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Working-Capital
Management
Chapter 15
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Keown Martin Petty - Chapter 15 2
Learning Objectives1. Describe the risk-return tradeoff involved in
managing a firms working capital.
2. Explain the determinants of net working capital.3. Calculate the firms cash conversion cycle and
interpret its determinants.
4. Calculate the effective cost of short-term credit.
5. List and describe the basic sources of short-termcredit.
6. Describe the special problems encountered bymultinational firms in managing working capital.
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Keown Martin Petty - Chapter 15 3
Slide Contents1. Principles Used in this Chapter
2. Working Capital
3. The Appropriate Level of Working Capital
4. Cash Conversion Cycle
5. Cost of Short-term Credit6. Multinational Working Capital Management
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1. Principles Used in this Chapter
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Keown Martin Petty - Chapter 15 5
Principles Used in this Chapter
Principle 1: The Risk-Return Trade-Off We Wont
Take On Additional Risk Unless We Expectto Be Compensated with Additional Return.
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2. Working Capital
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Keown Martin Petty - Chapter 15 7
Working Capital
Working capital The firms total investmentin current assets.
Net working capital The difference betweenthe firms current assets and its currentliabilities.
This chapter focuses on net working capital.
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Keown Martin Petty - Chapter 15 8
Managing Net Working Capital Managing net working capital is
concerned with managing the firms
liquidity. This entails managing tworelated aspects of the firmsoperations:
1. Investment in current assets
2. Use of short-term or current liabilities
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Keown Martin Petty - Chapter 15 9
Short-Term Sources of Financing
Includes current liabilities i.e. all forms offinancing that have maturities of 1 year orless.
Two issues to consider:
How much short-term financing should the firmuse?
What specific sources of short-term financingshould the firm select?
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Keown Martin Petty - Chapter 15 10
How Much Short-Term Financing
Should a Firm Use?
This question is addressed by hedging
the principle of working-capitalmanagement.
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Keown Martin Petty - Chapter 15 11
What Specific Sources of Short-Term
Financing Should the Firm Select? Three basic factors influence the decision:
The effective cost of credit
The availability of credit in the amount neededand for the period that financing is required
The influence of a particular credit source on
the cost and availability of other sources offinancing
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Keown Martin Petty - Chapter 15 12
Current Assets A firms current assets are assets that are
expected to be converted to cash within a
period of a year or less, such as cash andmarketable securities, accounts receivable,inventories.
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Keown Martin Petty - Chapter 15 13
Risk-Return Trade-off Holding more current assets will reduce the risk of
illiquidity.
However, liquid assets like cash and marketablesecurities earn relatively less compared to otherassets. Thus larger amount liquid investments willreduce overall rate of return
The Trade-off: Increased liquidity must be traded-offagainst the firms reduction in return on investment.
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Keown Martin Petty - Chapter 15 14
Use of Current versus
Long-term Debt Other things remaining the same, the greater the
firms reliance on short-term debt or current liabilities
in financing its assets, the greater the risk ofilliquidity.
Trade-off: A firm can reduce its risk of illiquiditythrough the use of long-term debt at the expense of
a reduction in its return on invested funds. Trade-offinvolves an increased risk of illiquidity versusincreased profitability.
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Keown Martin Petty - Chapter 15 15
Advantages of Current Liabilities:
Return
Flexibility
Current liabilities can be used to match the timingof a firms needs for short-term financing.Example: Obtaining seasonal financing versuslong-term financing for short-term needs.
Interest Cost
Interest rates on short-term debt are lower thanon long-term debt.
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Keown Martin Petty - Chapter 15 16
Disadvantages of Current
Liabilities: Risk
Risk of illiquidity increases due to:
Short-term debt must be repaid or rolled overmore often
Uncertainty of interest costs from year to year
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3. The Appropriate Level ofWorking Capital
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Keown Martin Petty - Chapter 15 18
Appropriate Level of
Working Capital
Managing working capital involvesinterrelated decisions regardinginvestments in current assets and use ofcurrent liabilities.
Hedging Principle or Principle of Self-
Liquidating Debt provides a guide to themaintenance of appropriate level ofliquidity.
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Keown Martin Petty - Chapter 15 19
Hedging Principle Involves matching the cash flow generating
characteristics of an asset with the maturity of the
source of financing used to finance its acquisition.
Thus a seasonal need for inventories should befinanced with a short-term loan or current liability.
On the other hand, investment in equipment expectedto last for a long time should be financed with long-term debt.
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Keown Martin Petty - Chapter 15 20
Permanent and Temporary
Assets
Permanent investments
Investments that the firm expects to holdfor a period longer than one year
Temporary Investments
Current assets that will be liquidated andnot replaced within the current year
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Keown Martin Petty - Chapter 15 21
Sources of Financing Total assets will equal the sum of
temporary, permanent and spontaneoussources of financing.
