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   - Discount% Daystaken- Disc.period 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 – = (1.0101)12.1667 – = 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 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 N OUTPUT I/YR 92 -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 - discount- comp.balance $100,000  $121,951 - 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 – = 15.45% INPUTS 12 N OUTPUT I/YR 100 -9 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 ...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... 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... 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