CHAPTER 16 Financing Current AssetsWorking 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.
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Major sources of short-term credit
Accounts payable (trade credit)
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.
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Advantages
Speed
Flexibility
Disadvantages
Fluctuating interest expense
Firm may be at risk of default as a result of temporary economic conditions
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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.
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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.
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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
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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.
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Payables = $8,219.18 (10) = $82,192
Payables = $8,219.18 (40) = $328,767
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.
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Periods/year = 365 / (40-10) = 12.1667
= (1.0101)12.1667 – 1 = 13.01%
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.
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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
Installment loan, add-on, 12 months
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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.
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Interest = 0.08($100,000) = $8,000
For a 1-year simple interest loan, kNOM = EAR
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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
Interest = 0.08 ($121,951) = $9,756
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Interest = 0.08 ($100,000) = $8,000
Monthly payment = $108,000/12 = $9,000
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.
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kNOM = 12 (0.012043)
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.
12.29%
0.1229
10