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Keown Martin Petty - Chapter 15 22
Temporary & Permanent Source Temporary sources of financing consist of
current liabilities such as short-term secured
and unsecured notes payable.
Permanent sources of financing include:intermediate-term loans, long-term debt,
preferred stock common equity
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Keown Martin Petty - Chapter 15 23
Spontaneous Sources of
Financing Spontaneous sources of financing arise
spontaneously in the firms day-to-day
operations. Trade credit is often made available spontaneously or
on demand from the firms supplies when the firmorders its supplies or more inventory of products to
sell. Trade credit appears on a balance sheet as accounts payable.
Wages and salaries payable, accrued interest and accruedtaxes also provide valuable sources of spontaneous financing.
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Keown Martin Petty - Chapter 15 24
Also see table 15-1
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Keown Martin Petty - Chapter 15 25
Hedging Principle Summary
Asset needs of the firm not financed by
spontaneous sources should be financedin accordance with this rule:
Permanent-asset investments are financedwith permanent sources, and temporaryinvestments are financed with temporarysources.
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4. Cash Conversion Cycle
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Keown Martin Petty - Chapter 15 27
Cash Conversion Cycle A firm can minimize its working capital by
speeding up collection on sales, increasing
inventory turns, and slowing down thedisbursement of cash.
Cash Conversion cycle (CCC) captures the
above. CCC = days of sales outstanding + days of
sales in inventory days of payablesoutstanding.
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Keown Martin Petty - Chapter 15 28
Figure 15-2 shows that both Dell and Applehave been effective in reducing their CCC.
CCC is below zero due to effectivemanagement of inventories and being able toreceive favorable credit terms.
See table 15-2 for Dells CCC.
Cash Conversion Cycle
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Keown Martin Petty - Chapter 15 29
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5. Cost of Short-term Credit
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Keown Martin Petty - Chapter 15 31
Cost of Short-term Credit Interest = principal x rate x time
Cost of short-term financing = APR orannual percentage rate
APR = (interest / principal) * (1 / time)
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Keown Martin Petty - Chapter 15 32
APR exampleA company plans to borrow $1,000 for 180
days. At maturity, the company will repay
the $1,000 principal amount plus $40interest. What is the APR?
APR = ($40/$1,000) X [1/(180/360)]
= .04 X (180/90)
= .08 or 8%
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Keown Martin Petty - Chapter 15 33
Annual Percentage Yield (APY) APR does not consider compound interest. To
account for the influence of compounding, must
calculate APY or annual percentage yield. APY = (1 + i/m)m 1
Where:
i is the nominal rate of interest per year; m is number of compounding period within a year.
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Keown Martin Petty - Chapter 15 34
APY example In the previous example,
# of compounding periods 360/180 = 2
Rate = 8%
APY = (1 + .08/2)21
= .0816 or 8.16%
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Keown Martin Petty - Chapter 15 35
APR or APY?
Because the differences between APR
and APY are usually small, we can usethe simple interest values of APR tocompute the cost of short-term credit.
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5. Sources of Short-term Credit
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Keown Martin Petty - Chapter 15 37
Sources of Short-term Credit Short-term credit sources can be
classified into two basic groups:
Unsecured
Secured
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Keown Martin Petty - Chapter 15 38
Unsecured Loans Unsecured loans include all of those sources
that have as their security only the lenders
faith in the ability of the borrower to repaythe funds when due.
Major sources:
Accrued wages and taxes, trade credit, unsecuredbank loans, and commercial paper
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Keown Martin Petty - Chapter 15 39
Secured Loans Involve the pledge of specific assets as
collateral in the event that the borrower
defaults in payment of principal or interest.
Primary Suppliers:
Commercial banks, finance companies, and factors
Principal sources of collateral:
Accounts receivable and inventories
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Keown Martin Petty - Chapter 15 40
Unsecured Source:
Accrued wages and taxes Since employees are paid periodically
(biweekly or monthly), firms accrue a wage
payable account that is, in essence, a loanfrom their employees.
Similarly, if taxes are deferred or paid
periodically, the firm has the use of the taxmoney.
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Keown Martin Petty - Chapter 15 41
Unsecured Source:
Trade Credit Trade credit arises spontaneously with the
firms purchases. Often, the credit terms
offered with trade credit involve a cashdiscount for early payment.
Terms such as 2/10 net 30 means a 2%discount is offered for payment within 10days, or the full amount is due in 30 days
A 2% penalty is involved for not payingwithin 10 days.
