principles of managerial finance 9th edition

Principles of Managerial Finance

9th Edition

Chapter 15

Working Capital And

Short-Term Financing

Learning Objectives

• Understand the two definitions of net working capital and

the tradeoff between profitability and risk as it relates to

changing levels of current assets and current liabilities.

• Discuss, in terms of profitability and risk, the aggressive

financing strategy and the conservative financing strategy

for meeting the firm’s total financing requirement.

• Review the key characteristics of the two major sources of

spontaneous short-term financing.

Learning Objectives

• Analyze credit terms offered by suppliers to determine

whether to take or give up cash discounts and whether

to stretch accounts payable.

• Describe the interest rates and basic types of unsecured

short-term bank loans, commercial paper, and short-

term international loans.

• Explain the characteristics of secured short-term loans

and the use of accounts receivable and inventory as

short-term loan collateral.

Long & Short Term Assets & Liabilities

Current Assets:CashMarketable SecuritiesPrepaymentsAccounts ReceivableInventory

Current Liabilities:Accounts PayableAccrualsShort-Term DebtTaxes Payable

Fixed Assets:InvestmentsPlant & MachineryLand and Buildings

Long-Term Financing:DebtEquity

Long & Short Term Assets & Liabilities

Current Assets:CashMarketable SecuritiesPrepaymentsAccounts ReceivableInventory

Current Liabilities:Accounts PayableAccrualsShort-Term DebtTaxes Payable

The collective term for decisions regarding short-term assets and short term liabilities is working capital management.

• Working Capital includes a firm’s current assets, which

consist of cash and marketable securities in addition

to accounts receivable and inventories.

• It also consists of current liabilities, including accounts

payable (trade credit), notes payable (bank loans),

and accrued liabilities.

• Net Working Capital is defined as total current assets

less total current liabilities.

Net Working Capital

Net Working Capital

raw materials purchases(payable generated)

Payment received(receivable exonerated)

inventoryprocessing

finished goodsinventory

sale of goods(receivable generated)

payment for purchases(payable exonerated)

The Firm’s Operating Cycle

• It is critical to point out that “profitability” and “liquidity” (or cash flow) are not necessarily the same.

• A business can be profitable, and yet experience serious cash flow problems.

•The more net working capital, the more liquid the firm and the lower its risk of becoming technically insolvent.

• The key is in the length of the operating cycle -- or how long it takes to convert cash back into cash.

Net Working Capital“Profitability” versus “Liquidity”

risk that firm is unable to meet its short-term obligation: technical insolvency

Net Working Capital

Current Assets Current Liabilities

Cash 500$ A/P 600$

M/S 200 N/P 800

A/R 800 Accruals 200

Inventories 1,200

Total 2,700$ Total 1,600$

The Current Position of Berenson Company

Will Berenson be able to pay its bills?

“Profitability” versus “Liquidity”

越往下越不容易轉換成現金

CurrentAssets

(Net WorkingCapital > 0)

Fixed Assets

Current Liabilities

Long-TermDebt

Equity

Positive Net Working Capital (low return and low risk)

low return

high return

low cost

high cost

highest cost

The Tradeoff Between Return & Risk

以長支短

由於 TA

CL

TA

CA

NWC 越正乃越保守的作法

CurrentAssets

Fixed Assets

Current Liabilities

(Net WorkingCapital < 0)

Long-TermDebt

Equity

Negative Net Working Capital

(high return and high risk)

low return

high return

low cost

high cost

highest cost

The Tradeoff Between Return & Risk

以短支長

由於 TA

CL

TA

CA

NWC 越小乃越積極的作法

The Tradeoff Between Profitability & Risk假設總資產不變

Effect on return

Net Working Capital StrategiesAsset Trends for a Growing Firm

time

fixed assets

permanent current assets

temporary or fluctuating current assets

Assets ($)Seasonal need of financing

Total asset

Permanent need of financing

Maturity Matching Strategy(moderate return/moderate risk)

time

fixed assets



Assets ($)

short-term

financing

long-term

financing

Net Working Capital Strategies

NWC>0

Aggressive Financing Strategy

(high return/high risk)

time

fixed assets



Assets ($)

short-term

financing

long-term

financing


NWC=0

Conservative Financing Strategy(low risk/low return)

time

fixed assets



Assets ($)

short-term

financing

long-term

financing


CA － CL>>0NWC>>0

Current Fixed Total Permanent Seasonal

Month Assets Assets Assets Funds Req. Funds Req.

