Elona Doc

1
Petty, Keown, Scott Jr., Martin, Burrow, Martin & Nguyen: Financial Management 4e 2006 Pearson Education Australia
BUACC6925 Topic 3
Working-capital management and short-term financing

Petty, Keown, Scott Jr., Martin, Burrow, Martin & Nguyen: Financial Management 4e 2006 Pearson Education Australia 2
Objectives
Understand why managing working capital is so important for many businesses Know what comprises the current assets and current liabilities of a firm Understand the factors that determine the appropriate level of working capital for a firm Know the various forms of short-term finance available to firms Be able to estimate the cost of the various sources of short-term finance
Working capital
Working capital = Current assets Net working capital = Current assets Current liabilities Managing net working capital is concerned with managing the firms liquidity
Managing Managing
investment in current assets the use and amount of current liabilities
2
Assets
Current assets
Cash,
marketable securities, inventory, accounts receivable
Long-term assets
Equipment,
buildings, land
Which earn higher rates of return? Which hel Risk-returnp atrvaodide -tohfef risk of illiquidity? Current assets earn low returns, but reduce the risk of illiquidity
Liabilities
Current liabilities
Short-term Bonds,
notes, accrued expenses, accounts payable
Long-term debt and equity

preference shares, ordinary shares
Which are more expensive for the firm? Which help avoid the risk of illiquidity?
Risk-return trade-off
Current liabilities are less expensive, but increase the risk of illiquidity
Current liabilities
Advantages
Flexibility:
Can match the timing of the firms need for short-term financing Lower interest costs
Disadvantage: A greater risk of illiquidity

Short-term
debt must be repaid or rolled over frequently Uncertainty of interest costs from year to year
3
Balance sheet Current assets Current liabilities Finance all current assets with current liabilities, and finance all fixed assets with long-term financing Fixed assets Long-term debt Preference shares Ordinary shares
Finance option 1
Finance option 2
Use long-term financing to finance some of our current assets Balance sheet Current assets Current liabilities Fixed assets Long-term debt Preference shares Ordinary shares
Less risky, more expensive

Finance option 3
Use current liabilities to finance some of our fixed assets Balance sheet Current assets Current liabilities Fixed assets Long-term debt Preference shares Ordinary shares
Less expensive, more risky 4

The cash-flow-generating characteristics of an asset should be matched with the maturity of the source of financing used for its acquisition
The hedging principle

Permanent assets Permanent financing
Balance sheet
Temporary current assets Temporary short-term financing Spontaneous financing
The hedging principle Categories of finance

Permanent finance
Intermediate-term
loans, long-term debt, preference shares,
ordinary shares
Spontaneous finance
Accounts
payable that arise spontaneously in day-to-day operations Trade credit, wages payable, accrued interest & taxes
Short-term finance
Unsecured
bank loans, commercial bills, promissory notes, loans secured by accounts receivable and inventories
5
How much short-term financing should the firm use?

The
hedging principle
What specific sources of short-term financing should the firm select?

Effective cost of credit Credit availability: quantity Influence
and period available on the cost and availability of other sources
of finance
Short-term financing
Interest = Principal x Rate x Time Example What interest do you pay for borrowing $10,000 at 8.5% p.a. for 9 months? Interest = $10,000 x 0.085 x 9/12
= $637.50
Cost of short-term credit Cost-of-credit

Nominal annual rate ( RATE )
Interest = Principal x RATE x Time
RATE = Interest / ( Principal x Time )
6
RATE = Interest / ( Principal x Time ) Example If you pay $637.50 in interest on $10,000 principal for 9 months, what is the nominal annual rate? RATE = $637.50 / ( $10,000 x 9/12 ) = 8.50%
Cost of short-term credit

Effective Annual Percentage Rate ( APR )
APR = ( 1 + r / m )m 1
where r = nominal rate of interest per year m = no of compounding periods per year

This function (Nominal Rate -> Effective is on a financial calculator!
APR = ( 1 + r / m )m 1
Example What is the effective annual percentage rate of a 9% loan with monthly payments? APR = ( 1 + 0.09 / 12 )12 1 = 9.38%

