Business finance ch 16 financing current assets

CHAPTER 16
Financing Current Assets






Working capital financing
policies
A/P (trade credit)
Commercial paper
S-T bank loans
16-1


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.
16-2


Moderate financing policy
$

Temp. C.A.
S-T
Loans
Perm C.A.

Fixed Assets

L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years

Lower dashed line would be more aggressive.

16-3


Conservative financing
policy
$

Marketable
securities

Perm C.A.

Zero S-T
Debt
L-T Fin:
Stock,
Bonds,
Spon. C.L.

Fixed Assets
Years
16-4


Short-term credit




Any debt scheduled for repayment within
one year.
Major sources of short-term credit







Accounts payable (trade credit)
Bank loans
Commercial loans
Accruals

From the firm’s perspective, S-T credit is
more risky than L-T debt.




Always a required payment around the
corner.
May have trouble rolling over loans.
16-5


Advantages and disadvantages
of using short-term financing


Advantages






Speed
Flexibility
Lower cost than long-term debt

Disadvantages



Fluctuating interest expense
Firm may be at risk of default as a result
of temporary economic conditions
16-6


Accrued liabilities




Continually recurring short-term
liabilities, such as accrued wages or
taxes.
Is there a cost to accrued liabilities?




They are free in the sense that no
explicit interest is charged.
However, firms have little control over

the level of accrued liabilities.
16-7


What is trade credit?






Trade credit is credit furnished by a
firm’s 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.

16-8


The cost of trade credit




A firm buys $3,000,000 net ($3,030,303
gross) on terms of 1/10, net 30.
The firm can forego discounts and pay

on Day 40, without penalty.
Net daily purchases = $3,000,000 /
365
= $8,219.18
16-9


Breaking down net and gross
expenditures








Firm buys goods worth $3,000,000.
That’s the cash price.
They must pay $30,303 more if they
don’t 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.
16-10


Breaking down trade credit



Payables level, if the firm takes discounts




Payables level, if the firm takes no
discounts




Payables = $8,219.18 (10) = $82,192

Payables = $8,219.18 (40) = $328,767

Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575
16-11


Nominal cost of costly trade
credit


The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain

$246,575 in extra trade credit:
kNOM

= $30,303 / $246,575

= 0.1229 = 12.29%


The $30,303 is paid throughout the
year, so the effective cost of costly
trade credit is higher.
16-12


Nominal trade credit cost
formula
Discount%
365days
kNOM 

1 - Discount% Daystaken- Disc.period
1
365
 
99 40 - 10
0.1229
12.29%

16-13

Effective cost of trade
credit


Periodic rate = 0.01 / 0.99 = 1.01%



Periods/year = 365 / (40-10) =
12.1667



Effective cost of trade credit


EAR = (1 + periodic rate)n – 1
= (1.0101)12.1667 – 1 = 13.01%

16-14


Commercial paper (CP)






Short-term notes issued by large,
strong companies. B&B couldn’t
issue CP--it’s 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.
16-15


Bank loans




The firm can borrow $100,000 for 1
year at an 8% nominal rate.
Interest may be set under one of
the following scenarios:






Simple annual interest
Discount interest
Discount interest with 10%

compensating balance
Installment loan, add-on, 12 months
16-16


Must use the appropriate EARs
to evaluate the alternative loan
terms





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.

16-17


Simple annual interest


“Simple interest” means no discount or
add-on.
Interest = 0.08($100,000) = $8,000
kNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, kNOM =
EAR
16-18


Discount interest




Deductible interest = 0.08 ($100,000)
= $8,000
Usable funds = $100,000 - $8,000
= $92,000

INPUTS

1
N

OUTPUT

I/YR

92

0

-100

PV

PMT

FV

8.6957
16-19


Raising necessary funds with
a discount interest loan





Under the current scenario, $100,000
is borrowed but $8,000 is forfeited
because it is a discount interest loan.
Only $92,000 is available to the firm.
If $100,000 of funds are required, then
the amount of the loan should be:
Amt borrowed = Amt needed / (1 – discount)
= $100,000 / 0.92 = $108,696
16-20


Discount interest loan with a

10% compensating balance
Amountneeded
Amountborrowed
1 - discount- comp.balance
$100,000

$121,951
1 - 0.08- 0.1



Interest = 0.08 ($121,951) = $9,756
Effective cost = $9,756 / $100,000 =
9.756%
16-21


Add-on interest on a 12month installment loan







Interest = 0.08 ($100,000) = $8,000
Face amount = $100,000 + $8,000 = $108,000
Monthly payment = $108,000/12 = $9,000
Avg loan outstanding = $100,000/2 = $50,000
Approximate cost = $8,000/$50,000 = 16.0%

To find the appropriate effective rate, recognize
that the firm receives $100,000 and must
make monthly payments of $9,000. This
constitutes an annuity.
16-22


Installment loan
From the calculator output below, we have:
kNOM

= 12 (0.012043)
= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS

12
N

OUTPUT

I/YR

100

-9

0

PV

PMT

FV

1.2043
16-23


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.
16-24