Jan 4,000$ 13,000$ 17,000$ 13,800$ 3,200$

Feb 3,000 13,000 16,000 13,800 2,200

Mar 2,000 13,000 15,000 13,800 1,200

Apr 1,000 13,000 14,000 13,800 200

May 800 13,000 13,800 13,800 -

Jun 1,500 13,000 14,500 13,800 700

Jul 3,000 13,000 16,000 13,800 2,200

Aug 3,700 13,000 16,700 13,800 2,900

Sep 4,000 13,000 17,000 13,800 3,200

Oct 5,000 13,000 18,000 13,800 4,200

Nov 3,000 13,000 16,000 13,800 2,200

Dec 2,000 13,000 15,000 13,800 1,200

Monthly Average 13,800$ 1,950$

Estimated Funds Requirements for Berenson Company

The Firm’s Financing Need: Berenson Company

(1) (2) (3)=(1)+(2) (4) (5)=(3)-(4)

固定資產加上部分流動資產，這一年期間裡最低時候的總資產

最低

不成長的公司


• A few points about the previous data chart are worth

expanding upon and depicted on the following chart:

– the permanent funds requirement is the lowest level

of total assets during the period

– the seasonal portion is the difference between the

total funds requirement (total assets) for each month

and the permanent funds component

– a portion of the firm’s current assets is permanent (for

Berenson, this figure is $800)

Berenson Funds Requirement

Berenson Company Funds Requirement

$12,500

$13,500

$14,500

$15,500

$16,500

$17,500

$18,500

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Fun

ds

Re

qu

ire

d (

$)

Total Funds Requirement

Seasonal Requirement

Permanent Requirement

Fixed Assets

Current Assets

Berenson Funds RequirementThe Firm’s Financing Need: Berenson Company

$13,800

$13,000

• The aggressive strategy is to finance the permanent

portion of the firms funds requirement ($13,800) with

long-term funds.

• The seasonal portion, which ranges from $0 in May to

$4,200 in October, will be financed with short-term

funds.

• The Aggressive Strategy can is described graphically in

the following chart.

Aggressive Financing Strategy


乃前面定義的 moderate strategy (moderate return/ moderate risk)

其實前面一開始所定義的 aggressive strategy 是以長期資金支應固定資產，短期資金支應所有的流動資產

Berenson Company Funds Requirement(Aggressive Strategy)

$12,500

$13,500

$14,500

$15,500

$16,500

$17,500

$18,500


Fu

nd

s R

equ

ired

($)

Long-Term Funds

Short-Term Funds

Aggressive Financing StrategyThe Firm’s Financing Need: Berenson Company

more aggressive 的作法是保持 CA － CL=0

Net working capital=CA － CL=800>0

C.L. Current asset

Fixed asset

$13,800

$13,000

• Let us assume that the annual cost of short-term funds

is 3% and the annual cost of long-term funds is 11%.

• Since Berenson’s average short-term borrowing is

$1,950 and the average long-term borrowing is $13,800,

we may calculate the cost of the aggressive strategy as

follows:

Cost Considerations of Aggressive Strategy

Financing Source Amount ($) Cost (%) Cost ($)

Short-Term 1,950$ 3% 58.50$

Long-Term 13,800$ 11% 1,518.00$

Total 1,576.50$

Cost of Aggressive Strategy for Berenson


平均而言

• The aggressive strategy is risky because it operates with a

small net working capital because only the permanent

portion is being financed with long-term funds, 而不是所有資金需求都由長期資金來支應

• For this example, the level of net working capital is $800

($13,800 permanent funds requirement - $13,000 fixed

assets).

• This strategy is also risky because the firm must draw on

its sources of short-term funding, which for various

reasons, may be difficult to obtain quickly when needed.

Risk Considerations of Aggressive Strategy


來支應流勳資產裡短期變動的部份

• The most conservative financing strategy should be to

finance all projected financing requirements with long-

term funds.

