CHAPTER 16 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. S-T Loans

Perm C.A.

Fixed Assets

L-T Fin: Stock, Bonds, Spon. C.L. Years

Lower dashed line would be more aggressive.

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Conservative financing policy

$
Marketable securities

Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

Perm C.A.

Fixed Assets Years

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Short-term credit

Any debt scheduled for repayment within one year. Major sources of short-term credit

From the firms perspective, S-T credit is more risky than L-T debt.

Accounts payable (trade credit) Bank loans Commercial loans Accruals

Always a required payment around the corner. May have trouble rolling over loans.
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Advantages and disadvantages of using short-term financing

Advantages

Speed Flexibility Lower cost than long-term debt Fluctuating interest expense Firm may be at risk of default as a result of temporary economic conditions
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Disadvantages

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.
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What is trade credit?

Trade credit is credit furnished by a firms 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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Breaking down net and gross expenditures

Firm buys goods worth $3,000,000. Thats the cash price. They must pay $30,303 more if they dont 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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Breaking down trade credit

Payables level, if the firm takes discounts

Payables = $8,219.18 (10) = $82,192 Payables = $8,219.18 (40) = $328,767 Total trade credit Free trade credit Costly trade credit $328,767 - 82,192 $246,575
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Payables level, if the firm takes no discounts

Credit breakdown

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.

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Nominal trade credit cost formula

k NOM Discount % 365 days 1 - Discount % Days taken - Disc. period 1 365 99 40 - 10 0.1229 12.29%

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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
= (1.0101)12.1667 1 = 13.01%

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Commercial paper (CP)

Short-term notes issued by large, strong companies. B&B couldnt issue CP--its 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 Discount interest Discount interest with 10% compensating balance 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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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

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Discount interest

Deductible interest = 0.08 ($100,000) = $8,000 Usable funds = $100,000 - $8,000 = $92,000
1 N I/YR
8.6957
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INPUTS OUTPUT

92 PV

0 PMT

-100 FV

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
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Discount interest loan with a 10% compensating balance

Amount borrowed Amount needed 1 - discount - comp. balance $100,000 $121,951 1 - 0.08 - 0.1

Interest = 0.08 ($121,951) = $9,756 Effective cost = $9,756 / $100,000 = 9.756%

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Add-on interest on a 12-month 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.
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Installment loan
From the calculator output below, we have:
kNOM EAR = 12 (0.012043) = 0.1445 = 14.45% = (1.012043)12 1 = 15.45% 12 N OUTPUT I/YR
1.2043
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INPUTS

100 PV

-9 PMT

0 FV

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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