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Financing Current Assets

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.

Moderate financing policy


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

Fixed Assets

Conservative financing policy


$
Marketable securities

Zero S-T Debt

Perm C.A.

L-T Fin: Stock, Bonds, Spon. C.L.

Fixed Assets Years

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 firms perspective, S-T credit is more risky than L-T debt.
Always a required payment around the corner. May have trouble rolling over loans.

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

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.

What is trade credit?


Trade credit is credit furnished by a firms 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.

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

Breaking down net and gross expenditures


Firm buys goods worth $3,000,000. Thats the cash price. They must pay $30,303 more if they dont 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.

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 Free trade credit Costly trade credit $328,767 - 82,192 $246,575

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.

Nominal trade credit cost formula


Discount % 365 days kNOM 1- Discount Days % taken - Disc. period 1 365 99 40 10 0.1229 12.29%

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%

Commercial paper (CP)


Short-term notes issued by large, strong companies. B&B couldnt issue CP--its 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.

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

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.

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

Discount interest
Deductible interest = 0.08 ($100,000) = $8,000 Usable funds = $100,000 - $8,000 = $92,000

INPUTS OUTPUT

1 N I/YR
8.6957

92 PV

0 PMT

-100 FV

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

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%

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.

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 OUTPUT

12 N I/YR
1.2043

100 PV

-9 PMT

0 FV

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.

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