• Conservative financing strategy:

– Short-term financing are then used in the event of an

emergency or an unexpected outflow of funds.

– This strategy is depicted graphically on the following slide.

Conservative Financing Strategy


CL=0

Berenson Company Funds Requirement(Conservative Strategy)

$12,500

$13,500

$14,500

$15,500

$16,500

$17,500

$18,500


Fun

ds

Re

qu

ire

d (

$)

Short-Term Funds

Long-Term Funds

Conservative Financing StrategyThe Firm’s Financing Need: Berenson Company

$18,000

Current asset

Fixed asset

$13,800

$13,000

$17,000

• Here again we assume that the annual cost of short-term funds is 3% and the annual cost of long-term funds is 11%.

• Long-term financing of $18,000, which equals the peak need (during October) is used under this strategy (no short-term funds are anticipated.

Cost Considerations of most Conservative Strategy

Financing Source Amount ($) Cost (%) Cost ($)

Short-Term -$ 3% -$

Long-Term 18,000$ 11% 1,980.00$

Total 1,980.00$

Cost of Most Conservative Strategy for Berenson


一年到頭都保持此水準

• The $5,000 of net working capital ($18,000 long-term

financing - $13,000 fixed assets) would indicate a low

level of risk for Berenson.

• In addition, Berenson will not need to use any of its

limited short-term borrowing capacity to meet current

obligations.

• As a result, should the need arise, the firm would be in a

good position to access sources of short term financing

if needed.

Risk Considerations of most Conservative Strategy


10 月份的 NWC=$5,000 為最高， 5 月份的 NWC=$800 為最低

Spontaneous Sources of Short-Term Financing

Accounts Payable & Accruals

• Credit Terms: DOI, EOM

• Credit Period (generally range from 0 to 120

days)

• Trade Discounts: (Example: 2/10 net 30)

McKinley Company made two purchases under the

terms 2/10 net 30. One purchase was made on Sept.

10th, the other on Sept. 20th. The payment dates

(under various assumptions) if the firm takes the

terms are shown on the following slide.

應計薪資、應計所得稅

Credit period


• Credit Terms: DOI, EOM

• Credit Period (generally range from 0 to 120 days)


Beginning

of Credit Discount Net Amount Discount Net Amount

Period Taken Paid Taken Paid

Date of Invoice Sept. 20 Oct. 10 Sept. 30 Oct. 20

End of Month Oct. 10 Oct. 30 Oct. 10 Oct. 30

September 10th Purchase September 20th Purchase

Payment Dates for McKinley Company

(Given Various Assumptions)

Accounts Payable & AccrualsDate of Invoice

2/10 net 30 DOI2/10 net 30 EOM End of month ，表示 credit

period 是從採購後的下個月第一天開始算起


• Credit Terms: EOM, DOI



Presti Corporation, operator of a small chain of video stores,

purchased $1,000 worth of merchandise on February 27 from

a supplier extending terms of 2/10 net 30 EOM. If the firm

takes the cash discount, it will have to pay $980 [$1,000 - (.02

x $1,000)] on March 10th saving $20. What is the cost of not

taking the cash discount should they choose to do so?






• Cost of Trade Credit

EC = % discount x 360 100% - %discount credit pd - discount pd

EC = 2% x 360 = 36.73% 100% - 2% 30 - 10


延遲 20 天付款的資金成本率 ( 隱含的借款利率 ) ，也就是放棄現金折扣的機會成本

0 10 30

$980 $1,000






The preceding example suggest that the firm should take

the cash discount as long as it can borrow from other

sources for less than 36.73%. Because nearly all firms

can borrow for less than this (even using credit cards!)

they should always take the terms 2/10 net 30.







• Stretching accounts payable

• Accruals


在不損害其信用紀錄的前提之下，公司常要求供應商在付款期間上再展延幾天

%2.1260

360

98

2

例如：展成 70 天內付清即可，則放棄現金折扣的資金成本率會降低成

如：延遲付薪，也可為公司取得短期無息資金

Unsecured Sources of Short-Term Loans

• The major type of loan made by banks to businesses is the short-term, self-liquidating loan which are intended to carry firms through seasonal peaks in financing needs.

