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17 - 1
CHAPTER 17
Financing Current Assets
Working capital financing policies
A/P (trade credit)
Commercial paper
S-T bank loans
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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.
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Moderate Financing Policy
$
Temp. C.A.
}
Perm C.A.
S-T
Loans
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
Lower dashed line, more aggressive.
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Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm C.A.
Fixed Assets
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years
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What is short-term credit, and what are
the major sources?
S-T credit: Any debt scheduled for
repayment within one year.
Major sources:
Accounts payable (trade credit)
Bank loans
Commercial paper
Accruals
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Is S-T credit riskier than L-T?
To company, yes. Required
repayment always looms. May
have trouble rolling over loans.
Advantages of short-term credit:
Low cost--visualize yield curve.
Can get funds relatively quickly.
Can repay without penalty.
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Is there a cost to accruals? Do firms
have much control over amount of
accruals?
Accruals are free in that no explicit
interest is charged.
Firms have little control over the
level of accruals. Levels are
influenced more by industry
custom, economic factors, and tax
laws.
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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.
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B&B buys $3,030,303 gross, or
$3,000,000 net, on terms of 1/10, net
30, and pays on Day 40. How much
free and costly trade credit, and what’s
the cost of costly trade credit?
Net daily purchases = $3,000,000/360
= $8,333.
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Gross/Net Breakdown
Company 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 level if take discount:
Payables = $8,333(10) = $83,333.
Payables level if don’t take discount:
Payables = $8,333(40) = $333,333.
Credit Breakdown:
Total trade credit
Free trade credit
Costly trade credit
= $333,333
= 83,333
= $250,000
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Nominal Cost of Costly Trade Credit
Firm loses 0.01($3,030,303) = $30,303
of discounts to obtain $250,000 in
extra trade credit, so
$30,303
kNom = $250,000 = 0.1212 = 12.12%.
But the $30,303 is paid all during the
year, not at year-end, so EAR rate is
higher.
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Nominal Cost Formula, 1/10, net 40
k Nom
Discount %
360


1  Discount % Days  Discount
period
taken
1 360


 0.0101  12
99 30
 0.1212  12 .12 %.
Pays 1.01% 12 times per year.
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Effective Annual Rate, 1/10, net 40
Periodic rate = 0.01/0.99 = 1.01%.
Periods/year = 360/(40 – 10) = 12.
EAR = (1 + Periodic rate)n – 1.0
= (1.0101)12 – 1.0 = 12.82%.
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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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A bank is willing to lend B&B $100,000
for 1 year at an 8 percent nominal rate.
What is the EAR under the following
five loans?
1. Simple annual interest, 1 year.
2. Simple interest, paid monthly.
3. Discount interest.
4. Discount interest with 10 percent
compensating balance.
5. Installment loan, add-on, 12 months.
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Why must we use EAR to evaluate the
alternative loans?
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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Simple Annual Interest, 1-Year Loan
“Simple interest” means not
discount or add-on.
Interest = 0.08($100,000) = $8,000.
k Nom
$8,000
 EAR 
 0.08  8.0%.
$100,000
On a simple interest loan of one year,
kNom = EAR.
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Simple Interest, Paid Monthly
Monthly interest = (.08/12)(100,000)
= $666.67.
0
1
12
...
100,000 -666.67
INPUTS
OUTPUT
12
N
-666.67
-100,000.00
I/YR
0.6667
100000 -666.67 -100000
PV
PMT
FV
(More…)
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kNom = (Monthly rate)(12)
= 0.66667(12) = 8.00%.
12
0.08 

EAR  1 
  1  8.30%.
12 

or: 8
NOM%, 12
P/YR,
EFF% = 8.30%.
Note: If interest were paid quarterly, then:
4
0.08 

EAR  1 
  1  8.24%.
4 

Daily, EAR = 8.33%.
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8% Discount Interest, 1 Year
Interest deductible = 0.08($100,000)
= $8,000.
Usable funds = $100,000 – $8,000
= $92,000.
0
1
i=?
92,000
INPUTS
OUTPUT
1
N
92
I/YR
PV
8.6957% = EAR
-100,000
0
-100
PMT FV
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Discount Interest (Continued)
Amount needed
Amt. borrowed = 1 - Nominal rate (decimal)
$100,000
= 0.92
= $108,696.
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Need $100,000. Offered loan with
terms of 8% discount interest, 10%
compensating balance.
Amount borrowed =
=
Amount needed
1 - Nominal rate - CB
$100,000 = $121,951.
1 - 0.08 - 0.1
(More...)
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Interest = 0.08($121,951) = $9,756.
Interest paid
Cost 
.
Amount received
$9,756
EAR 
 9.756%.
$100,000
EAR correct only if borrow for 1 year.
(More...)
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8% Discount Interest with 10%
Compensating Balance (Continued)
0
121,951
-9,756
-12,195
100,000
1
i=?
Loan
Prepaid interest
CB
Usable funds
INPUTS
OUTPUT
1
N
-121,951
+ 12,195
-109,756
100000 0 -109756
I/YR
PV PMT
FV
9.756% = EAR
This procedure can handle variations.
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1-Year Installment Loan, 8% “Add-On”
Interest = 0.08($100,000) = $8,000.
Face amount = $100,000 + $8,000 = $108,000.
Monthly payment = $108,000/12 = $9,000.
Average loan
= $100,000/2 = $50,000.
outstanding
Approximate cost = $8,000/$50,000 = 16.0%.
(More...)
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Installment 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:
0
i=?
100,000
1
2
-9,000 -9,000
...
Months
12
-9,000
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INPUTS
OUTPUT
12
N
100000 -9000
PMT
I/YR
PV
0
FV
1.2043% = rate per month
kNom = APR = (1.2043)(12) = 14.45%.
EAR = (1.012043)12 - 1
= 15.45%.
14.45
12
1
NOM
enters nom rate
P/YR
enters 12 pmts/yr
EFF% = 15.4489 = 15.45%.
P/YR to reset calculator.
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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.
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What are the differences between
pledging and factoring receivables?
If receivables are pledged, the lender
has recourse against both the
original buyer of the goods and the
borrower.
When receivables are factored, they
are generally sold, and the buyer
(lender) has no recourse to the
borrower.
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What are three forms of inventory
financing?
Blanket lien.
Trust receipt.
Warehouse receipt.
The form used depends on the
type of inventory and situation at
hand.
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Legal stuff is vital.
Security agreement: Standard form
under Uniform Commercial Code.
Describes when lender can claim
collateral.
UCC Form-1: Filed with Secretary of
State to establish claim. Future
lenders do search, won’t lend if prior
UCC-1 is on file.