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Chapter 20

Chapter 20. Short-Term Financial Planning. Chapter 20. Short-Term Financial Planning. Chapter Outline. 20.1 Forecasting Short-Term Financing Needs 20.2 The Matching Principle 20.3 Short-Term Financing with Bank Loans 20.4 Short-Term Financing with Commercial Paper

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Chapter 20

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  1. Chapter 20 Short-Term Financial Planning

  2. Chapter 20 Short-Term Financial Planning

  3. Chapter Outline 20.1 Forecasting Short-Term Financing Needs 20.2 The Matching Principle 20.3 Short-Term Financing with Bank Loans 20.4 Short-Term Financing with Commercial Paper 20.5 Short-Term Financing with Secured Financing 20.6 Putting it All Together: Creating a Short-Term Financial Plan

  4. Learning Objectives Forecast cash flows and short-term financing needs Understand the principle of matching short-term needs to short-term funding sources Know the types of different bank loans and their tradeoffs

  5. Learning Objectives Understand the use of commercial paper as an alternative to bank financing Use financing secured by accounts receivable or inventory Know how to create a short-term financial plan

  6. 20.1 Forecasting Short-Term Financing Needs The first step in short-term financing is to forecast the company’s future cash flows to discover: Cash surplus or deficit? Temporary or permanent?

  7. 20.1 Forecasting Short-Term Financing Needs For example, look at the quarterly cash flows for Springfield Snowboards on the following slide. Is this company considered profitable?

  8. Table 20.1 Projected Financial Statements for Springfield Snowboards, 2010, Assuming Level Sales

  9. 20.1 Forecasting Short-Term Financing Needs Springfield is considered a profitable company. Quarterly net income is almost $500,000. Based on these current projections, Springfield will be able to fund projected sales growth from operating profit and will accumulate excess cash on an on-going basis.

  10. 20.1 Forecasting Short-Term Financing Needs Three reasons for short-term financing Negative cash flow shocks Positive cash flow shocks Seasonalities

  11. 20.1 Forecasting Short-Term Financing Needs Negative Cash Flow Shocks A circumstance in which cash flows are temporarily negative for an unexpected reason. Firm will have to arrange for other financing to cover the shortfall.

  12. 20.1 Forecasting Short-Term Financing Needs Positive Cash Flow Shocks Increased expected sales often require increased short-term financing for items like marketing and production. Negative cash flow is created before the positive cash flow arrives.

  13. 20.1 Forecasting Short-Term Financing Needs Seasonalities When sales are concentrated during a few months, sources and uses of cash are also likely to be seasonal.   In Table 20.1 we assumed sales occur uniformly throughout the year. In reality, for a snowboard manufacturer, sales are likely to be seasonal.

  14. Table 20.2 Projected Financial Statements for Springfield Snowboards, 2013, Assuming Seasonal Sales

  15. 20.1 Forecasting Short-Term Financing Needs The Cash Budget A forecast of cash inflows and outflows on a quarterly or monthly basis. Forecasting cash inflows Assume that Springfield receives payment for 70% of sales in the quarter they are made, with the remaining 30% coming in the following quarter.

  16. Table 20.3 Projected Cash Receipts for Springfield Snowboards, Assuming Seasonal Sales

  17. 20.1 Forecasting Short-Term Financing Needs The Cash Budget Forecasting Cash Outflows Since Springfield produces a constant amount each quarter and sells seasonally, they pay a constant amount to suppliers each quarter. Other cash disbursements: Selling, general and administrative expenses Taxes Interest Capital expenditures

  18. Table 20.4 Projected Cash Disbursements for Springfield Snowboards, Assuming Seasonal Sales

  19. 20.1 Forecasting Short-Term Financing Needs The Cash Budget

  20. 20.2 The Matching Principle The matching principle Short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds.

  21. 20.2 The Matching Principle Permanent working capital The amount that a firm must keep invested in short-term assets to support continuing operations. Temporary working capital The difference between the actual level of investment in short-term assets and the permanent working capital investment.

  22. Table 20.6 Projected Levels of Working Capital for Springfield Snowboards, 2013, Assuming Seasonal Sales

  23. 20.2 The Matching Principle Aggressive Financing Policy Financing part or all of the permanent working capital with short-term debt Funding risk Conservative Financing Policy Financing short-term needs with long-term debt Nonproductive use of cash

  24. Figure 20.1 Financing Policy Choices for Springfield Snowboards

  25. Figure 20.1 Financing Policy Choices for Springfield Snowboards (cont.)

  26. 20.3 Short-Term Financing with Bank Loans Promissory note Single, End of Period Payment Loan Benchmark rate, such as prime rate or LIBOR Line of Credit Uncommitted Committed Revolving Evergreen

  27. 20.3 Short-Term Financing with Bank Loans Promissory note Bridge Loan Often discount loan with fixed interest rate With a discount loan, borrower pays interest at the beginning of the loan period.

  28. 20.3 Short-Term Financing with Bank Loans Common Loan Stipulations Commitment Fees Loan Origination Fee Compensating Balance Requirements

  29. 20.3 Short-Term Financing with Bank Loans Commitment Fees Example: $1 million committed line of credit with 10% EAR and 0.5% EAR commitment fee. Firm borrows $800,000 and repays at year-end.

  30. 20.3 Short-Term Financing with Bank Loans Loan Origination Fee: Timmons Towel and Diaper Service is offered a $500,000 loan for three months at an APR of 12% with a loan origination fee of 1%. The origination fee is charged on the principal, so the fee is 0.01  $500,000 = $5000, so the actual amount borrowed is $495,000. The interest payment for three months is $500,000 (0.12/4) = $15,000.

