months.

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Why must we use Effective Annual

Rates (EARs) to evaluate the loans?

In our examples, the nominal(quoted) rate is 8% in all cases.

We want to compare loan cost ratesand choose the alternative with thelowest cost.

Because the loans have differentterms, we must make thecomparison on the basis of EARs.

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Simple Annual Interest, 1-Year Loan

Simple interest means not discountor add-on.

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

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

.k EARNom = = = =$8,

$100,. .000

0000 08 8 0%

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8% Discount Interest, 1 Year

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

Usable funds = $100,000 - $8,000= $92,000 .

N I/YR PV PMT FV1 92 0 -100

8.6957% = EAR

0 1i = ?

92,000 -100,000

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Discount Interest (Continued)

Amt. borrowed =

= = $108,696 .

Amount needed1 - Nominal rate (decimal)

$100,0000.92

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Need $100,000. Offered loan with

terms of 8% discount interest, 10%compensating balance.

(More...)

Face amount of loan =

= = $121,951 .

Amount needed1 - Nominal rate - CB

$100,0001 - 0.08 - 0.1

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Interest = 0.08 ($121,951) = $9,756.

.receivedAmount

paidInterestCost =

EAR correct only if amount is borrowedfor 1 year.

(More...)

EAR = =$9,$100,

.756000

9 756% .

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This procedure can handle variations.

N I/YR PV PMT FV1 100000 -1097569.756% = EAR

0

0 1i = ?

121,951 Loan -121,951+ 12,195-109,756

-9,756 Prepaid interest-12,195 CB

100,000 Usable funds

8% Discount Interest with 10%

Compensating Balance (Continued)

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1-Year Installment Loan, 8% Add-On

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

Face amount = $100,000 + $8,000 = $108,000 .Monthly payment = $108,000/12 = $9,000 .

= $100,000/2 = $50,000 .

Approximate cost = $8,000/$50,000 = 16.0% .

Average loan

outstanding

(More...)

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Installment Loan

To find the EAR, recognize that the firmhas received $100,000 and must makemonthly payments of $9,000 . Thisconstitutes an ordinary annuity asshown below:

-9,000100,000

0 1 12i=?

-9,000 -9,000

Months2...

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N I/YR PV PMT FV

12 100000 -9000

1.2043% = rate per month

0

kNom = APR = (1.2043%)(12) = 14.45%.EAR = (1.012043) 12 - 1 = 15.45%.

14.45 NOM enters nominal rate

12 P/YR enters 12 pmts/yr EFF% = 15.4489 = 15.45%.

1 P/YR to reset calculator.

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What is a secured loan?

In a secured loan , the borrower pledges assets as collateral for theloan.

For short-term loans, the mostcommonly pledged assets arereceivables and inventories .

Securities are great collateral, butgenerally firms needing short-termloans generally do not have securities.

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What are the differences between

pledging and factoring receivables?

If receivables are pledged , the lender

has recourse against both theoriginal buyer of the goods and theborrower.

When receivables are factored , theyare generally sold, and the buyer (lender) has no recourse to theborrower.

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What are three forms of inventory

financing?

Blanket lien.

Trust receipt.

Warehouse receipt.

The form used depends on thetype of inventory and situation athand.

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Copyright 2002 Harcourt Inc All rights reserved

Legal stuff is vital.

Security agreement: Standard form

under Uniform Commercial Code.Describes when lender can claimcollateral.

UCC Form-1: Filed with Secretary of State to establish claim. Futurelenders do search, wont lend if prior UCC-1 is on file.

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