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Working-Capital Management Chapter 14
 

Working-Capital Management Chapter 14

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    Working-Capital Management Chapter 14 Working-Capital Management Chapter 14 Presentation Transcript

    • Working-Capital Management Chapter 14
      • What is Working Capital?
        • The firm’s investment in current assets
      Working-Capital Management
      • Net Working Capital
        • The difference between the firm’s current assets and current liabilities
      Working-Capital Management
    • Working-Capital Management
      • Current Assets
        • cash, marketable securities, inventory, accounts receivable
      • Long-Term Assets
        • equipment, buildings, land
      • Which earn higher rates of return ?
        • Long-term assets
      • Which help avoid risk of illiquidity ?
        • Current Assets
    • Working-Capital Management
      • Current Assets
        • cash, marketable securities, inventory, accounts receivable
      • Long-Term Assets
        • equipment, buildings, land
      • Risk-Return Trade-off:
      • Current assets earn low returns, but help reduce the risk of illiquidity.
    • Working-Capital Management
      • Current Liabilities
        • short-term notes, accrued expenses, accounts payable
      • Long-Term Debt and Equity
        • bonds, preferred stock, common stock
      • Which are more expensive for the firm?
      • Which help avoid risk of illiquidity ?
    • Working-Capital Management
      • Current Liabilities
        • short-term notes, accrued expenses, accounts payable
      • Long-Term Debt and Equity
        • bonds, preferred stock, common stock
      • Risk-Return Trade-off:
      • Current liabilities are less expensive, but increase the risk of illiquidity.
      • Balance Sheet
      • Current Assets Current Liabilities
      • Fixed Assets Long-Term Debt
      • Preferred Stock
      • Common Stock
      • To illustrate, let’s finance all current assets with current liabilities , and finance all fixed assets with long-term financing .
      • Balance Sheet
      • Current Assets Current Liabilities
      • Fixed Assets Long-Term Debt
      • Preferred Stock
      • Common Stock
      • Suppose we use long-term financing to finance some of our current assets .
      • This strategy would be less risky , but more expensive!
      • Balance Sheet
      • Current Assets Current Liabilities
      • Fixed Assets Long-Term Debt
      • Preferred Stock
      • Common Stock
      • Suppose we use current liabilities to finance some of our fixed assets .
      • This strategy would be less expensive , but more risky !
    • The Hedging Principle
      • Permanent Assets (those held > 1 year)
        • should be financed with permanent and spontaneous sources of financing.
      • Temporary Assets (those held < 1 year)
        • should be financed with temporary sources of financing.
      • Balance Sheet
      • Temporary Temporary
      • Current Assets Short-term financing
      • Permanent Permanent
      • Fixed Assets Financing
      • and
      • Spontaneous
      • Financing
    • The Hedging Principle
      • Permanent Financing
        • intermediate-term loans, long-term debt, preferred stock, common stock
      • Spontaneous Financing
        • accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes)
      • Short-term financing
        • unsecured bank loans, commercial paper, loans secured by A/R or inventory
    • Sources of Short-term Credit
      • Unsecured
        • accrued wages and taxes
        • trade credit
        • bank credit
        • commercial paper
      • Secured
        • accounts receivable loans
        • inventory loans
    • Working Capital
    • Working Capital
      • Working capital – The firm’s total investment in current assets.
      • Net working capital – The difference between the firm’s current assets and its current liabilities.
      • This chapter focuses on net working capital.
    • Managing Net Working Capital
      • Managing net working capital is concerned with managing the firm’s liquidity. This entails managing two related aspects of the firm’s operations:
          • Investment in current assets
          • Use of short-term or current liabilities
    • Risk-Return Trade-off
    • Use of Current versus Fixed Assets
      • Holding more current assets will reduce the risk of illiquidity.
      • 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
      • The Trade-off : Increased liquidity must be traded-off against the firm’s reduction in return on investment.
    • Use of Current versus Long-term Debt
      • 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.
      • 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.
    • Advantages of Current Liabilities: Return
      • Flexibility
        • 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.
      • Interest Cost
        • Interest rates on short-term debt are lower than on long-term debt.
    • Disadvantages of Current Liabilities: Risk
      • Risk of illiquidity increases due to:
        • Short-term debt must be repaid or rolled over more often
        • Uncertainty of interest costs from year to year
    • The Appropriate Level of Working Capital
    • Appropriate Level of Working Capital
      • Managing working capital involves interrelated decisions regarding investments in current assets and use of current liabilities.
      • Hedging Principle or Principle of Self-Liquidating Debt provides a guide to the maintenance of appropriate level of liquidity.
    • Hedging Principle
      • Involves matching the cash flow generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition.
      • Thus a seasonal need for inventories should be financed with a short-term loan or current liability.
      • On the other hand, investment in equipment expected to last for a long time should be financed with long-term debt.
    • Permanent and Temporary Assets
      • Permanent investments
        • Investments that the firm expects to hold for a period longer than one year
      • Temporary Investments
        • Current assets that will be liquidated and not replaced within the current year
    • Sources of Financing
      • Total assets will equal the sum of temporary, permanent and spontaneous sources of financing.
    • Temporary & Permanent Source
      • Temporary sources of financing consist of current liabilities such as short-term secured and unsecured notes payable.
      • Permanent sources of financing include: intermediate-term loans, long-term debt, preferred stock common equity
    • Spontaneous Sources of Financing
      • Spontaneous sources of financing arise spontaneously in the firm’s day-to-day operations.
        • 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.
          • Trade credit appears on a balance sheet as accounts payable.
          • Wages and salaries payable, accrued interest and accrued taxes also provide valuable sources of spontaneous financing.
    • Also see table 15-1
    • Hedging Principle Summary
      • 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.
    • Cash Conversion Cycle
    • Cash Conversion Cycle
      • A firm can minimize its working capital by speeding up collection on sales, increasing inventory turns, and slowing down the disbursement of cash.
      • Cash Conversion cycle (CCC) captures the above.
      • CCC = days of sales outstanding + days of sales in inventory – days of payables outstanding.
    • Sources of Short-term Credit
    • Sources of Short-term Credit
      • Short-term credit sources can be classified into two basic groups:
        • Unsecured
        • Secured
    • Unsecured Loans
      • 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.
      • Major sources:
        • Accrued wages and taxes, trade credit, unsecured bank loans, and commercial paper
    • Secured Loans
      • Involve the pledge of specific assets as collateral in the event that the borrower defaults in payment of principal or interest.
      • Primary Suppliers:
        • Commercial banks, finance companies, and factors
      • Principal sources of collateral:
        • Accounts receivable and inventories
    • Unsecured Source: Trade Credit
      • Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms offered with trade credit involve a cash discount for early payment.
      • 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
      • A 2% penalty is involved for not paying within 10 days.
    • Effective Cost of Passing Up a Discount
      • Terms 2/10 net 30
      • The equivalent APR of this discount is:
      • APR = $.02/$.98 X [1/(20/360)]
      • = .3673 or 36.73%
      • The effective cost of delaying payment for 20 days is 36.73%