Working Capital Management Chapter 15
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Transcript of Working Capital Management Chapter 15
Working Capital Working Capital ManagementManagement
Chapter 15 Chapter 15
Chapter ObjectivesChapter Objectives
Managing current assets and current Managing current assets and current liabilitiesliabilities
Appropriate level of working capitalAppropriate level of working capital Estimating the cost of short-term creditEstimating the cost of short-term credit Sources of short-term creditSources of short-term credit Multinational working-capital Multinational working-capital
managementmanagement
Working CapitalWorking Capital
Working Capital Working Capital Traditionally is the firm’s total investment in Traditionally is the firm’s total investment in
current assetscurrent assets
Net working capitalNet working capital Difference between the firm’s current assets Difference between the firm’s current assets
and its current liabilitiesand its current liabilities Net working capital = Current assets – Net working capital = Current assets –
current liabilitiescurrent liabilities
Managing Net Working Managing Net Working CapitalCapital
Equals managing liquidityEquals managing liquidity Entails two aspects of operations:Entails two aspects of operations:
Investment in current assetsInvestment in current assets Use of short-term or current liabilitiesUse of short-term or current liabilities
Risk-Return Trade-offRisk-Return Trade-off
Holding liquid investments reduces Holding liquid investments reduces overall rate of returnoverall rate of return
Increased liquidity must be traded-off Increased liquidity must be traded-off against the firm’s reduction in return on against the firm’s reduction in return on investmentinvestment
Managing this trade-off is an important Managing this trade-off is an important theme of working-capital managementtheme of working-capital management
Liquidity RiskLiquidity Risk
Other things remaining the same, the Other things remaining the same, the greater the firm’s reliance on short-term greater the firm’s reliance on short-term debt or current liabilities in financing its debt or current liabilities in financing its assets, the greater the risk of illiquidityassets, the greater the risk of illiquidity
A firm can reduce its risk of illiquidity A firm can reduce its risk of illiquidity through the use of long-term debt at the through the use of long-term debt at the expense of a reduction in its return on expense of a reduction in its return on invested fundsinvested funds
Advantages of Current Advantages of Current LiabilitiesLiabilities
FlexibilityFlexibility Can be used to match the timing of a firm’s Can be used to match the timing of a firm’s
needs for short-term financingneeds for short-term financing
Interest CostInterest Cost Interest rates on short-term debt are lower Interest rates on short-term debt are lower
than on long-term debtthan on long-term debt
Disadvantages of Current Disadvantages of Current LiabilitiesLiabilities
RiskRisk Short-term debt must be repaid or rolled Short-term debt must be repaid or rolled
over more oftenover more often
UncertaintyUncertainty Uncertainty of interest costs from year to Uncertainty of interest costs from year to
yearyear
Appropriate Level of Appropriate Level of Working CapitalWorking Capital
Involves interrelated decisions Involves interrelated decisions Can be a significant problemCan be a significant problem Can utilize a type of benchmark Can utilize a type of benchmark
Hedging Principle or Principle of self-Hedging Principle or Principle of self-liquidating debtliquidating debt
Hedging PrincipleHedging Principle
Also known as Principle of Self-Also known as Principle of Self-liquidating debtliquidating debt
Involves matching the cash flow Involves matching the cash flow generating characteristics of an asset generating characteristics of an asset with the maturity of the source of with the maturity of the source of financing used to finance its acquisitionfinancing used to finance its acquisition
Permanent and Permanent and Temporary AssetsTemporary Assets
Permanent investments Permanent investments Investments that the firm expects to hold for Investments that the firm expects to hold for
a period longer than 1 yeara period longer than 1 year
Temporary InvestmentsTemporary Investments Current assets that will be liquidated and not Current assets that will be liquidated and not
replaced within the current yearreplaced within the current year
Temporary FinancingTemporary Financing
Temporary sources of financing are Current Temporary sources of financing are Current liabilities:liabilities: short-term notes payableshort-term notes payable unsecured bank loansunsecured bank loans commercial papercommercial paper loans secured by accounts receivable and loans secured by accounts receivable and
inventoriesinventories
Permanent FinancingPermanent Financing
Permanent Sources of financing include:Permanent Sources of financing include: Intermediate-term loansIntermediate-term loans long-term debtlong-term debt preferred stock and common equitypreferred stock and common equity
Spontaneous FinancingSpontaneous Financing
Spontaneous Sources of financingSpontaneous Sources of financing Arise in the firm’s day-to-day operationArise in the firm’s day-to-day operation Trade credit is often made available Trade credit is often made available
spontaneously or on demand from the firms spontaneously or on demand from the firms supplies when the firm orders its supplies or supplies when the firm orders its supplies or inventoryinventory
Also includes accrued payablesAlso includes accrued payables
Hedging PrincipleHedging Principle
Asset needs of the firm not financed by Asset needs of the firm not financed by spontaneous sources should be financed spontaneous sources should be financed in accordance with this rule:in accordance with this rule:
Permanent-asset investments are Permanent-asset investments are financed with permanent sources, and financed with permanent sources, and temporary investments are financed with temporary investments are financed with temporary sourcestemporary sources
Cost of Short-term CreditCost of Short-term Credit
Interest = principal X rate X timeInterest = principal X rate X time Cost of short-term financing = APR or Cost of short-term financing = APR or
annual percentage rateannual percentage rate APR = interest/(principal X time)APR = interest/(principal X time)
oror APR = (interest/principal) X (1/time)APR = (interest/principal) X (1/time)
APRAPR
A company plans to borrow $1,000 for 90 A company plans to borrow $1,000 for 90 days. At maturity, the company will days. At maturity, the company will repay the $1,000 principal amount plus repay the $1,000 principal amount plus $30 interest. What is the APR?$30 interest. What is the APR?
