Working-Capital Management Chapter 14
<ul><li>What is Working Capital? </li></ul><ul><ul><li>The firm’s investment in current assets </li></ul></ul>Working-Capi...
<ul><li>Net Working Capital </li></ul><ul><ul><li>The difference between the firm’s current assets and current liabilities...
Working-Capital Management <ul><li>Current Assets </li></ul><ul><ul><li>cash, marketable securities, inventory, accounts r...
Working-Capital Management <ul><li>Current   Assets </li></ul><ul><ul><li>cash, marketable securities, inventory, accounts...
Working-Capital Management <ul><li>Current Liabilities </li></ul><ul><ul><li>short-term notes, accrued expenses, accounts ...
Working-Capital Management <ul><li>Current   Liabilities </li></ul><ul><ul><li>short-term notes, accrued expenses, account...
<ul><li>Balance Sheet </li></ul><ul><li>Current Assets  Current Liabilities </li></ul><ul><li>  Fixed Assets   Long-Term D...
<ul><li>Balance Sheet </li></ul><ul><li>Current Assets  Current Liabilities </li></ul><ul><li>  Fixed Assets   Long-Term D...
<ul><li>Balance Sheet </li></ul><ul><li>Current Assets  Current Liabilities </li></ul><ul><li>  Fixed Assets   Long-Term D...
The Hedging Principle <ul><li>Permanent   Assets  (those held  >  1 year) </li></ul><ul><ul><li>should be financed with pe...
<ul><li>Balance Sheet </li></ul><ul><li>Temporary   Temporary </li></ul><ul><li>Current Assets    Short-term financing </l...
The Hedging Principle <ul><li>Permanent Financing </li></ul><ul><ul><li>intermediate-term loans, long-term debt, preferred...
Sources of Short-term Credit <ul><li>Unsecured </li></ul><ul><ul><li>accrued wages and taxes </li></ul></ul><ul><ul><li>tr...
Working Capital
Working Capital <ul><li>Working capital  – The firm’s total investment in current assets. </li></ul><ul><li>Net working ca...
Managing Net Working Capital <ul><li>Managing net working capital is concerned with managing the firm’s liquidity. This en...
Risk-Return Trade-off
Use of Current versus Fixed Assets <ul><li>Holding more current assets will reduce the risk of illiquidity.  </li></ul><ul...
Use of Current versus  Long-term Debt <ul><li>Other things remaining the same, the greater the firm’s reliance on short-te...
Advantages of Current Liabilities: Return <ul><li>Flexibility </li></ul><ul><ul><li>Current liabilities can be used to mat...
Disadvantages of Current Liabilities: Risk <ul><li>Risk of illiquidity increases due to: </li></ul><ul><ul><li>Short-term ...
The Appropriate Level of Working Capital
Appropriate Level of  Working Capital <ul><li>Managing working capital involves interrelated decisions regarding investmen...
Hedging Principle <ul><li>Involves matching the cash flow generating characteristics of an asset with the maturity of the ...
Permanent and Temporary Assets <ul><li>Permanent investments  </li></ul><ul><ul><li>Investments that the firm expects to h...
Sources of Financing <ul><li>Total assets will equal the sum of temporary, permanent and spontaneous sources of financing....
Temporary & Permanent Source <ul><li>Temporary sources of financing consist of current liabilities such as short-term secu...
Spontaneous Sources of Financing <ul><li>Spontaneous sources of financing arise spontaneously in the firm’s day-to-day ope...
Also see table 15-1
Hedging Principle Summary <ul><li>Asset needs of the firm not financed by spontaneous sources should be financed in accord...
Cash Conversion Cycle
Cash Conversion Cycle <ul><li>A firm can minimize its working capital by speeding up collection on sales, increasing inven...
Sources of Short-term Credit
Sources of Short-term Credit <ul><li>Short-term credit sources can be classified into two basic groups: </li></ul><ul><ul>...
Unsecured Loans <ul><li>Unsecured loans include all of those sources that have as their security only the lender’s faith i...
Secured Loans <ul><li>Involve the pledge of specific assets as collateral in the event that the borrower defaults in payme...
Unsecured Source: Trade Credit <ul><li>Trade credit arises spontaneously with the firm’s purchases. Often, the credit term...
Effective Cost of Passing Up a Discount <ul><li>Terms 2/10 net 30 </li></ul><ul><li>The equivalent APR of this discount is...
