© Prentice Hall, 2004 22 Corporate Financial Management 3e Emery Finnerty Stowe Liquidity...
-
Upload
griffin-cummings -
Category
Documents
-
view
221 -
download
1
Transcript of © Prentice Hall, 2004 22 Corporate Financial Management 3e Emery Finnerty Stowe Liquidity...
© Prentice Hall, 2004
2222
Corporate Financial Management 3e
Emery Finnerty Stowe
Liquidity Management
Working Capital Management
Working capital = current assets – current liabilities
Working capital management refers to choosing the levels and mix of: cash, marketable securities, receivables and
inventories. different types of short-term financing.
Considerations in Working Capital Management
Sales impact
Liquidity
Relations with stakeholders suppliers customers
Short-term financing mix profitability risk considerations
Working Capital Management
Maturity matching approach
Conservative approach
Aggressive approach
Maturity Matching Approach
Hedge risk by matching the maturities of assets and liabilities.
Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing.
There are no excess funds.
Maturity Matching Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed AssetsLong Term
Financing
Short Term Financing
Conservative Approach
Long-term funds are used to finance both permanent as well as some temporary short-term assets.
When there are excess funds, they are invested in marketable securities.
Conservative Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed Assets
Marketable securitiesLong Term
Financing
Short Term Financing
Aggressive Approach
Use less long-term and more short-term financing than the conservative approach.
Aggressive Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed Assets Long Term
Financing
Short Term Financing
Cost and Risk Considerations
Yield curve is usually upward sloping.
Short-term rates are more volatile than long-term rates.
Firm's ability to obtain needed short-term financing.
Cash Conversion Cycle
The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable.
Cash Conversion Cycle
Purchase Inventory
Sale on Credit
Collect Acct. Receivable
Payment of Accts. Payable
Inventory Conversion Period
Cash Conversion Cycle
Time
Payables Deferral Period
Receivables Collection Period
Cash Conversion Cycle
period
deferral
Payables
period
collection
sReceivable
period
conversion
Inventory
cycle
conversion
Cash
Inventory Conversion Period
The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.
turnoverInventory
365
Sales/365 ofCost
Inventory
period
conversion
Inventory
Receivables Collection Period
The receivables collection period is the average number of days it takes to collect on accounts receivable. Equal to days sales outstanding (DSO)
turnoversReceivable
365
Sales/365
sReceivable
period
collection
sReceivable
Payables Deferral Period
The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same.
365expenses)/ tiveadministra and general Selling,sales of(Cost
payable taxespayroll benefits,Wages,payable Accounts
period
deferral
Payables
Cash Conversion Cycle
Given the following information about Vision Opticals, compute the firm’s cash conversion cycle.
InventoryAccounts ReceivableAccounts PayableWages, Benefits, Payroll Taxes
SalesCost of SalesSelling & Other Expenses
$19,000$21,000
$5,600$9,000
$227,000$93,000$22,000
Inventory Conversion Period
turnoverInventory
365
Sales/365 ofCost
Inventory
period
conversion
Inventory
days 74.575$93,000/36
$19,000
period
conversion
Inventory
Receivables Collection Period
turnoversReceivable
365
Sales/365
sReceivable
period
collection
sReceivable
days 77.3365$227,000/3
$21,000
period
collection
sReceivable
Payables Deferral Period
days 34.46365/)000,22$000,93($
000,9$600,5$
365expenses)/ tiveadministra and general Selling,sales of(Cost
payable taxespayroll benefits,Wages,payable Accounts
period
deferral
Payables
Cash Conversion Cycle
period
deferral
Payables
period
collection
sReceivable
period
conversion
Inventory
cycle
conversion
Cash
days 34.46days 77.33days 57.74
cycle
conversion
Cash
days 62
Cash Management
How much liquidity (cash plus marketable securities) should the firm have?
What should be the relative proportions of cash and marketable securities?
Demands for Cash
Transactions demand
Precautionary demand
Speculative demand
Compensating balances
Short-Term Investment Alternatives
U.S. Treasury securities T-bills, T-notes, and T-bonds
U.S. federal agency securities
Negotiable certificates of deposit
Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock
Other Factors in Cash Management
Compensating balance requirements
Optimal amount of marketable securities transaction costs maturity risk yield
Special tax situations
Float
Float is the difference between the available (or collected) balance at the bank and the firm’s book or ledger balance.
Disbursement float occurs when the firm writes a check but the check has not yet cleared the banking system.
Collection float occurs when a check has been deposited but the funds are not yet credited to the firm’s bank account.
Float Management Techniques
Wire transfers
Zero balance accounts (ZBAs)
Controlled disbursing
Centralized processing of payables
Lockboxes
Lockbox Systems
Discount Music Stores is evaluating a lockbox system which will reduce float by 3 days. The lockbox system costs $15,000 per year. The firm’s daily collections average $150,000, and its opportunity cost of funds is 6% per year.
Should the firm utilize this lockbox system?
Lockbox Systems
Funds freed up due to a reduction in float = (3 days)($150,000 per day) or $450,000.
Annual value of float reduction = $450,000(6%) = $27,000.
After deducting the $15,000 cost of the lockbox system, the firm nets $12,000 before taxes.
Short-Term Financing
Trade Credit
Secured and Unsecured Bank Loans
Commercial Paper
Cost of Trade Credit
Discount Music Stores buys its inventory on “3/10, net 30” terms. What is the cost of not taking the discount?