• These loans are generally obtained as companies build

up inventory and experience growth in accounts

receivable.

• As receivables and inventories are converted into cash,

the loans are then retired.

• These loans come in three basic forms: single-payment

notes, lines of credit, and revolving credit agreements.

Bank Loans

所以稱為 self-liquidating

Unsecured, short-term

Unsecured Sources of Short-Term LoansBank Loans

• Most banks loans are based on the prime rate of interest

which is the lowest rate of interest charged by the

nation’s leading banks on loans to their most reliable

business borrowers.

• Banks generally determine the rate to be charged to

various borrowers by adding a premium to the prime

rate to adjust it for the borrowers “riskiness.”

Loan Interest Rates


• On a fixed-rate loan, the rate of interest is determined at

a set increment above the prime rate and remains at

that rate until maturity.

• On a floating-rate loan, the increment above the prime

rate is initially established and is then allowed to float

with prime until maturity.

• Like ARMs, the increment above prime is generally

lower on floating rate loans than on fixed-rate loans.

Fixed & Floating-Rate Loans

Adjustable-rate mortgage


• Once the nominal (stated) rate of interest is established,

the method of computing interest is determined.

• Interest can be paid either when a loan matures or in

advance.

• If interest is paid at maturity, the effective (true) rate of

interest -- assuming the loan is outstanding for exactly

one year -- may be computed as follows:

Method of Computing Interest

Interest Amount Borrowed

有效利率


• If the interest is paid in advance, it is deducted from the loan

so that the borrower actually receives less money than

requested.

• Loans of this type are called discount loans. The effective

rate of interest on a discount loan assuming it is outstanding

for exactly one year may be computed as follows:


InterestBorrowedAmount

Interest



(10% X $10,000) = 10.0% $10,000

Booster Company, a manufacturer of athletic apparel,

wants to borrow $10,000 at a stated rate of 10% for 1 year.

If interest is paid at maturity, the effective interest rate

may be computed as follows:

t=0 t=1

+$10,000 -$11,000



(10% X $10,000) = 11.1% $10,000 - $1,000

Booster Company, a manufacturer of athletic apparel,

wants to borrow $10,000 at a stated rate of 10% for 1 year.

If this loan were a discount loan, the effective rate of

interest would be:

t=0 t=1

+$9,000 -$10,000


• A single-payment note is a short-term, one-time loan

payable as a single amount at its maturity (including

principal and interest).

• The “note” states the terms of the loan, which include the

length of the loan as well as the interest rate.

• Most have maturities of 30 days to 9 or more months.

• The interest is usually tied to prime and may be either

fixed or floating.

Single-Payment Notes



Golden Manufacturing recently borrowed $100,000 from each of 2 banks -- A and B. Loan A is a fixed rate note, and loan B is a floating rate note. Both loans were 90-day notes with interest due at the end of 90 days. The rates were set at 1.5% above prime for A and 1.0% above prime for B when prime was 9%.

Based on this information, the total interest cost on loan A is $2,625 [$100,000 x 10.5% x (90/360)]. The effective cost is 2.625% for 90 days. The effective annual rate may be calculated as follows:

EAR = (1 + periodic rate)m - 1 = (1+.02625)4 - 1 = 10.92%



Thus, the effective cost is 2.562% for 90 days. The effective annual rate may be calculated as follows:


During the 90 days that loan B was outstanding, the prime rate was 9% for the first 30 days, 9.5% for the next 30 days, and 9.25% for the final 30 days. As a result, the periodic rate was .833% [10% x (30/360)] for the first 30 days, .875% for the second 30 days, and .854% for the final 30 days. Therefore, its total interest cost was $2,562 [$100,000 x (.833% + .875% + .854%)].

10.5% × (30/360)

10.25%× (30/360) 在 90 天期滿時一次拿到

$2,562/$100,000


• A line of credit is an agreement between a commercial

bank and a business specifying the amount of

unsecured short-term borrowing the bank will make

available to the firm over a given period of time.

• It is usually made for a period of 1 year and often places

various constraints on borrowers.

• Although not guaranteed, the amount of a LOC is the

maximum amount the firm can owe the bank at any

point in time.