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Keown Martin Petty - Chapter 15 42
Effective Cost of Passing Up a
DiscountTerms 2/10 net 30
The equivalent APR of this discount is:
APR = $.02/$.98 X [1/(20/360)]
= .3673 or 36.73%
The effective cost of delaying payment for 20days is 36.73%
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Keown Martin Petty - Chapter 15 43
Unsecured Source:
Bank Credit
Commercial banks provide unsecured
short-term credit in two forms: Lines of credit
Transaction loans (notes payable)
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Keown Martin Petty - Chapter 15 44
Line of Credit Informal agreement between a borrower and a
bank about the maximum amount of credit the
bank will provide the borrower at any one time. There is no legal commitment on the part of the
bank to provide the stated credit.
Usually requires that the borrower maintain a
minimum balance in the bank throughout the loanperiod, called a compensating balance.
Interest rate on line of credit tends to be floating.
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Keown Martin Petty - Chapter 15 45
Revolving Credit
Revolving credit is a variant of the line ofcredit form of financing.
A legal obligation is involved.
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Keown Martin Petty - Chapter 15 46
Transaction Loans Transaction loan is made for a specific
purpose. This is the type of loan that mostindividuals associate with bank credit and isobtained by signing a promissory note.
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Keown Martin Petty - Chapter 15 47
Commercial Paper The largest and most credit worthy companies are
able to use commercial paper a short-term promise
to pay that is sold in the market for short-term debtsecurities.
Maturity: Usually 6 months or less.
Interest Rate: Slightly lower ( to 1%) than theprime rate on commercial loans.
New issues of commercial paper are placed directly ordealer placed.
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Keown Martin Petty - Chapter 15 48
Commercial Paper: Advantages Interest rates
Rates are generally lower than rates on bank loans.
Compensating-balance requirement
No minimum balance requirements are associated withcommercial paper.
Amount of credit
Offers the firm with very large credit needs a single source forall its short-term financing.
Prestige
Signifies credit status.
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Keown Martin Petty - Chapter 15 49
Secured Sources of Loans Secured loans have assets of firm pledged as
collateral. If there is a default, the lender has firstclaim to the pledged assets. Because of its liquidity,
accounts receivable is regarded as the prime sourcefor collateral.
Accounts Receivable loans
Pledging Accounts Receivable Factoring Accounts Receivable
Inventory loans
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Keown Martin Petty - Chapter 15 50
Pledging Accounts Receivable Borrower pledges accounts receivable as collateral for a loan
obtained from either a commercial bank or a finance company.
The amount of the loan is stated as a percentage of the face value
of the receivables pledged. If the firm pledges a general line, then all of the accounts are
pledged as security. (Simple and inexpensive)
If the firm pledges specific invoices each invoice must be evaluated
for creditworthiness. (more expensive) Credit Terms: Interest rate is 2-5% higher than the banks
prime rate. In addition, handling fee of 1-2% of the facevalue of receivables is charged.
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Keown Martin Petty - Chapter 15 51
Factoring Accounts Receivable Factoring accounts receivable involves the
outright sale of a firms accounts to a
financial institution called a factor.
A factor is a firm (such as commercialfinancing firm or a commercial bank) thatacquires the receivables of other firms. Thefactor bears the risk of collection in exchangefor a fee of 1-3 % of the value of allreceivables factored.
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Keown Martin Petty - Chapter 15 52
Inventory Loans These are loans secured by inventories
The amount of the loan that can be obtained dependson the marketability and perishability of the inventory
Types:
Floating lien agreement
Chattel Mortgage agreement Field warehouse-financing agreement
Terminal warehouse agreement
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Keown Martin Petty - Chapter 15 53
Types of Inventory Loans Floating Lien Agreement
The borrower gives the lender a lienagainst all its inventories.
Chattel Mortgage Agreement
The inventory is identified and theborrower retains title to the inventory butcannot sell the items without the lendersconsent
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Keown Martin Petty - Chapter 15 54
Types of Inventory Loans
Field warehouse-financing
agreement Inventories used as collateral are physically
separated from the firms other inventoriesand are placed under the control of a third-
party field-warehousing firm
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Keown Martin Petty - Chapter 15 55
Types of Inventory Loans
Terminal warehouse agreement
Inventories pledged as collateral aretransported to a public warehouse that isphysically removed from the borrowerspremises.
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6. Multinational Working-Capital Management
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K M ti P tt Ch t 15 57
Multinational Working-Capital
Management The basic principle is the same for both
domestic and multinational corporations.
However, since multinationals spend andreceive money in different countries, it isexposed to exchange rate risk.
Exposed position (exposed assets-exposedliabilities) is of interest to the firm.