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Working-Capital Management Chapter 14

  1. 1. Working-Capital Management Chapter 14
  2. 2. <ul><li>What is Working Capital? </li></ul><ul><ul><li>The firm’s investment in current assets </li></ul></ul>Working-Capital Management
  3. 3. <ul><li>Net Working Capital </li></ul><ul><ul><li>The difference between the firm’s current assets and current liabilities </li></ul></ul>Working-Capital Management
  4. 4. Working-Capital Management <ul><li>Current Assets </li></ul><ul><ul><li>cash, marketable securities, inventory, accounts receivable </li></ul></ul><ul><li>Long-Term Assets </li></ul><ul><ul><li>equipment, buildings, land </li></ul></ul><ul><li>Which earn higher rates of return ? </li></ul><ul><ul><li>Long-term assets </li></ul></ul><ul><li>Which help avoid risk of illiquidity ? </li></ul><ul><ul><li>Current Assets </li></ul></ul>
  5. 5. Working-Capital Management <ul><li>Current Assets </li></ul><ul><ul><li>cash, marketable securities, inventory, accounts receivable </li></ul></ul><ul><li>Long-Term Assets </li></ul><ul><ul><li>equipment, buildings, land </li></ul></ul><ul><li>Risk-Return Trade-off: </li></ul><ul><li>Current assets earn low returns, but help reduce the risk of illiquidity. </li></ul>
  6. 6. Working-Capital Management <ul><li>Current Liabilities </li></ul><ul><ul><li>short-term notes, accrued expenses, accounts payable </li></ul></ul><ul><li>Long-Term Debt and Equity </li></ul><ul><ul><li>bonds, preferred stock, common stock </li></ul></ul><ul><li>Which are more expensive for the firm? </li></ul><ul><li>Which help avoid risk of illiquidity ? </li></ul>
  7. 7. Working-Capital Management <ul><li>Current Liabilities </li></ul><ul><ul><li>short-term notes, accrued expenses, accounts payable </li></ul></ul><ul><li>Long-Term Debt and Equity </li></ul><ul><ul><li>bonds, preferred stock, common stock </li></ul></ul><ul><li>Risk-Return Trade-off: </li></ul><ul><li>Current liabilities are less expensive, but increase the risk of illiquidity. </li></ul>
  8. 8. <ul><li>Balance Sheet </li></ul><ul><li>Current Assets Current Liabilities </li></ul><ul><li> Fixed Assets Long-Term Debt </li></ul><ul><li> Preferred Stock </li></ul><ul><li> Common Stock </li></ul><ul><li>To illustrate, let’s finance all current assets with current liabilities , and finance all fixed assets with long-term financing . </li></ul>
  9. 9. <ul><li>Balance Sheet </li></ul><ul><li>Current Assets Current Liabilities </li></ul><ul><li> Fixed Assets Long-Term Debt </li></ul><ul><li> Preferred Stock </li></ul><ul><li> Common Stock </li></ul><ul><li>Suppose we use long-term financing to finance some of our current assets . </li></ul><ul><li>This strategy would be less risky , but more expensive! </li></ul>
  10. 10. <ul><li>Balance Sheet </li></ul><ul><li>Current Assets Current Liabilities </li></ul><ul><li> Fixed Assets Long-Term Debt </li></ul><ul><li> Preferred Stock </li></ul><ul><li> Common Stock </li></ul><ul><li>Suppose we use current liabilities to finance some of our fixed assets . </li></ul><ul><li>This strategy would be less expensive , but more risky ! </li></ul>
  11. 11. The Hedging Principle <ul><li>Permanent Assets (those held > 1 year) </li></ul><ul><ul><li>should be financed with permanent and spontaneous sources of financing. </li></ul></ul><ul><li>Temporary Assets (those held < 1 year) </li></ul><ul><ul><li>should be financed with temporary sources of financing. </li></ul></ul>
  12. 12. <ul><li>Balance Sheet </li></ul><ul><li>Temporary Temporary </li></ul><ul><li>Current Assets Short-term financing </li></ul><ul><li>Permanent Permanent </li></ul><ul><li>Fixed Assets Financing </li></ul><ul><li>and </li></ul><ul><li> Spontaneous </li></ul><ul><li> Financing </li></ul>
  13. 13. The Hedging Principle <ul><li>Permanent Financing </li></ul><ul><ul><li>intermediate-term loans, long-term debt, preferred stock, common stock </li></ul></ul><ul><li>Spontaneous Financing </li></ul><ul><ul><li>accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes) </li></ul></ul><ul><li>Short-term financing </li></ul><ul><ul><li>unsecured bank loans, commercial paper, loans secured by A/R or inventory </li></ul></ul>
  14. 14. Sources of Short-term Credit <ul><li>Unsecured </li></ul><ul><ul><li>accrued wages and taxes </li></ul></ul><ul><ul><li>trade credit </li></ul></ul><ul><ul><li>bank credit </li></ul></ul><ul><ul><li>commercial paper </li></ul></ul><ul><li>Secured </li></ul><ul><ul><li>accounts receivable loans </li></ul></ul><ul><ul><li>inventory loans </li></ul></ul>
  15. 15. Working Capital
  16. 16. Working Capital <ul><li>Working capital – The firm’s total investment in current assets. </li></ul><ul><li>Net working capital – The difference between the firm’s current assets and its current liabilities. </li></ul><ul><li>This chapter focuses on net working capital. </li></ul>
  17. 17. Managing Net Working Capital <ul><li>Managing net working capital is concerned with managing the firm’s liquidity. This entails managing two related aspects of the firm’s operations: </li></ul><ul><ul><ul><li>Investment in current assets </li></ul></ul></ul><ul><ul><ul><li>Use of short-term or current liabilities </li></ul></ul></ul>