APR = ($30/$1,000) X [1/(90/360)]APR = ($30/$1,000) X [1/(90/360)] .12 or 12%.12 or 12%
APYAPY
APR does not consider compound APR does not consider compound interest. To account for the influence of interest. To account for the influence of compounding, must calculate APY or compounding, must calculate APY or annual percentage yieldannual percentage yield
APY = (1 + i/m)APY = (1 + i/m)mm – 1 – 1 Where:Where: I is the nominal rate of interest I is the nominal rate of interest
per year; m is number of compounding per year; m is number of compounding period within a yearperiod within a year
APY CalculationAPY Calculation
A company plans to borrow $1,000 for 90 A company plans to borrow $1,000 for 90 days. At maturity, the company will days. At maturity, the company will repay the $1,000 principal amount plus repay the $1,000 principal amount plus $30 interest. What is the APY? $30 interest. What is the APY?
Number of compounding periods 360/90 Number of compounding periods 360/90 = 4= 4
Rate = 12% (previously calculated)Rate = 12% (previously calculated) APY = (1 + .12/4)APY = (1 + .12/4)44 –1 = .126 or 12.6% –1 = .126 or 12.6%
APR or APYAPR or APY
Because the differences between APR Because the differences between APR and APY are usually small, use the and APY are usually small, use the simple interest values of APR to compute simple interest values of APR to compute the cost of short-term creditthe cost of short-term credit
Short-term Sources of Short-term Sources of FinancingFinancing
Include all forms of financing that have Include all forms of financing that have maturities of 1 year or less (or current maturities of 1 year or less (or current liabilities)liabilities)
Two issues:Two issues: How much short-term financing should the How much short-term financing should the
firm use? (Hedging Principle)firm use? (Hedging Principle) What specific sources of short-term What specific sources of short-term
financing should the firm select?financing should the firm select?
What Specific Sources of What Specific Sources of Short-term Financing Short-term Financing Should the Firm Select?Should the Firm Select?
Three factors influence the decision:Three factors influence the decision: The effective cost of creditThe effective cost of credit The availability of creditThe availability of credit The influence of a particular credit source The influence of a particular credit source
on other sources of financingon other sources of financing
Sources of Short-term Sources of Short-term CreditCredit
Short-term credit sources can be Short-term credit sources can be classified into two basic groups:classified into two basic groups:
Secured Secured UnsecuredUnsecured
Secured LoansSecured Loans
Involve the pledge of specific assets as Involve the pledge of specific assets as collateral in the event the borrower defaults in collateral in the event the borrower defaults in payment of principal or interestpayment of principal or interest
Primary Suppliers:Primary Suppliers: Commercial banks, finance companies, and Commercial banks, finance companies, and
factorsfactors
The principal sources of collateral include The principal sources of collateral include accounts receivable and inventoriesaccounts receivable and inventories
Unsecured LoansUnsecured Loans
All sources that have as their security All sources that have as their security only the lender’s faith in the ability of the only the lender’s faith in the ability of the borrower to repay the funds when dueborrower to repay the funds when due
Major sources:Major sources: accrued wages and taxes, trade credit, accrued wages and taxes, trade credit,
unsecured bank loans, and commercial unsecured bank loans, and commercial paperpaper
Cash DiscountsCash Discounts
Often, the credit terms associated with Often, the credit terms associated with trade credit involve a cash discount for trade credit involve a cash discount for early payment. early payment.
Terms such as 2/10 net 30 means a 2 Terms such as 2/10 net 30 means a 2 percent discount is offered for payment percent discount is offered for payment within 10 days, or the full amount is due within 10 days, or the full amount is due in 30 daysin 30 days
A 2 percent penalty is involved for not A 2 percent penalty is involved for not paying within 10 days.paying within 10 days.
Effective Cost of Passing Effective Cost of Passing Up a DiscountUp a Discount
Terms 2/10 net 30 Terms 2/10 net 30 Means a 2 percent discount is available Means a 2 percent discount is available
for payment in 10 days or full amount is for payment in 10 days or full amount is due in 30 days. due in 30 days.