  31. 20.3 Short-Term Financing with Bank Loans Loan Origination Fee: Putting these cash flows on a timeline: Thus the actual three-month interest rate paid is

  32. 20.3 Short-Term Financing with Compensating Balances Compensating Balance Requirement Timmons Towel and Diaper Service’s keeps 10% of the loan principal in a non-interest-bearing account with the bank. The loan was for $500,000, so this means that Timmons must hold 0.10  500,000 = $50,000 in an account at the bank. Thus the firm has only $450,000 of the loan proceeds actually available for use, although it must pay interest on the full loan amount.

  33. 20.3 Short-Term Financing with Compensating Balances Compensating Balance Requirement At the end of the loan period, the firm owes $500,000  (1 + 0.12/4) = $515,000, and so must pay $515,000 – 50,000 = $465,000 after using its compensating balance. Putting these cash flows on a timeline:

  34. 20.3 Short-Term Financing with Compensating Balances Compensating Balance Requirement Thus the actual three-month interest rate paid is

  35. Example 20.1 Compensating Balance Requirements and the Effective Annual Rate Problem: Assume that Timmons Towel and Diaper Service’s bank pays 1% (APR with quarterly compounding) on its compensating balance accounts. What is the EAR of Timmons’ three-month loan?

  36. Example 20.1 Compensating Balance Requirements and the Effective Annual Rate Solution: Plan: The interest earned on the $50,000 will reduce the net payment Timmons must make to pay off the loan. Once we compute the final payment, we can determine the implied three-month interest rate and then convert into an EAR.

  37. Example 20.1 Compensating Balance Requirements and the Effective Annual Rate Execute: The balance held in the compensating balance account will grow to 50,000(1 + 0.01/4) = $50,125. Thus the final loan payment will be 500,000 + 15,000 – 50,125 = $464,875. Notice that the interest on the compensating balance accounts offsets some of the interest that Timmons pays on the loan. Putting the new cash flows on a timeline:

  38. Example 20.1 Compensating Balance Requirements and the Effective Annual Rate Execute (cont’d): The actual three-month interest rate paid is: Expressing this as an EAR gives 1.03314 – 1 = 13.89%.

  39. Example 20.1 Compensating Balance Requirements and the Effective Annual Rate Evaluate: As expected, because the bank allowed Timmons to deposit the compensating balance in an interest-bearing account, the interest earned on the compensating balance reduced the overall interest cost of Timmons for the loan.

  40. Example 20.1a Compensating Balance Requirements and the Effective Annual Rate Problem: Assume that Timmons Towel and Diaper Service’s bank pays 1.5% (APR with monthly compounding) on its compensating balance accounts. What is the EAR of Timmons’ three-month loan?

  41. Example 20.1a Compensating Balance Requirements and the Effective Annual Rate Solution: Plan: The interest earned on the $50,000 will reduce the net payment Timmons must make to pay off the loan. Once we compute the final payment, we can determine the implied three-month interest rate and then convert into an EAR.

  42. Example 20.1a Compensating Balance Requirements and the Effective Annual Rate Execute: The balance held in the compensating balance account will grow to $50,000(1 + 0.015/12)3 = $50,188. Thus the final loan payment will be $500,000 + $15,000 – $50,188 = $464,812. Notice that the interest on the compensating balance accounts offsets some of the interest that Timmons pays on the loan. Putting the new cash flows on a timeline:

  43. Example 20.1a Compensating Balance Requirements and the Effective Annual Rate Execute (cont’d): The actual three-month interest rate paid is: Expressing this as an EAR gives 1.03294 – 1 = 13.82%.

  44. Example 20.1a Compensating Balance Requirements and the Effective Annual Rate Evaluate: As expected, because the bank allowed Timmons to deposit the compensating balance in an interest-bearing account, the interest earned on the compensating balance reduced the overall interest cost of Timmons for the loan.

  45. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Problem: Bills, Inc. has a 3-month $750,000 loan from its bank. The interest payable on the loan is 8% (APR with quarterly compounding) and the bank requires a 10% compensating balance. Assume Bills, Inc.’s bank pays 1% (APR with quarterly compounding) on its compensating balance accounts. What is the EAR of Bills’ $750,000 3-month loan?

  46. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Solution: Plan: The interest earned on the $75,000, will reduce the net payment Bills must make to pay off the loan. Once the final payment is computed, you can determine the implied three-month interest rate and convert to EAR. Bills, Inc. must maintain a $75,000 compensating balance ($750,000 x 10%)

  47. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Execute: The balance held in the compensating balance account will grow to (75,000)(1 + 0.01/4) = $75,187.50. The interest Bills owes on the loan at the end of the 3-month period is $15,000 ($750,000 x (0.08/4)). The final loan payment will be 750,000 + 15,000 – 75,187.50 = $689,812.50.

  48. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Execute (cont’d): Since Bills only has the use of $675,000 ($750,000 - $75,000), the actual 3 month rate paid is (689,812.50 / 675,000) – 1 = 2.19%. EAR is 1.02194 – 1 = 9.05%

  49. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Execute (cont’d): If Bills’ bank had not paid interest on the compensating balance, Bills would have paid back $765,000 - $75,000 = $690,000 on the $675,000 loan. So the 3 month rate would have been $690,000/$675,000-1=2.22% EAR is 1.02224-1=9.19%

  50. Example 20.1b Compensating Balance Requirements and the Effective Annual Rate Evaluate: The interest earned on the compensating balance reduced the overall interest cost for the loan.

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