CHAPTER 17 Financing Current Assets

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CHAPTER 17Financing Current Assets

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

2
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

Temp. C.A.

S-T Loans
L-T Fin Stock, Bonds, Spon. C.L.
Perm C.A.
Fixed Assets
Years
Lower dashed line, more aggressive.
4
Conservative Financing Policy

Marketable Securities
Zero S-T debt
L-T Fin Stock, Bonds, Spon. C.L.
Perm C.A.
Fixed Assets
Years
5
What is short-term credit, and what are the major
sources?

• S-T credit Any debt scheduled for repayment
  within one year.
• Major sources
• Accounts payable (trade credit)
• Bank loans
• Commercial paper
• Accruals

6
Is S-T credit riskier than L-T?

• To company, yes. Required repayment always
  looms. May have trouble rolling over loans.
• Advantages of short-term credit
• Low cost--visualize yield curve. Can get funds
  relatively quickly. Can repay without penalty.

7
Is there a cost to accruals? Do firms have much
control over amount of accruals?

• Accruals are free in that no explicit interest is
  charged.
• Firms have little control over the level of
  accruals. Levels are influenced more by industry
  custom, economic factors, and tax laws.

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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.

9
BB buys 3,030,303 gross, or 3,000,000 net, on
terms of 1/10, net 30, and pays on Day 40. How
much free and costly trade credit, and whats the
cost of costly trade credit?

• Net daily purchases 3,000,000/360
• 8,333.

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Gross/Net Breakdown

• Company 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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Payables level if take discount Payables
8,333(10) 83,333.
Payables level if dont take discount
Payables 8,333(40) 333,333.
Credit Breakdown Total trade credit
333,333 Free trade credit 83,333
Costly trade credit 250,000
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Nominal Cost of Costly Trade Credit
Firm loses 0.01(3,030,303) 30,303 of
discounts to obtain 250,000 in extra trade
credit, so
But the 30,303 is paid all during the year, not
at year-end, so EAR rate is higher.
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Nominal Cost Formula, 1/10, net 40
Pays 1.01 12 times per year.
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Effective Annual Rate, 1/10, net 40
Periodic rate 0.01/0.99 1.01. Periods/year
360/(40 10) 12. EAR (1 Periodic rate)n
1.0 (1.0101)12 1.0 12.82.
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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.

16
A bank is willing to lend BB 100,000 for 1 year
at an 8 percent nominal rate. What is the EAR
under the following five loans?
1. Simple annual interest, 1 year. 2. Simple
interest, paid monthly. 3. Discount
interest. 4. Discount interest with 10 percent
compensating balance. 5. Installment loan,
add-on, 12 months.
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Why must we use EAR to evaluate the alternative
loans?

• 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, 1-Year Loan
Simple interest means not discount or
add-on. Interest 0.08(100,000) 8,000.
On a simple interest loan of one year, kNom EAR.
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Simple Interest, Paid Monthly
Monthly interest (.08/12)(100,000)
666.67.
0
1
12
...
-666.67
100,000
-666.67
-100,000.00
12 100000 -666.67 -100000 N I/YR PV PMT FV
0.6667
INPUTS
OUTPUT
(More)
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kNom (Monthly rate)(12) 0.66667(12) 8.00.
or 8 NOM, 12 P/YR, EFF 8.30.
Note If interest were paid quarterly, then
Daily, EAR 8.33.
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8 Discount Interest, 1 Year
Interest deductible 0.08(100,000)
8,000. Usable funds 100,000 8,000
92,000.
0
1
i ?
92,000
-100,000
1
92
0
-100
INPUTS
N
PV
I/YR
PMT
FV
OUTPUT
8.6957 EAR
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Discount Interest (Continued)
Amount needed 1 - Nominal rate
(decimal)
Amt. borrowed
108,696.
100,000 0.92
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Need 100,000. Offered loan with terms of 8
discount interest, 10 compensating balance.
Amount needed 1 - Nominal rate - CB
Amount borrowed
121,951.
100,000 1 - 0.08 - 0.1
(More...)
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Interest 0.08(121,951) 9,756.
EAR correct only if borrow for 1 year.
(More...)
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8 Discount Interest with 10 Compensating
Balance (Continued)
0
1
i ?
121,951 Loan
-121,951 12,195 -109,756
-9,756 Prepaid interest
-12,195 CB
100,000 Usable funds
INPUTS
1
100000
-109756
0
N
I/YR
PV
PMT
FV
OUTPUT
9.756 EAR
This procedure can handle variations.
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1-Year Installment Loan, 8 Add-On
Interest 0.08(100,000) 8,000. Face amount
100,000 8,000 108,000. Monthly payment
108,000/12 9,000.
100,000/2 50,000. Approximate cost
8,000/50,000 16.0.
Average loan outstanding
(More...)
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Installment Loan
To find the EAR, recognize that the firm has
received 100,000 and must make monthly payments
of 9,000. This constitutes an ordinary annuity
as shown below
Months
0
1
12
2
i ?
...
-9,000
100,000
-9,000
-9,000
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12
100000
-9000
0
INPUTS
N
PV
I/YR
FV
PMT
OUTPUT
1.2043 rate per month
kNom APR (1.2043)(12) 14.45. EAR
(1.012043)12 - 1 15.45.
14.45 NOM enters nom rate 12
P/YR enters 12 pmts/yr EFF
15.4489 15.45.
1 P/YR to reset calculator.
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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.

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What are the differences between pledging and
factoring receivables?

• If receivables are pledged, the lender has
  recourse against both the original buyer of the
  goods and the borrower.
• When receivables are factored, they are generally
  sold, and the buyer (lender) has no recourse to
  the borrower.

31
What are three forms of inventory financing?

• Blanket lien.
• Trust receipt.
• Warehouse receipt.
• The form used depends on the type of inventory
  and situation at hand.

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Legal stuff is vital.

• Security agreement Standard form under Uniform
  Commercial Code. Describes when lender can claim
  collateral.
• UCC Form-1 Filed with Secretary of State to
  establish claim. Future lenders do search, wont
  lend if prior UCC-1 is on file.