Working Capital Management  Chapter 15
Chapter Objectives <ul><li>Managing current assets and current liabilities </li></ul><ul><li>Appropriate level of working ...
Working Capital <ul><li>Working Capital  </li></ul><ul><ul><li>Traditionally is the firm’s total investment in current ass...
Managing Net Working Capital <ul><li>Equals managing liquidity </li></ul><ul><li>Entails two aspects of operations: </li><...
Risk-Return Trade-off <ul><li>Holding liquid investments reduces overall rate of return </li></ul><ul><li>Increased liquid...
Liquidity Risk <ul><li>Other things remaining the same, the greater the firm’s reliance on short-term debt or current liab...
Advantages of Current Liabilities <ul><li>Flexibility </li></ul><ul><ul><li>Can be used to match the timing of a firm’s ne...
Disadvantages of Current Liabilities <ul><li>Risk </li></ul><ul><ul><li>Short-term debt must be repaid or rolled over more...
Appropriate Level of Working Capital <ul><li>Involves interrelated decisions  </li></ul><ul><li>Can be a significant probl...
Hedging Principle <ul><li>Also known as Principle of Self-liquidating debt </li></ul><ul><li>Involves matching the cash fl...
Permanent and Temporary Assets <ul><li>Permanent investments  </li></ul><ul><ul><li>Investments that the firm expects to h...
Temporary Financing <ul><li>Temporary sources of financing are Current liabilities: </li></ul><ul><ul><li>short-term notes...
Permanent Financing <ul><li>Permanent Sources of financing include: </li></ul><ul><ul><li>Intermediate-term loans </li></u...
Spontaneous Financing <ul><li>Spontaneous Sources of financing </li></ul><ul><ul><li>Arise in the firm’s day-to-day operat...
Hedging Principle <ul><li>Asset needs of the firm not financed by spontaneous sources should be financed in accordance wit...
Cost of Short-term Credit <ul><li>Interest = principal X rate X time </li></ul><ul><li>Cost of short-term financing = APR ...
APR <ul><li>A company plans to borrow $1,000 for 90 days.  At maturity, the company will repay the $1,000 principal amount...
APY <ul><li>APR does not consider compound interest.  To account for the influence of compounding, must calculate APY or  ...
APY Calculation <ul><li>A company plans to borrow $1,000 for 90 days.  At maturity, the company will repay the $1,000 prin...
APR or APY <ul><li>Because the differences between APR and APY are usually small, use the simple interest values of APR to...
Short-term Sources of  Financing <ul><li>Include all forms of financing that have maturities of 1 year or less (or current...
What Specific Sources of Short-term Financing Should the Firm Select? <ul><li>Three factors influence the decision: </li><...
Sources of Short-term Credit <ul><li>Short-term credit sources can be classified into two basic groups: </li></ul><ul><li>...
Secured Loans <ul><li>Involve the pledge of specific assets as collateral in the event the borrower defaults in payment of...
Unsecured Loans <ul><li>All sources that have as their security only the lender’s faith in the ability of the borrower to ...
Cash Discounts <ul><li>Often, the credit terms associated with  trade credit involve a cash discount for early payment.  <...
Effective Cost of Passing Up a Discount <ul><li>Terms 2/10 net 30  </li></ul><ul><li>Means a 2 percent discount is availab...
Unsecured Sources of Loans <ul><li>Bank Credit: </li></ul><ul><ul><li>Lines of credit </li></ul></ul><ul><ul><li>Transacti...
Line of Credit <ul><li>Line of Credit </li></ul><ul><ul><li>Informal agreement between a borrower and a bank about the max...
Revolving Credit <ul><li>Revolving Credit </li></ul><ul><ul><li>Variant of the line of credit form of financing </li></ul>...
Transaction Loans <ul><li>Transactions loans </li></ul><ul><ul><li>Made for a specific purpose </li></ul></ul><ul><ul><li>...
Commercial Paper <ul><li>The largest and most credit worthy companies are able to use commercial paper– a short-term promi...
Advantages of Commercial Paper <ul><li>Interest rates </li></ul><ul><ul><li>Rates are generally lower than rates on bank l...
Secured Sources of Loans <ul><li>Accounts Receivable loans </li></ul><ul><ul><li>Pledging Accounts Receivable </li></ul></...
Pledging Accounts Receivable <ul><li>Under pledging, the borrower simply pledges accounts receivable as collateral for a l...
Factoring Accounts Receivable  <ul><li>Factoring accounts receivable involves the outright sale of a firm’s accounts to a ...
Inventory Loans <ul><li>Loans secured by inventories </li></ul><ul><li>The amount of the loan depends on the marketability...
Types of Inventory Loans <ul><li>Floating Lien Agreement </li></ul><ul><ul><li>The borrower gives the lender a lien agains...
<ul><li>Field warehouse-financing agreement </li></ul><ul><li>Inventories used as collateral are physically separated from...
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Working Capital Management Chapter 15

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Working Capital Management Chapter 15

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