CHAPTER 16 Financing Current Assets

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CHAPTER 16Financing Current Assets

• Working capital financing policies
• A/P (trade credit)
• Commercial paper
• S-T bank loans

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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.

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Moderate financing policy
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Conservative financing policy
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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.

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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

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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.

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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.

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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

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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.

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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

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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.

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Nominal trade credit cost formula
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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

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Commercial paper (CP)

• Short-term notes issued by large, strong
  companies. BB 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.

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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

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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.

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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

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Discount interest

• Deductible interest 0.08 (100,000)
• 8,000
• Usable funds 100,000 - 8,000
• 92,000

1
0
-100
92
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
8.6957
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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

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Discount interest loan with a 10 compensating
balance

• Interest 0.08 (121,951) 9,756
• Effective cost 9,756 / 100,000 9.756

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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.

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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
-9
0
100
INPUTS
N
I/YR
PMT
PV
FV
OUTPUT
1.2043
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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.