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CHAPTER 17 Financing Current Assets

CHAPTER 17 Financing Current Assets. Working capital financing policies A/P (trade credit) Commercial paper S-T bank loans. Working Capital Financing Policies. Moderate : Match the maturity of the assets with the maturity of the financing.

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CHAPTER 17 Financing Current Assets

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  1. CHAPTER 17Financing Current Assets • Working capital financing policies • A/P (trade credit) • Commercial paper • S-T bank loans

  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 L-T Fin: Stock, Bonds, Spon. C.L. Perm C.A. Fixed Assets Years Lower dashed line, more aggressive.

  4. Conservative Financing Policy $ Marketable Securities Zero S-T debt L-T Fin: Stock, Bonds, Spon. C.L. Perm C.A. Fixed Assets Years

  5. What is short-term credit, and what are the major sources? • S-T credit: Any debt scheduled for repayment within one year. • Major sources: • Accounts payable (trade credit) • Bank loans • Commercial paper • Accruals

  6. Is S-T credit riskier than L-T? To company, yes. Required repayment always looms. May have trouble rolling over loans. • Advantages of short-term credit: Low cost--visualize yield curve. Can get funds relatively quickly. Can repay without penalty.

  7. Is there a cost to accruals? Do firms have much control over amount of accruals? • Accruals are free in that no explicit interest is charged. • Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

  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. B&B buys $3,030,303 gross, or $3,000,000 net, on terms of 1/10, net 30, and pays on Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit? Net daily purchases = $3,000,000/360 = $8,333.

  10. Gross/Net Breakdown • Company 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. Payables level if take discount: Payables = $8,333(10) = $83,333. Payables level if don’t take discount: Payables = $8,333(40) = $333,333. Credit Breakdown: Total trade credit = $333,333 Free trade credit = 83,333 Costly trade credit = $250,000

  12. $30,303 $250,000 kNom = = 0.1212 = 12.12%. Nominal Cost of Costly Trade Credit Firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $250,000 in extra trade credit, so But the $30,303 is paid all during the year, not at year-end, so EAR rate is higher.

  13. Nominal Cost Formula, 1/10, net 40 Pays 1.01% 12 times per year.

  14. Effective Annual Rate, 1/10, net 40 Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 360/(40 – 10) = 12. EAR = (1 + Periodic rate)n – 1.0 = (1.0101)12 – 1.0 = 12.82%.

  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. A bank is willing to lend B&B $100,000 for 1 year at an 8 percent nominal rate. What is the EAR under the following five loans? 1. Simple annual interest, 1 year. 2. Simple interest, paid monthly. 3. Discount interest. 4. Discount interest with 10 percent compensating balance. 5. Installment loan, add-on, 12 months.

  17. Why must we use EAR to evaluate the alternative loans? • 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, 1-Year Loan “Simple interest” means not discount or add-on. Interest = 0.08($100,000) = $8,000. On a simple interest loan of one year, kNom = EAR.

  19. Simple Interest, Paid Monthly Monthly interest = (.08/12)(100,000) = $666.67. 0 1 12 ... 100,000 -666.67 -666.67 -100,000.00 12 100000 -666.67 -100000 N I/YR PV PMT FV 0.6667 INPUTS OUTPUT (More…)

  20. kNom = (Monthly rate)(12) = 0.66667(12) = 8.00%. or: 8 NOM%, 12 P/YR, EFF% = 8.30%. Note: If interest were paid quarterly, then: Daily, EAR = 8.33%.

  21. 8% Discount Interest, 1 Year Interest deductible = 0.08($100,000) = $8,000. Usable funds = $100,000 – $8,000 = $92,000. 0 1 i = ? 92,000 -100,000 1 92 0 -100 INPUTS N I/YR PV PMT FV OUTPUT 8.6957% = EAR

  22. Discount Interest (Continued) Amount needed 1 - Nominal rate (decimal) Amt. borrowed = = = $108,696. $100,000 0.92

  23. Need $100,000. Offered loan with terms of 8% discount interest, 10% compensating balance. Amount needed 1 - Nominal rate - CB Amount borrowed = = = $121,951. $100,000 1 - 0.08 - 0.1 (More...)

  24. Interest = 0.08($121,951) = $9,756. EAR correct only if borrow for 1 year. (More...)

  25. 8% Discount Interest with 10% Compensating Balance (Continued) 0 1 i = ? 121,951 Loan -121,951 + 12,195 -109,756 -9,756 Prepaid interest -12,195 CB 100,000 Usable funds INPUTS 1 100000 0 -109756 N I/YR PV PMT FV OUTPUT 9.756% = EAR This procedure can handle variations.

  26. 1-Year Installment Loan, 8% “Add-On” Interest = 0.08($100,000) = $8,000. Face amount = $100,000 + $8,000 = $108,000. Monthly payment = $108,000/12 = $9,000. = $100,000/2 = $50,000. Approximate cost = $8,000/$50,000 = 16.0%. Average loan outstanding (More...)

  27. Installment Loan To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below: Months 0 1 2 12 i = ? ... 100,000 -9,000 -9,000 -9,000

  28. 12 100000 -9000 0 INPUTS N I/YR PV PMT FV OUTPUT 1.2043% = rate per month kNom = APR = (1.2043)(12) = 14.45%. EAR = (1.012043)12 - 1 = 15.45%. 14.45 NOM enters nom rate 12 P/YR enters 12 pmts/yr EFF% = 15.4489 = 15.45%. 1 P/YR to reset calculator.

  29. 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.

  30. What are the differences betweenpledgingandfactoringreceivables? • If receivables are pledged, the lender has recourse against both the original buyer of the goods and the borrower. • When receivables are factored, they are generally sold, and the buyer (lender) has no recourse to the borrower.

  31. What are three forms of inventory financing? • Blanket lien. • Trust receipt. • Warehouse receipt. • The form used depends on the type of inventory and situation at hand.

  32. Legal stuff is vital. • Security agreement: Standard form under Uniform Commercial Code. Describes when lender can claim collateral. • UCC Form-1: Filed with Secretary of State to establish claim. Future lenders do search, won’t lend if prior UCC-1 is on file.

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