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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
17 - 2
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.
17 - 3
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.
17 - 4
Conservative Financing Policy
$
Marketable Securities
Zero S-T
debt
Perm C.A.
Fixed Assets
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Years
17 - 5
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.
17 - 8
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.
17 - 9
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.
17 - 10
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
17 - 12
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%.
17 - 15
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.
17 - 16
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…)
17 - 20
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...)
17 - 25
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.