CHAPTER 16 Financing Current Assets

1. CHAPTER 16Financing 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. $ Temp. C.A. S-T Loans Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L. Fixed Assets Years Lower dashed line would be more aggressive. Moderate financing policy

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

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

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 1 92 0 -100 INPUTS 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 • 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% 12 100 -9 0 INPUTS 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.