0 10 30
+$970,000 –$1,000,000
Suppose DMS buys $1,000,000 worth of inventory; if they forgo the 3% discount to pay on day 30 they are borrowing $970,000 for 20 days and paying $30,000 interest:
Cost of Trade Credit: APY vs. APR
1%Discount %100
%Discount 1
PeriodDiscount Period Total
365
APY
PeriodDiscount -Period Total
365
%Discount %100
%Discount APR
Cost of Trade Credit: APR
0 10 30
+$970,000 –$1,000,000
days 20
365
000,970$
$30,000APR
%44.56APR
Cost of Trade Credit: APY
36520)1(
000,000,1$000,970$
r
970$
000,1$)1( 36520 r
%35.747435.01970$
000,1$ 20
365
r
0 10 30
+$970,000 –$1,000,000
Effective Use of Trade Credit
Advantages: Readily available Informal Flexible Stretching payments
Disadvantages High cost of discounts foregone Stretching of payments can hurt reputation
Bank Loans
Short-term unsecured loans Transaction loan Line of credit Revolving credit agreement
Term loans Bullet maturity Balloon payment
Cost of Bank Loans
Prime rate + “spread”
LIBOR + “spread”
Compensating balances
Compensating Balance Requirements
Let P = amount of loan f = loan term r = interest rate on loan B = incremental cash balance as a result of
compensating balance requirements y = interest earned (if any) on compensating balances
Interest charges = rPf
Interest received = yBf
Compensating Balance Requirements
f-
-APR
1
balance ngcompensati amount Loan
receivedInterest chargesInterest
fBP
yBfrPf 1
Compensating Balance Requirements
Custom Controls is considering a 1-year loan of $150,000 at an interest rate of 14%. Due to compensating balance requirements, Custom Controls will have to maintain a deposit balance of $20,000 which it would not have otherwise maintained at the lending bank. The deposit will earn 6% per year.
What is the APR of this loan?
Compensating Balance Requirements
Without the 6% yield on the compensating balance, the APR = 16.15%
fBP
yBfrPfAPR
1
1
1
000,20$000,150$
000,20$06.0000,150$14.0APR
= 15.23%
Discount Loans
The interest charge is deducted in advance for discount loans.
Let r = interest rate on the loan
f = the term of the loan
P = the principal amount
The APR of a discount loan is given by:
fr
r
frPfP
rPfAPR
1
1
A Comparison of Single Payment Loans
Ole Tools Inc. needs to borrow $5,000 for 6 months. Four single payment loan alternatives are available as shown below. In each case, the interest rate is 15% per year. Compute the APR and APY of each alternative.
Loan Interest Payment CompensatingBalance
ABCD
in arrearsin arrears
in advancein advance
NoYes (10%)
NoYes (10%)
A Comparison of Single Payment Loans
Interest charge on the loan is $5,000× (.15) ×(0.5 years) or $375.
For loans A & B, this amount is added to the repayment at loan maturity.
For discount loans (loans C & D), this amount is deducted from the loan amount at loan initiation.
Compensating balances (for loans B & D), is $5,000×0.10 = $500.
A Comparison of Single Payment Loans
A
B
C
D
$5,000
$4,500
$4,625
$4,125
($5,375)
($4,875)
($5,000)
($4,500)
%22.165.
1
625,4$
375$
APR
Loan CF0 CF1 APR
%155.
1
000,5$
375
APR
%67.165.
1
500,4$
375
APR
%18.185.
1
125,4$
375$
APR
A Comparison of Single Payment Loans
A
B
C
D
$5,000
$4,500
$4,625
$4,125
($5,375)
($4,875)
($5,000)
($4,500)
Loan CF0 CF1 APR
15.00%
16.67%
16.22%
18.18%
APY
15.56%
17.36%
16.87%
19.01%
1000,5$
375,5$2
1500,4$
875,4$2
1625,4$
000,5$2
1125,4$
500,4$2
Discounted Installment Loans
Sheridan Systems borrows $12,000 for 3 months at 15%. The interest is paid in advance, and Sheridan will pay the loan in 3 monthly installments of $3,000 at the end of the first two months and $6,000 at the end of the third month.
Compute the APY and APR of this loan.
Discounted Installment Loans
The interest cost of this loan is ($12,000)(15%)(3/12 years) or $450.
Since the interest is deducted in advance, Sheridan will get $12,000 - $450 or $11,550 at loan initiation.
Discounted Installment Loans
0 1 3
–$6,000
32 )1(
000,6$
)1(
000,3$
1
000,3$550,11$
rrr
monthper %72.1r
2
–$3,000+$11,550 –$3,000
%6.200172.012 APR
%68.221)0172.1( 12 APY
Commercial Paper
Commercial paper is a negotiable business IOU note.
It is sold by the largest, most creditworthy firms on a discount basis.
Maturity is set to less than 270 days. Registration with the SEC is not required.
40% of commercial paper is sold through dealers. Commission of about 0.125% on an annualized basis.
Factors Affecting the Short-Term Financing Mix
Cost of each source of funds / incl’g options
Desired level of current assets
Seasonal component of current assets
Extent of maturity-matching
Flotation costs
Restricted access to long-term capital
Bankruptcy costs
Firm's choice of risk level