Lines of Credit (LOC)就像信用卡的信用額度

銀行並不保證，在信用額度來借錢的話，一定借得到


• In order to obtain the LOC, the borrower may be

required to submit a number of documents including a

cash budget, and recent (and pro forma) financial

statements.

• The interest rate on a LOC is normally floating and

pegged to prime.

• In addition, banks may impose operating restrictions

giving it the right to revoke the LOC if the firm’s financial

condition changes.

Lines of Credit (LOC)

此外，銀行給 LOC 時，常會附帶要求借款人要能 annual cleanups: 每年底或某些時間點要將餘額還清


• Both LOCs and revolving credit agreements often

require the borrower to maintain compensating

balances.

• A compensating balance is simply a certain checking

account balance equal to a certain percentage of the

amount borrowed (typically 10 to 20 percent).

• This requirement effectively increases the cost of the

loan to the borrower.




Exact Graphics borrowed $1 million under a LOC at 10%

with a compensating balance requirement of 20% or

$200,000. Therefore, the firm has access to only $800,000

and must pay interest charges of $100,000. The

compensating balance therefore raises the effective cost

of the loan to 12.5% ($100,000/$800,000) which is 2.5%

more than the stated rate of interest.

If the firm normally maintains a checking account balance of $200,000 or more, then the stated rate will equal the effective rate of interest, because none of the $1 million borrowed is needed to satisfy the compensating balance.

Compensating balance 之作用類似 discount loan


Revolving Credit Agreements (RCA)

• A RCA is nothing more than a guaranteed line of credit.

• Because the bank guarantees the funds will be

available, they typically charge a commitment fee which

applies to the unused portion of of the borrowers credit

line.

• A typical fee is around 0.5% of the average unused

portion of the funds.

• Although more expensive than the LOC, the RCA is less

risky from the borrowers perspective.


Revolving Credit Agreements (RCA)

During the past year, Blount Company borrowed (on

average) $1.5 million under its $2 million RCA. As a

result, they had to pay 0.5% on the unused balance of

$500,000 -- or $2,500. In addition, Blount paid $160,000 in

interest on the $1.5 million it actually used. As a result,

the effective annual cost of the RCA was 10.83%

[($160,000 + $2500)/$1,500,000].

Unsecured Sources of Short-Term LoansCommercial Paper

• Commercial paper is a short-term, unsecured promissory note

issued by a firm with a high credit standing.

• Generally only large firms in excellent financial condition can

issue commercial paper.

• Most commercial paper has maturities ranging from 3 to 270

days, is issued in multiples of $100,000 or more, and is sold at

a discount form par value. “discount bond”

• Commercial paper is traded in the money market and is

commonly held as a marketable security investment.

誰賣 ? 大公司誰買 ? 其他企業或金融機構誰是承銷商及經紀商 ? 票券公司、銀行…如何加強發行公司的信用 ? 向銀行取得信用額度

Unsecured Sources of Short-Term LoansCommercial Paper

Deems Corporation has just issued $1 million worth of 90-

day commercial paper at $980,000. At the end of 90 days,

Deems will pay the purchase the full $1 million. The cost

to Deems is therefore 2.04% ($20,000/$980,000) for 90

days. The effective annual rate of interest can be

calculated as follows:


Unsecured Sources of Short-Term LoansInternational Loans

• 當 A 公司向國外採購時， A 公司會去找他的往來銀行開立信用狀 (letter of

Credit, LC) ：向供應商保證該筆貨款一定會支付

• 設在國外的分公司或工廠在採購時會向當地銀行融資以避免匯率風險

• Sometimes multinational firms will borrow from Eurocurrency loan market (

以美金為計價單位 )

• The main difference between international and domestic transactions is that

payments are often made or received in a foreign currency

• A U.S exporter that generates receivables in a foreign currency faces the

risk that the U.S. dollar will appreciate relative to the foreign currency.

• Likewise, the risk to a U.S. importer with foreign currency accounts payables

is that the U.S. dollar will depreciate relative to the foreign currency.

U.S. exporter

Secured Sources of Short-Term LoansCharacteristics

• Although it may reduce the loss in the case of default, from the

viewpoint of lenders, collateral does not reduce the riskiness of

default on a loan.