  18. 18. Risk-Return Trade-off
  19. 19. Use of Current versus Fixed Assets <ul><li>Holding more current assets will reduce the risk of illiquidity. </li></ul><ul><li>However, liquid assets like cash and marketable securities earn relatively less compared to other assets. Thus larger amount liquid investments will reduce overall rate of return </li></ul><ul><li>The Trade-off : Increased liquidity must be traded-off against the firm’s reduction in return on investment. </li></ul>
  20. 20. Use of Current versus Long-term Debt <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>Trade-off : 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. Trade-off involves an increased risk of illiquidity versus increased profitability. </li></ul>
  21. 21. Advantages of Current Liabilities: Return <ul><li>Flexibility </li></ul><ul><ul><li>Current liabilities can be used to match the timing of a firm’s needs for short-term financing. Example: Obtaining seasonal financing versus long-term financing for short-term needs. </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>
  22. 22. Disadvantages of Current Liabilities: Risk <ul><li>Risk of illiquidity increases due to: </li></ul><ul><ul><li>Short-term debt must be repaid or rolled over more often </li></ul></ul><ul><ul><li>Uncertainty of interest costs from year to year </li></ul></ul>
  23. 23. The Appropriate Level of Working Capital
  24. 24. Appropriate Level of Working Capital <ul><li>Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities. </li></ul><ul><li>Hedging Principle or Principle of Self-Liquidating Debt provides a guide to the maintenance of appropriate level of liquidity. </li></ul>
  25. 25. Hedging Principle <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><ul><li>Thus a seasonal need for inventories should be financed with a short-term loan or current liability. </li></ul><ul><li>On the other hand, investment in equipment expected to last for a long time should be financed with long-term debt. </li></ul>
  26. 26. 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 one 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>
  27. 27. Sources of Financing <ul><li>Total assets will equal the sum of temporary, permanent and spontaneous sources of financing. </li></ul>
  28. 28. Temporary & Permanent Source <ul><li>Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable. </li></ul><ul><li>Permanent sources of financing include: intermediate-term loans, long-term debt, preferred stock common equity </li></ul>
  29. 29. Spontaneous Sources of Financing <ul><li>Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations. </li></ul><ul><ul><li>Trade credit is often made available spontaneously or on demand from the firm’s supplies when the firm orders its supplies or more inventory of products to sell. </li></ul></ul><ul><ul><ul><li>Trade credit appears on a balance sheet as accounts payable. </li></ul></ul></ul><ul><ul><ul><li>Wages and salaries payable, accrued interest and accrued taxes also provide valuable sources of spontaneous financing. </li></ul></ul></ul>
  30. 30. Also see table 15-1
  31. 31. Hedging Principle Summary <ul><li>Asset needs of the firm not financed by spontaneous sources should be financed in accordance with this rule: </li></ul><ul><ul><li>Permanent-asset investments are financed with permanent sources, and temporary investments are financed with temporary sources. </li></ul></ul>
  32. 32. Cash Conversion Cycle
  33. 33. Cash Conversion Cycle <ul><li>A firm can minimize its working capital by speeding up collection on sales, increasing inventory turns, and slowing down the disbursement of cash. </li></ul><ul><li>Cash Conversion cycle (CCC) captures the above. </li></ul><ul><li>CCC = days of sales outstanding + days of sales in inventory – days of payables outstanding. </li></ul>
  34. 34. Sources of Short-term Credit
  35. 35. Sources of Short-term Credit <ul><li>Short-term credit sources can be classified into two basic groups: </li></ul><ul><ul><li>Unsecured </li></ul></ul><ul><ul><li>Secured </li></ul></ul>
  36. 36. Unsecured Loans <ul><li>Unsecured loans include all of those 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>
  37. 37. Secured Loans <ul><li>Involve the pledge of specific assets as collateral in the event that 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>Principal sources of collateral: </li></ul><ul><ul><li>Accounts receivable and inventories </li></ul></ul>
  38. 38. Unsecured Source: Trade Credit <ul><li>Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms offered with trade credit involve a cash discount for early payment. </li></ul><ul><li>Terms such as 2/10 net 30 means a 2% discount is offered for payment within 10 days, or the full amount is due in 30 days </li></ul><ul><li>A 2% penalty is involved for not paying within 10 days. </li></ul>
  39. 39. Effective Cost of Passing Up a Discount <ul><li>Terms 2/10 net 30 </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> = .3673 or 36.73% </li></ul><ul><li>The effective cost of delaying payment for 20 days is 36.73% </li></ul>
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