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. L-T Fin:

Stock,
Bonds,
Fixed Assets 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:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
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Short-term credit
 Any debt scheduled for repayment within one
year.
 Major sources of short-term credit
 Accounts payable (trade credit)
 Bank loans
 Commercial loans
 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 and disadvantages of
using short-term financing
 Advantages
 Speed
 Flexibility
 Lower cost than long-term debt
 Disadvantages
 Fluctuating interest expense
 Firm may be at risk of default as a result of
temporary economic conditions

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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 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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Breaking down net and gross
expenditures
 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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Breaking down trade credit
 Payables level, if the firm takes discounts
 Payables = $8,219.18 (10) = $82,192
 Payables level, if the firm takes no discounts
 Payables = $8,219.18 (40) = $328,767
 Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575

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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
Discount % 365 days
k NOM  
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 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
 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

INPUTS 1 92 0 -100
N I/YR PV PMT FV
OUTPUT 8.6957

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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
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 Discount interest loan with a
10% compensating balance
Amount needed
Amount borrowed 
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 = 12 (0.012043)
= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043

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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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