B6005Financial Management
Lecture 11
Current Liability Management
2B6005 Dr. Siri Chutikamoltham
Asset L&E
Current Assets
Current Liabilities
Fixed Assets
LT Liabilities
Balance Sheet
3B6005 Dr. Siri Chutikamoltham
Learning Objectives
Understand working capital financing policy
Understand benefits and costs of major current liabilities
Understand the trade-offs of long term and short term debt
Calculate costs of trade credits
Calculate costs of different types of loans
4B6005 Dr. Siri Chutikamoltham
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.
5B6005 Dr. Siri Chutikamoltham
Years
$
Perm NOWC
Fixed Assets
Temp. NOWC
Lower dashed line, more aggressive.
} S-TLoans
L-T Fin:Stock &Bonds,
Moderate Financing Policy
6B6005 Dr. Siri Chutikamoltham
Conservative Financing Policy
Fixed Assets
Years
$
Perm NOWCL-T capital:Stock < Bonds
Marketable Securities
Zero S-Tdebt
7B6005 Dr. Siri Chutikamoltham
Short-Term Liabilities
Accounts payable (trade credit)
Short-term bank loans
Accruals
Commercial paper
8B6005 Dr. Siri Chutikamoltham
Accruals
Major Accruals: wage accruals, tax accruals, customer deposits.
Is there a cost to accruals?
Accruals are free in that no explicit interest is charged.
Can firms control accruals?
Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.
9B6005 Dr. Siri Chutikamoltham
Commercial Paper (CP)
Short term notes issued by large, strong companies.
A cheap source of fund for issuers.
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.
10B6005 Dr. Siri Chutikamoltham
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 for small firms.
Trade credit is spontaneous and relatively easy to get, but the cost can be high.
11B6005 Dr. Siri Chutikamoltham
Terms of Sales Trade credit terms of 1/10, net 30 means:
Customers will get a discount of 1% if the account is paid within 10 days; otherwise the account must be paid in full within 30 days.
From the supplier’s perspective:
sales = $100
Sales of the goods or service = $99
Finance charge = $1
Payables amount for the first 10 days = free trade credit.
The amount owed from Day 11th to 30th = costly trade credit.
12B6005 Dr. Siri Chutikamoltham
Cost of Trade Credit to Customer Annualized opportunity cost of forgoing the discount = a/(1-a)
x 365/(c-b)
a = discount percentage
b = discount period
c = credit period
Ex. 1/10, net 30
a = 1, b = 10, c = 30
Note: Can use 360 or 365 days when annualize.
The typical discount ranges from 0.5% to 10%.
Discount period is generally 10 days.
Credit period ranges from 30 –90 days.
13B6005 Dr. Siri Chutikamoltham
Example: Annualized Nominal Cost of Credit
Terms 1/10, net 30
Annualized nominal cost of foregoing the discount
= 1%/(1-1%) x 365/(30-10)
= 0.01/(1-0.01) x 365/(20)
= 18.09%
14B6005 Dr. Siri Chutikamoltham
Pop QuizWhat is the annualized cost of foregoing the
discount if the credit terms are 2/10, net 30?
15B6005 Dr. Siri Chutikamoltham
Back to SKI SKI buys equipments in the amount of $506,985 per year,
net of discount, on terms of 1/10, net 30, but routinely pays on Day 40 (stretching its AR!!).
Find free and costly trade credit.
Net daily purchases = $506,985/365 = $1,389.
Annual gross purchase = $506,985/(1-0.01)
= $512,106
Difference = 512,106 – 506,985 = $5,121.
16B6005 Dr. Siri Chutikamoltham
Gross/Net Purchase Breakdown
Company buys goods worth $506,985. That’s the net cash price.
They must pay $5,121 more if they don’t take discounts.
Think of the extra $5,121 as a financing cost similar to the interest on a loan.
Should SKI take the discount?
17B6005 Dr. Siri Chutikamoltham
Payables amount if don’t take discount: Payables = $1,389(40) = $55,560.
Total trade credit = $55,560 Free trade credit = 13,890 Costly trade credit = $41,670
Free and Costly Trade Credit
Payables amount if take discount: Payables = $1,389(10) = $13,890.
18B6005 Dr. Siri Chutikamoltham
Annualized Nominal Cost of Costly Trade Credit
But the $5,121 is paid several times during the year, not at year-end, so EAR rate is higher than the nominal rate.
Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so:rNom = $5,121 / $41,670 = 12.29%
19B6005 Dr. Siri Chutikamoltham
Nominal Cost Formula 1/10, net 30 but pays on 40th day
SKI pays a nominal trade credit cost of 1.01% for 12.167 times per year.
rNom = Discount %
1 - Discount %
×365 days
Days
Taken
Discount
Period-
20B6005 Dr. Siri Chutikamoltham
Effective Annual Rate, 1/10, net 30, but pays on the 40th day
Periodic rate = 0.01/0.99 = 1.01%.
Periods/year = 365/(40 – 10)
= 12.1667.
EAR = (1 + Periodic rate)n – 1.0
= (1.0101)12.1667 – 1.0
= 13.01%.
21B6005 Dr. Siri Chutikamoltham
What should be the EAR for SKI if they do not stretch the terms 1/10, net 30?
rNOM = 20.13%
22B6005 Dr. Siri Chutikamoltham
Short-term vs Long-term Bank LoanPROS
1. Lower Cost
2. Quickly
3. Repay w/o penalty
CONS
Roll Over (may not be able to)
Riskier due to volatility of ST interest rates
23B6005 Dr. Siri Chutikamoltham
Compare Costs of Loans
A bank is willing to lend SKI $100,000 for 1 year at an 8 percent nominal rate. Which loan should SKI take?
1.Simple annual interest, 1 year.
2.Simple interest, paid monthly.
3.Discount interest.
4.Installment loan, add-on, 12 months.
24B6005 Dr. Siri Chutikamoltham
How should SKI evaluate the loans?
The nominal rate is 8%
Compare effective cost of the loan and choose the lowest cost alternatives
Because the loans have different terms, we must make comparison base on EAR
25B6005 Dr. Siri Chutikamoltham
1. Simple Annual Interest, 1-Year Loan
“Simple interest” means the interest rate is compounded only once a year, and there is no discount or add-on.
Interest = 0.08($100,000) = $8,000
KNOM = EAR = 8,000/100,000 = 8%
For a simple interest loan of one year, kNom = EAR.
26B6005 Dr. Siri Chutikamoltham
2. Simple Interest, Paid Monthly
EAR = (1 + periodic rate)^#times – 1.0 = 8.3%
Periodic Rate = 8% / 12 = 0.67%
EAR = (1+0.67%)^12 – 1 = 8.3%
27B6005 Dr. Siri Chutikamoltham
3. An 8% Discount Interest Loan, calculate interest only once per year
Interest deductible = 0.08($100,000) = $8,000.Usable funds = $100,000 - $8,000 = $92,000.
N I/YR PV PMT FV
1 92 0 -100
8.6957% Nominal rate? EAR = ?
0 1i = ?
92,000 -100,000
28B6005 Dr. Siri Chutikamoltham
Discount Interest (Cont)IF SKI needs $100,000 usable fund, how
much is the face amount of loan ?
Face Amt. Of Loan =
= = $108,696.
Amount needed 1 - %Nominal interest rate
$ 100,0000.92
29B6005 Dr. Siri Chutikamoltham
4. Add-on Loan1-Year Installment Loan of $100,000, 8%
“Add-On”
Interest = 0.08($100,000) = $8,000.
Face amount of loan = $100,000 + $8,000 = $108,000, after the interest is added on.
Monthly payment = $108,000/12 = $9,000.
(More...)
30B6005 Dr. Siri Chutikamoltham
Cost of Add-on Loan
To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below:
-9,000100,000
0 1 12i=?
-9,000 -9,000
Months2
...
31B6005 Dr. Siri Chutikamoltham
N I/YR PV PMT FV
12 100000 -9000
1.2043% = rate per month
0
Annualized kNom = (1.2043%)(12) = 14.45%.Since loan amortization (of interest and principle) happens 12 times a year, there is a compounding. Must find EAR.EAR = (1.012043)^12 – 1 = 15.45%
32B6005 Dr. Siri Chutikamoltham
Summary
Major sources of short term financing
Suppliers’ credits ( payables)
Short term loans
Goal: shorter cash conversion cycle = more suppliers’ credit, if only cheaper than other financing.
Must evaluate costs of different types of credits, based on EAR