Ó 2005, Pearson Prentice Hall

1. Chapter 18 – Working-Capital Management and Short-term Financing Ó 2005, Pearson Prentice Hall

2. Sources of Short-term Credit Unsecured • Accrued wages and taxes. • Trade credit. • Bank credit. • Commercial paper. Secured • Accounts receivable loans. • Inventory loans.

3. Unsecured sources: Trade Credit Cost of trade credit varies directly with the size of the cash discount and inversely with the length of time between the end of the discount period and the final due date. • Stretching of trade credit • Delaying payments beyond the prescribed credit period • Continued violation of trade terms can eventually lead to a loss of credit. • For short periods and at infrequent intervals, it may offer the firm an emergency source of short-term credit

4. Unsecured sources: Bank Credit • Maturity is less than 1 year • Interest rate depends on the creditworthiness of borrower and level of interest rate in the economy as a whole. • Line of credit • Banks usually requires that the line of credit have a zero balance for some specific period of time • No fixed interest rate (usually ½ or other spread over the bank prime rate). • Borrower maintain a minimum balance in the bank throughout the loan period called compensating balance (CB). CB increases the effective cost of the loan to the borrower.

5. Unsecured sources: Bank Credit • Revolving credit • Transaction Loan • Obtain by signing P/N • Similar to line of credit regarding cost, term to maturity, compensating balance requirement. • Banks usually requires that the line of credit have a zero balance for some specific period of time to ensure that borrower is not using S-T bank credit to finance part of permanent needs for funds.

6. Unsecured sources: commercial paper • Only for largest and most creditworthy companies • S-T promise to pay (marketable) • Placed directly or dealer placed. • Interest is slightly lower than prime rate. Usually discounted. • No compensating balance required but desirable to maintain CB. • Effective cost of financing is higher because of 3 & 4. • Amount of credit is large. • Prestige: firm’s credit status • Risk: Commercial paper market is highly impersonal.

7. Cost of Short-Term Credit Interest = principal x rate x time Example: Borrow $10,000 at 8.5% for 9 months. Interest = $10,000 x .085 x 3/4 year = $637.50

8. APR = x Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR) interest 1 principal time

9. APR = x Cost of Short-Term Credit interest 1 principal time Example: If you pay $637.50 in interest on $10,000 principal for 9 months: APR = 637.50/10,000 x 1/.75 = .085 = 8.5% APR

10. APY = ( 1 + ) - 1 Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: i m m i = the nominal rate of interest m = the # of compounding periods per year

11. Cost of Short-Term Credit What is the (APY) of a 9% loan with monthly payments? APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938 = 9.38%

12. Unsecured sources: Trade Credit • Credit terms and cash discount • 2/10 net 30 Cost of not taking the discount (cost of S-T financing) APR = (.02/.98) x 1/(20/360) = 36.73% APY = (1+ .3673/18) 18 –1 = 43.85%

13. Unsecured sources: Bank Credit • MM Co., has a $300,000 line of credit that requires a compensating balance equal to 10% of the loan amount. The rate paid on the loan is 12% p.a. $200,000 loan is borrowed for 6 months. • Compensating balance 10% = $20,000 • Net borrowed amount = $180,000 • Interest = $200,000 x .12/2 = $12,000 (interest is paid at the end) • APR = (12,000/ 180,000) x 1/(180/360) = 13.33%

14. Unsecured sources: Bank Credit • Compensating balance 10% = $20,000 • Interest = 12% x ½ = 12, 000 (interest is paid at the beginning) • Net borrowed amount = $200,000 – 20,000 – 12,000 = 168,000 = principle – CB – interest - fees • APR = (12,000 / 168,000) x1/(180/360) =14.29%

15. Unsecured sources: Bank Credit • B - .1B - .6B = 200,000  B = $238,095 • Compensating balance 10% = $23,810 • Interest = 12% x ½ = 14, 285.7 (interest is paid at the beginning) • Net borrowed amount = $200,000 • APR = (14,285.7/ 200,000) x1/(180/360) =14.29%

16. Working-Capital Management Current Assets • Cash, marketable securities, inventory, accounts receivable. Long-Term Assets • Equipment, buildings, land. • Which earn higher rates of return? • Which help avoid risk of illiquidity?

17. Working-Capital Management CurrentAssets • Cash, marketable securities, inventory, accounts receivable. Long-TermAssets • Equipment, buildings, land. Risk-Return Trade-off: Current assets earn low returns, but help reduce the risk of illiquidity.

18. Working-Capital Management Current Liabilities • Short-term notes, accrued expenses, accounts payable. Long-Term Debt and Equity • Bonds, preferred stock, common stock. • Which are more expensive for the firm? • Which help avoid risk of illiquidity?

19. Working-Capital Management CurrentLiabilities • Short-term notes, accrued expenses, accounts payable. Long-Term Debt and Equity • Bonds, preferred stock, common stock. Risk-Return Trade-off: Current liabilities are less expensive, but increase the risk of illiquidity.

20. Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

21. Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!

22. Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!

23. The Hedging Principle PermanentAssets (those held > 1 year) • Should be financed with permanent and spontaneous sources of financing. TemporaryAssets (those held < 1 year) • Should be financed with temporary sources of financing.

24. Balance Sheet Temporary Temporary Current Assets Short-term financing Permanent Permanent Fixed Assets Financing and Spontaneous Financing

25. The Hedging Principle Permanent Financing • Intermediate-term loans, long-term debt, preferred stock, common stock. Spontaneous Financing • Accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes). Short-term financing • Unsecured bank loans, commercial paper, loans secured by A/R or inventory.

26. Secured sources: A/R loans • Pledging A/R • Pledge A/R for a loan from either commercial bank or a finance company. • All borrower’s A/R are pledged. • Lender has no control over the quality of A/R. • Loan at low % (75%) of the face value of the A/R. • Specific invoices (A/R) are pledged. • Loan at a bit higher % (85-90%) of the face value of the A/R.

27. Secured sources: A/R loans • Interest is 2-5% higher than bank prime rate. Finance companies charge even higher rate. • Lender charge handling fees (1-2%) • Disadvantage: Higher cost of financing. • Advantage: financing available on continuous basis • Lender may provide credit service.

28. Secured sources: A/R loans • Factoring A/R • Outright sales of A/R to FI called factor. • Factor bears the risk of collection and services for fees (1-3% face value of all A/R) • Does not make payment for factored account until the accounts have been collected or credit terms have been met. • For immediate payment  borrow from factor • Net borrowed amount = A/R face value – factor’s fees (1-3%) – reserve (6-10%) –interest on the loan.

29. Secured sources: Inventory loan • The amount of loan obtain depends on the marketability and perishability of the inventory. • Raw material  excellent • WIP inventory  very poor (no marketability) • Floating or blanket lien • Chattel mortgage • Field warehouse receipt • Terminal warehouse receipt