• When collateral is used, lenders prefer to match the maturity of

the collateral with the life of the loan.

• As a result, for short-term loans, lenders prefer to use accounts

receivable and inventory as a source of collateral.

Lender 較喜歡 borrower 按時還款付息，而不喜歡倒帳再以抵押品出售來降低損失 lender 寧願忍受低利率，但低風險且無擔保品的貸款，而不要高風險，高利率而有擔保品的貸款 !

Secured Sources of Short-Term LoansCharacteristics

• Depending on the liquidity of the collateral, the loan itself

is normally between 30 and 100 percent of the book

value of the collateral.

• Perhaps more surprisingly, the rate of interest on

secured loans is typically higher than that on

comparable unsecured debt.

• In addition, lenders normally add a service charge or

charge a higher rate of interest for secured loans.

Percentage advance

所以 borrower 會先借 unsecured loan ( 較便宜 ) 用完後再去借 secured loan

主要 lender 為商業銀行及 commercial finance company

因為 secured loan 簽約、執行都較麻煩

Secured Sources of Short-Term Loans

• Pledging accounts receivable occurs when accounts

receivable is used as collateral for a loan.

• After investigating the desirability and liquidity of the

receivables, banks will normally lend between 50 and 90

percent of the face value of acceptable receivables.

• In addition, to protect its interests, the lender files a lien

on the collateral and is made on a non-notification basis

(the customer is not notified).

Accounts Receivable as Collateral

A publicly disclosed legal claim on collateral 抵押權

Borrower 從顧客那邊收到貨款後，再轉手給銀行

除了利率之外， lender 還常會收一筆 3% 的 service charge


• Factoring accounts receivable involves the outright sale of

receivables at a discount to a factor.

• Factors are financial institutions that specialize in purchasing

accounts receivable and may be either departments in banks or

companies that specialize in this activity.

• Factoring is normally done on a notification basis and a non-

recourse basis where the factor receives payment directly from

the customer.

Accounts Receivable as Collateral 銀行要評估 AR 裡那些是可以作 factoring?

Factor幫客戶設一個帳號，當貨款收到或繳款日到期時 ( 或兩者那一個較早 ) ， Factor 才會把應該收到的貨款減去佣金後轉進此帳戶，這個帳戶餘額為正時 factor 要支付利息，為負時 ( 客戶向 factor預支借錢 ) ，客戶要支付利息

Commission, 為 factor賺取的部份

信用風險移轉給銀行

對企業的好處是 (1)早點收到現金 (2) 降低現金流量的不確定性 (3) 不需用應收帳款管理部門了


• The most important characteristic of inventory as

collateral is its marketability.

• Perishable items such as fruits or vegetables may be

marketable, but since the cost of handling and storage is

relatively high, they are generally not considered to be a

good form of collateral.

• Specialized items with limited sources of buyers are also

generally considered not to be desirable collateral.

Inventory as Collateral


• A floating inventory lien is a lenders claim on the

borrower’s general inventory as collateral.

• This is most desirable when the level of inventory is

stable and it consists of a diversified group of relatively

inexpensive items.

• Because it is difficult to verify the presence of the

inventory, lenders generally advance less than 50% of

the book value of the average inventory and charge 3 to

5 percent above prime for such loans.


如汽車輪胎、五金、鞋子


• A trust receipt inventory loan is an agreement under

which the lender advances 80 to 100 percent of the cost

of a borrower’s relatively expensive inventory in

exchange for a promise to repay the loan on the sale of

each item.

• The interest charged on such loans is normally 2% or

more above prime and are often made by a

manufacturer’s wholly -owned subsidiary (captive

finance company).

• Good examples would include GE Capital and GMAC.


lender 會定期檢查 borrower 的存貨水準


• A warehouse receipt loan is an arrangement in which

the lender receives control of the pledged inventory

which is stored by a designated agent on the lenders

behalf.

• The inventory may stored at a central warehouse (terminal warehouse) or on the borrowers property (field warehouse).

• Regardless of the arrangement, the lender places a

guard over the inventory and written approval is required

for the inventory to be released.

• Costs run from about 3 to 5 percent above prime.


borrower 還要支付倉儲費用及保險費用

principles of managerial finance 9th edition

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