The equivalent APR of this discount is:The equivalent APR of this discount is: APR = .02/.98 X [1/(20/360)]APR = .02/.98 X [1/(20/360)] The effective cost of delaying payment The effective cost of delaying payment
for 20 days is 36.73%for 20 days is 36.73%
Unsecured Sources of Unsecured Sources of LoansLoans
Bank Credit:Bank Credit: Lines of creditLines of credit Transaction loans (notes payable)Transaction loans (notes payable)
Commercial PaperCommercial Paper
Line of CreditLine of Credit
Line of CreditLine of Credit Informal agreement between a borrower Informal agreement between a borrower
and a bank about the maximum amount of and a bank about the maximum amount of credit the bank will provide the borrower at credit the bank will provide the borrower at any one time. any one time.
There is no legal commitment on the part There is no legal commitment on the part of the bank to provide the stated creditof the bank to provide the stated credit
Usually require that the borrower maintain Usually require that the borrower maintain a minimum balance in the bank through the a minimum balance in the bank through the loan period or a compensating balanceloan period or a compensating balance
Revolving CreditRevolving Credit
Revolving CreditRevolving Credit Variant of the line of credit form of financingVariant of the line of credit form of financing A legal obligation is involvedA legal obligation is involved
Transaction LoansTransaction Loans
Transactions loansTransactions loans Made for a specific purposeMade for a specific purpose The type of loan that most individuals The type of loan that most individuals
associate with bank credit and is obtained by associate with bank credit and is obtained by signing a promissory notesigning a promissory note
Commercial PaperCommercial Paper
The largest and most credit worthy The largest and most credit worthy companies are able to use commercial companies are able to use commercial paper– a short-term promise to pay that paper– a short-term promise to pay that is sold in the market for short-term debt is sold in the market for short-term debt securitiessecurities
Advantages of Advantages of Commercial PaperCommercial Paper
Interest ratesInterest rates Rates are generally lower than rates on bank loansRates are generally lower than rates on bank loans
Compensating-balance requirementCompensating-balance requirement No minimum balance requirements are associated No minimum balance requirements are associated
with commercial paperwith commercial paper Amount of creditAmount of credit
Offers the firm with very large credit needs a single Offers the firm with very large credit needs a single source for all its short-term financingsource for all its short-term financing
PrestigePrestige Signifies credit statusSignifies credit status
Secured Sources of LoansSecured Sources of Loans
Accounts Receivable loansAccounts Receivable loans Pledging Accounts ReceivablePledging Accounts Receivable Factoring Accounts ReceivableFactoring Accounts Receivable
Inventory loansInventory loans
Pledging Accounts Pledging Accounts ReceivableReceivable
Under pledging, the borrower simply pledges Under pledging, the borrower simply pledges accounts receivable as collateral for a loan accounts receivable as collateral for a loan obtained from either a commercial bank or a obtained from either a commercial bank or a finance companyfinance company
The amount of the loan is stated as a The amount of the loan is stated as a percentage of the face value of the receivables percentage of the face value of the receivables pledgedpledged
Flexible source of financingFlexible source of financing Can be costlyCan be costly
Factoring Accounts Factoring Accounts Receivable Receivable
Factoring accounts receivable involves Factoring accounts receivable involves the outright sale of a firm’s accounts to the outright sale of a firm’s accounts to a financial institution called a factora financial institution called a factor
A factor is a firm that acquires the A factor is a firm that acquires the receivables of other firmsreceivables of other firms
Inventory LoansInventory Loans
Loans secured by inventoriesLoans secured by inventories The amount of the loan depends on the The amount of the loan depends on the
marketability and perishability of the inventorymarketability and perishability of the inventory Types:Types:
Floating lien agreementFloating lien agreement Chattel Mortgage agreementChattel Mortgage agreement Field warehouse-financing agreementField warehouse-financing agreement Terminal warehouse agreementTerminal warehouse agreement
Types of Inventory LoansTypes of Inventory Loans
Floating Lien AgreementFloating Lien Agreement The borrower gives the lender a lien against The borrower gives the lender a lien against
all its inventories.all its inventories. The simplest but least-secure formThe simplest but least-secure form
Chattel Mortgage AgreementChattel Mortgage Agreement The inventory is identified and the borrower The inventory is identified and the borrower
retains title to the inventory but cannot sell retains title to the inventory but cannot sell the items without the lender’s consentthe items without the lender’s consent
Field warehouse-financing agreementField warehouse-financing agreement Inventories used as collateral are Inventories used as collateral are
physically separated from the firm’s other physically separated from the firm’s other inventories and are placed under the inventories and are placed under the control of a third-party field-warehousing control of a third-party field-warehousing firmfirm
Terminal warehouse agreementTerminal warehouse agreement The inventories pledged as collateral are The inventories pledged as collateral are
transported to a public warehouse that is transported to a public warehouse that is physically removed from the borrower’s physically removed from the borrower’s premises.premises.