Fm10e ch18

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Fm10e ch18

  1. 1.  2005, Pearson Prentice Hall Chapter 18 – Working-Capital Management and Short-term Financing
  2. 2. 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><li>Which help avoid risk of illiquidity ? </li></ul>
  3. 3. 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>
  4. 4. 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>
  5. 5. 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>
  6. 6. <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 , </li></ul>
  7. 7. <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>
  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>Suppose we use long-term financing to finance some of our current assets . </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>
  11. 11. <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>
  12. 12. 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>
  13. 13. <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>
  14. 14. 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>
  15. 15. Cost of Short-Term Credit <ul><li>Interest = principal x rate x time </li></ul><ul><li>Example : Borrow $10,000 at 8.5% for 9 months. </li></ul><ul><li>Interest = $10,000 x .085 x 3/4 year </li></ul><ul><li>= $637.50 </li></ul>
  16. 16. <ul><li>We can use this simple relationship: </li></ul><ul><li>Interest = principal x rate x time </li></ul><ul><li>to solve for rate , and get the </li></ul><ul><li>Annual Percentage Rate (APR) </li></ul><ul><li>interest 1 </li></ul><ul><li>principal time </li></ul>Cost of Short-Term Credit APR = x
  17. 17. <ul><li>interest 1 </li></ul><ul><li>principal time </li></ul><ul><li>Example : If you pay $637.50 in interest on $10,000 principal for 9 months: </li></ul><ul><li>APR = 637.50 / 10,000 x 1 / .75 = .085 </li></ul><ul><li>= 8.5% APR </li></ul>Cost of Short-Term Credit APR = x
  18. 18. <ul><li>Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: </li></ul><ul><li> i m </li></ul><ul><li> m </li></ul><ul><li>i = the nominal rate of interest </li></ul><ul><li>m = the # of compounding periods per year </li></ul>Cost of Short-Term Credit APY = ( 1 + ) - 1
  19. 19. Cost of Short-Term Credit <ul><li>What is the (APY) of a 9% loan with monthly payments? </li></ul><ul><li>APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938 </li></ul><ul><li>= 9.38% </li></ul>
  20. 20. 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>

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