Financing current assets ppt @ bec doms bagalkot mba finanece

1. Financing Current Assets

2. Working capital financing policies
 Moderate – Match the maturity of the
assets with the maturity of the financing.
 Aggressive – Use short-term financing to
finance permanent assets.
 Conservative – Use permanent capital for
permanent assets and temporary assets.

3. Moderate financing policy
$ Temp. C.A.
S-T
Loans
Perm C.A. L-T Fin:
Stock,
Bonds,
Fixed Assets Spon. C.L.
Years
Lower dashed line would be more aggressive.

4. Conservative financing policy
Marketable
$ securities
Zero S-T
Debt
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years

5. Short-term credit
 Any debt scheduled for repayment within one
year.
 Major sources of short-term credit
 Accounts payable (trade credit)
 Bank loans
 Commercial loans
 Accruals
 From the firm’s perspective, S-T credit is more
risky than L-T debt.
 Always a required payment around the corner.
 May have trouble rolling over loans.

6. Advantages and disadvantages of
using short-term financing
 Advantages
 Speed
 Flexibility
 Lower cost than long-term debt
 Disadvantages
 Fluctuating interest expense
 Firm may be at risk of default as a result of temporary
economic conditions

7. Accrued liabilities
 Continually recurring short-term liabilities,
such as accrued wages or taxes.
 Is there a cost to accrued liabilities?
 They are free in the sense that no explicit interest
is charged.
 However, firms have little control over the level
of accrued liabilities.

8. What is trade credit?
 Trade credit is credit furnished by a firm’s
suppliers.
 Trade credit is often the largest source of short-
term credit, especially for small firms.
 Spontaneous, easy to get, but cost can be high.

9. The cost of trade credit
 A firm buys $3,000,000 net ($3,030,303 gross)
on terms of 1/10, net 30.
 The firm can forego discounts and pay on Day
40, without penalty.
Net daily purchases = $3,000,000 / 365
= $8,219.18

10. Breaking down net and gross
expenditures
 Firm buys goods worth $3,000,000. That’s the
cash price.
 They must pay $30,303 more if they don’t take
discounts.
 Think of the extra $30,303 as a financing cost
similar to the interest on a loan.
 Want to compare that cost with the cost of a
bank loan.

11. Breaking down trade credit
 Payables level, if the firm takes discounts
 Payables = $8,219.18 (10) = $82,192
 Payables level, if the firm takes no discounts
 Payables = $8,219.18 (40) = $328,767
 Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit$246,575

12. Nominal cost of costly trade credit
 The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain $246,575 in
extra trade credit:
kNOM = $30,303 / $246,575
= 0.1229 = 12.29%
 The $30,303 is paid throughout the year, so
the effective cost of costly trade credit is
higher.

13. Nominal trade credit cost formula
Discount % 365 days
k NOM = ×
1 - Discount % Days taken - Disc. period
1 365
= ×
99 40 - 10
= 0.1229
= 12.29%

14. Effective cost of trade credit
 Periodic rate = 0.01 / 0.99 = 1.01%
 Periods/year = 365 / (40-10) = 12.1667
 Effective cost of trade credit
 EAR = (1 + periodic rate)n – 1
= (1.0101)12.1667 – 1 = 13.01%

15. Commercial paper (CP)
 Short-term notes issued by large, strong
companies. B&B couldn’t issue CP--it’s too
small.
 CP trades in the market at rates just above T-
bill rate.
 CP is bought with surplus cash by banks and
other companies, then held as a marketable
security for liquidity purposes.

16. Bank loans
 The firm can borrow $100,000 for 1 year
at an 8% nominal rate.
 Interest may be set under one of the
following scenarios:
 Simple annual interest
 Discount interest
 Discount interest with 10% compensating balance
 Installment loan, add-on, 12 months

17. Must use the appropriate EARs to
evaluate the alternative loan terms
 Nominal (quoted) rate = 8% in all cases.
 We want to compare loan cost rates and
choose lowest cost loan.
 We must make comparison on EAR =
Equivalent (or Effective) Annual Rate basis.

18. Simple annual interest
 “Simple interest” means no discount or add-on.
Interest = 0.08($100,000) = $8,000
kNOM = EAR = $8,000 / $100,000 = 8.0%
For a 1-year simple interest loan, kNOM = EAR

19. Discount interest
 Deductible interest = 0.08 ($100,000)
= $8,000
 Usable funds = $100,000 - $8,000
= $92,000
INPUTS 1 92 0 -100
N I/YR PV PMT FV
OUTPUT 8.6957

20. Raising necessary funds with a
discount interest loan
 Under the current scenario, $100,000 is
borrowed but $8,000 is forfeited because
it is a discount interest loan.
 Only $92,000 is available to the firm.
 If $100,000 of funds are required, then
the amount of the loan should be:
Amt borrowed = Amt needed / (1 – discount)
= $100,000 / 0.92 = $108,696

21. Discount interest loan with a 10%
compensating balance
Amount needed
Amount borrowed =
1 - discount - comp. balance
$100,000
= = $121,951
1 - 0.08 - 0.1
 Interest = 0.08 ($121,951) = $9,756
 Effective cost = $9,756 / $100,000 = 9.756%

22. Add-on interest on a 12-month
installment loan
 Interest = 0.08 ($100,000) = $8,000
 Face amount = $100,000 + $8,000 = $108,000
 Monthly payment = $108,000/12 = $9,000
 Avg loan outstanding = $100,000/2 = $50,000
 Approximate cost = $8,000/$50,000 = 16.0%
 To find the appropriate effective rate, recognize that
the firm receives $100,000 and must make monthly
payments of $9,000. This constitutes an annuity.

23. Installment loan
From the calculator output below, we have:
kNOM = 12 (0.012043)
= 0.1445 = 14.45%
EAR = (1.012043)12 – 1 = 15.45%
INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043

24. What is a secured loan?
 In a secured loan, the borrower pledges assets
as collateral for the loan.
 For short-term loans, the most commonly
pledged assets are receivables and inventories.
 Securities are great collateral, but generally not
available.