, Prentice Hall, Inc.

Ch. 18:

Management

and Short-Term Financing

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?

Working-Capital Management

• Current Assets– cash, marketable securities, inventory,

accounts receivable

• Long-Term Assets– equipment, buildings, land

• Risk-Return Trade-off: Current assets earn low returns, but

help reduce the risk of illiquidity.

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?

Working-Capital Management

• Current Liabilities– 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.

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,

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,

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.

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.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

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.

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.

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!

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

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.

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.

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!

The Hedging Principle

• Permanent Assets (those held > 1 year)– should be financed with permanent and

spontaneous sources of financing.

• Temporary Assets (those held < 1 year)– should be financed with temporary

sources of financing.

Balance Sheet

Temporary

Current Assets

Balance Sheet

Temporary Temporary

Current Assets Short-term financing

Balance Sheet

Temporary Temporary

Current Assets Short-term financing

Permanent

Fixed Assets

Balance Sheet

Temporary Temporary

Current Assets Short-term financing

Permanent Permanent

Fixed Assets Financing

and

Spontaneous

Financing

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

Cost of Short-Term Credit

Interest = principal x rate x time

ex: borrow $10,000 at 8.5% for 9 months

Interest = $10,000 x .085 x 3/4 year

= $637.50

We can use this simple relationship:

Interest = principal x rate x timeto solve for rate, and get the

Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x timeto solve for rate, and get the

Annual Percentage Rate (APR)

Cost of Short-Term Credit

APR = x

We can use this simple relationship:

Interest = principal x rate x timeto solve for rate, and get the

Annual Percentage Rate (APR)

interest 1

principal time

Cost of Short-Term Credit

Cost of Short-Term Credit

APR = x interest 1

principal time

Cost of Short-Term Credit

APR = x interest 1

principal time

example: If you pay $637.50 in interest on $10,000 principal for 9 months:

Cost of Short-Term Credit

APR = x 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

Cost of Short-Term Credit

Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

Cost of Short-Term Credit

APY = ( 1 + ) - 1

Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

i m

m

Cost of Short-Term Credit

APY = ( 1 + ) - 1

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

Cost of Short-Term Credit

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%

Sources of Short-term Credit

• Unsecured

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

– bank credit

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

– bank credit

– commercial paper

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

– bank credit

– commercial paper

• Secured

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

– bank credit

– commercial paper

• Secured– accounts receivable loans

Sources of Short-term Credit

• Unsecured– accrued wages and taxes

– trade credit

– bank credit

– commercial paper

• Secured– accounts receivable loans

– inventory loans