7
Unsecured loans
Only
security is the lenders faith in the ability of the borrower to repay the funds Sources: trade credit, promissory notes, bills of exchange
Secured loans
Involves the pledge of specific assets as collateral Sources: banks, finance companies, factors
Sources of short-term credit

Accrued wages and taxes Trade credit Bank overdrafts Promissory notes Bills of exchange Accounts receivable loans Inventory loans
Sources of short-term credit Trade credit

Spontaneously generated as part of daytoday operations No formal agreements are generally involved in obtaining credit The amount of credit expands and contracts in line with the firms needs Discounts for early repayment are sometimes available
8
Example What is the penalty of delaying repayment of trade credit until 60 days have passed when the credit terms offered are 3/20, net 60? Work on a notional loan of $1 Penalty for missing discount is 3 cents
Were effectively borrowing $0.97 for 40 days and being charged 3 cents interest RATE = Interest / (Principal x Time) = 0.03 / (0.97 x 40 / 365 ) = 28.22%
Trade credit cash discounts

The bank allows a customer to write cheques for more finance than is in the cheque account Overdraft limits Prime / Indicator rate Establishment / service fees Unused limit fee
RATE = u ( L + b ( j / u 1) ) / b
Bank overdrafts
Promissory notes or Commercial bills

A short-term financial instrument whereby the borrower promises to repay the face value, at maturity, to the holder Terms
Borrower = Issuer = Drawer Investor = Lender = Holder V = Face value to be repaid at P = Original sum borrowed
maturity
D = Interest = Discount = V P n = number of days duration for
the loan
9
RATE = ( V P ) / ( P x n / 365 ) = 365 ( V / P 1 ) / n P = 365 x V / ( 365 + RATE x n )
A company draws a promissory note with a face value of $10,000. It is issued on 1 Dec and matures on 31 Dec. 1. What is the interest rate if the company receives $9,850? RATE = 365 ( $10,000 / $9,850 1 ) / 30 = 18.53% 2. How much is obtained by the drawer if the interest rate is 13%? P = 365 x $10,000 / ( 365 + 0.13 x 30 ) = $9,894.28
Cost of promissory note finance

Similar to promissory notes but another party is usually involved Parties

Drawer = Borrower Discounter = Lender Acceptor = Guarantor
Bank accepted bills are called Bank bills Acceptors provide certainty to the lenders Fees: facility, activity, acceptance Negotiable on secondary markets
Bills of exchange
Loans secured with accounts receivable used as collateral Pledging accounts receivable
Loan
a percentage of accounts receivable pledged
General line on all accounts Specific invoices as security
Factoring accounts receivable

Outright sale of accounts receivable to a factor The factor bears the risk of collection of accounts The
factor is often a finance company
Accounts receivable loans

10
Inventory used as collateral for shortterm secured loans Size of loan depends on
Marketability of inventory Size of inventory
How financially secure is the borrowers business? Costs are usually high
Inventory loans

Elona Doc

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Elona Doc

Uploaded by

Copyright:

Available Formats

1

Working-capital management and short-term financing

investment in current assets the use and amount of current liabilities

marketable securities, inventory, accounts receivable

notes, accrued expenses, accounts payable

Long-term debt and equity

Disadvantage: A greater risk of illiquidity

Less risky, more expensive

Less expensive, more risky 4

The hedging principle

Permanent assets Permanent financing

The hedging principle Categories of finance

loans, long-term debt, preference shares,

How much short-term financing should the firm use?

What specific sources of short-term financing should the firm select?

and period available on the cost and availability of other sources

Cost of short-term credit Cost-of-credit

RATE = Interest / ( Principal x Time )

Cost of short-term credit

Effective Annual Percentage Rate ( APR )

Cost of short-term credit

Cost of short-term credit

Sources of short-term credit

Sources of short-term credit Trade credit

Trade credit cash discounts

Promissory notes or Commercial bills

D = Interest = Discount = V P n = number of days duration for

RATE = ( V P ) / ( P x n / 365 ) = 365 ( V / P 1 ) / n P = 365 x V / ( 365 + RATE x n )

Cost of promissory note finance

Similar to promissory notes but another party is usually involved Parties

a percentage of accounts receivable pledged

General line on all accounts Specific invoices as security

Factoring accounts receivable

factor is often a finance company

Accounts receivable loans

You might also like