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Working Capital Management Chapter 15
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Working Capital Management Chapter 15


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  • 1. Working Capital Management Chapter 15
  • 2. Chapter Objectives
    • Managing current assets and current liabilities
    • Appropriate level of working capital
    • Estimating the cost of short-term credit
    • Sources of short-term credit
    • Multinational working-capital management
  • 3. Working Capital
    • Working Capital
      • Traditionally is the firm’s total investment in current assets
    • Net working capital
      • Difference between the firm’s current assets and its current liabilities
      • Net working capital = Current assets – current liabilities
  • 4. Managing Net Working Capital
    • Equals managing liquidity
    • Entails two aspects of operations:
      • Investment in current assets
      • Use of short-term or current liabilities
  • 5. Risk-Return Trade-off
    • Holding liquid investments reduces overall rate of return
    • Increased liquidity must be traded-off against the firm’s reduction in return on investment
    • Managing this trade-off is an important theme of working-capital management
  • 6. Liquidity Risk
    • Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
    • A firm can reduce its risk of illiquidity through the use of long-term debt at the expense of a reduction in its return on invested funds
  • 7. Advantages of Current Liabilities
    • Flexibility
      • Can be used to match the timing of a firm’s needs for short-term financing
    • Interest Cost
      • Interest rates on short-term debt are lower than on long-term debt
  • 8. Disadvantages of Current Liabilities
    • Risk
      • Short-term debt must be repaid or rolled over more often
    • Uncertainty
      • Uncertainty of interest costs from year to year
  • 9. Appropriate Level of Working Capital
    • Involves interrelated decisions
    • Can be a significant problem
    • Can utilize a type of benchmark
      • Hedging Principle or Principle of self-liquidating debt
  • 10. Hedging Principle
    • Also known as Principle of Self-liquidating debt
    • Involves matching the cash flow generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition
  • 11. Permanent and Temporary Assets
    • Permanent investments
      • Investments that the firm expects to hold for a period longer than 1 year
    • Temporary Investments
      • Current assets that will be liquidated and not replaced within the current year
  • 12. Temporary Financing
    • Temporary sources of financing are Current liabilities:
      • short-term notes payable
      • unsecured bank loans
      • commercial paper
      • loans secured by accounts receivable and inventories
  • 13. Permanent Financing
    • Permanent Sources of financing include:
      • Intermediate-term loans
      • long-term debt
      • preferred stock and common equity
  • 14. Spontaneous Financing
    • Spontaneous Sources of financing
      • Arise in the firm’s day-to-day operation
      • Trade credit is often made available spontaneously or on demand from the firms supplies when the firm orders its supplies or inventory
      • Also includes accrued payables
  • 15. Hedging Principle
    • Asset needs of the firm not financed by spontaneous sources should be financed in accordance with this rule:
    • Permanent-asset investments are financed with permanent sources, and temporary investments are financed with temporary sources
  • 16. Cost of Short-term Credit
    • Interest = principal X rate X time
    • Cost of short-term financing = APR or annual percentage rate
    • APR = interest/(principal X time)
    • or
    • APR = (interest/principal) X (1/time)
  • 17. APR
    • A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000 principal amount plus $30 interest. What is the APR?
    • APR = ($30/$1,000) X [1/(90/360)]
    • .12 or 12%
  • 18. APY
    • APR does not consider compound interest. To account for the influence of compounding, must calculate APY or annual percentage yield
    • APY = (1 + i/m) m – 1
    • Where: I is the nominal rate of interest per year; m is number of compounding period within a year
  • 19. APY Calculation
    • A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000 principal amount plus $30 interest. What is the APY?
    • Number of compounding periods 360/90 = 4
    • Rate = 12% (previously calculated)
    • APY = (1 + .12/4) 4 –1 = .126 or 12.6%
  • 20. APR or APY
    • Because the differences between APR and APY are usually small, use the simple interest values of APR to compute the cost of short-term credit
  • 21. Short-term Sources of Financing
    • Include all forms of financing that have maturities of 1 year or less (or current liabilities)
    • Two issues:
      • How much short-term financing should the firm use? (Hedging Principle)
      • What specific sources of short-term financing should the firm select?
  • 22. What Specific Sources of Short-term Financing Should the Firm Select?
    • Three factors influence the decision:
    • The effective cost of credit
    • The availability of credit
    • The influence of a particular credit source on other sources of financing
  • 23. Sources of Short-term Credit
    • Short-term credit sources can be classified into two basic groups:
    • Secured
    • Unsecured
  • 24. Secured Loans
    • Involve the pledge of specific assets as collateral in the event the borrower defaults in payment of principal or interest
    • Primary Suppliers:
      • Commercial banks, finance companies, and factors
    • The principal sources of collateral include accounts receivable and inventories
  • 25. Unsecured Loans
    • All sources that have as their security only the lender’s faith in the ability of the borrower to repay the funds when due
    • Major sources:
      • accrued wages and taxes, trade credit, unsecured bank loans, and commercial paper
  • 26. Cash Discounts
    • Often, the credit terms associated with trade credit involve a cash discount for early payment.
    • Terms such as 2/10 net 30 means a 2 percent discount is offered for payment within 10 days, or the full amount is due in 30 days
    • A 2 percent penalty is involved for not paying within 10 days.
  • 27. Effective Cost of Passing Up a Discount
    • Terms 2/10 net 30
    • Means a 2 percent discount is available for payment in 10 days or full amount is due in 30 days.
    • The equivalent APR of this discount is:
    • APR = .02/.98 X [1/(20/360)]
    • The effective cost of delaying payment for 20 days is 36.73%
  • 28. Unsecured Sources of Loans
    • Bank Credit:
      • Lines of credit
      • Transaction loans (notes payable)
    • Commercial Paper
  • 29. Line of Credit
    • Line of Credit
      • Informal agreement between a borrower and a bank about the maximum amount of credit the bank will provide the borrower at any one time.
      • There is no legal commitment on the part of the bank to provide the stated credit
      • Usually require that the borrower maintain a minimum balance in the bank through the loan period or a compensating balance
  • 30. Revolving Credit
    • Revolving Credit
      • Variant of the line of credit form of financing
      • A legal obligation is involved
  • 31. Transaction Loans
    • Transactions loans
      • Made for a specific purpose
      • The type of loan that most individuals associate with bank credit and is obtained by signing a promissory note
  • 32. Commercial Paper
    • The largest and most credit worthy companies are able to use commercial paper– a short-term promise to pay that is sold in the market for short-term debt securities
  • 33. Advantages of Commercial Paper
    • Interest rates
      • Rates are generally lower than rates on bank loans
    • Compensating-balance requirement
      • No minimum balance requirements are associated with commercial paper
    • Amount of credit
      • Offers the firm with very large credit needs a single source for all its short-term financing
    • Prestige
      • Signifies credit status
  • 34. Secured Sources of Loans
    • Accounts Receivable loans
      • Pledging Accounts Receivable
      • Factoring Accounts Receivable
    • Inventory loans
  • 35. Pledging Accounts Receivable
    • Under pledging, the borrower simply pledges accounts receivable as collateral for a loan obtained from either a commercial bank or a finance company
    • The amount of the loan is stated as a percentage of the face value of the receivables pledged
    • Flexible source of financing
    • Can be costly
  • 36. Factoring Accounts Receivable
    • Factoring accounts receivable involves the outright sale of a firm’s accounts to a financial institution called a factor
    • A factor is a firm that acquires the receivables of other firms
  • 37. Inventory Loans
    • Loans secured by inventories
    • The amount of the loan depends on the marketability and perishability of the inventory
    • Types:
      • Floating lien agreement
      • Chattel Mortgage agreement
      • Field warehouse-financing agreement
      • Terminal warehouse agreement
  • 38. Types of Inventory Loans
    • Floating Lien Agreement
      • The borrower gives the lender a lien against all its inventories.
      • The simplest but least-secure form
    • Chattel Mortgage Agreement
      • The inventory is identified and the borrower retains title to the inventory but cannot sell the items without the lender’s consent
  • 39.
    • Field warehouse-financing agreement
    • Inventories used as collateral are physically separated from the firm’s other inventories and are placed under the control of a third-party field-warehousing firm
    • Terminal warehouse agreement
    • The inventories pledged as collateral are transported to a public warehouse that is physically removed from the borrower’s premises.