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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 Moderate Financing Policy
◼ This policy minimizes the risk that the firm will
be unable to pay off its maturity obligations.
◼ The firm could attempt to match exactly the
maturity structure of its assets and liabilities.
◼ Ex. Inventory excepted to be sold in 30 days
could be financed with a 30-day bank loan.
Machine expected to last for 5 years could be
financed with a 5-year loan.

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 Aggressive Financing Policy
◼ Under aggressive policy, the firm finances all of its
fixed assets with long-term capital and part of its
permanent current assets with short-term debt.
◼ This strategy is aggressive because firm will be
subject to dangers from rising interest rates as
well as to loan renewal problems.
◼ However, short-term debt is much cheaper
than long-term debt, and some firms are willing
to sacrifice safety for the chance of higher profits.
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Aggressive Policy
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.
16-3

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 Conservative Financing Policy
◼ Long-term sources are being used to finance all
permanent operating assets requirements and also to
meet some of the temporary NOWC.

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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:
1. Speed: short-term loan can be obtained much faster than
long-term credit.

2. Flexibility: short-term credit agreements are generally less

restrictive than long-term credit agreements.

3. Lower cost than long-term debt: interest rates are

generally lower on short-term debt.

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 Advantages and disadvantages of
using short-term financing
Disadvantages
1.Fluctuating interest expense: if a firm borrows on a long
term basis, its interest expense will be relatively stable over
time, but if it uses short-term credit, its interest will fluctuate
widely.

2. Firm may be at risk of default as a result of temporary

economic conditions
➢ If the borrower is in a weak financial position, the lender
may not extend the loan, which could force the firm into
bankruptcy.
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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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 Cost of Trade Credit
◼ Example: a firm buys an average of $3,000,000 of a
product from a supplier each year at the net, or cash
price, ($3,030,303 gross) on terms of 1/10, net 30.
◼ The firm can forego discounts and pays on day 40,
without penalty.

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 Cost of Trade Credit
◼ So, we can compute the net daily purchases as
follows:

Net daily purchases = net yearly purchases / 365 days

= 3,000,000/365 = 8,219.8

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 Breaking down net and gross
expenditures:
◼ Firms buy goods worth 3,000,000. That’s the cash
price (if discount is taken)
◼ They must pay $30,303 more if they don’t take
discounts. (gross amount)
◼ Think of the extra $30,303 as a financing cost similar
to interest on loan.
◼ We want to compare that cost with the cost of a
bank loan.

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 Breaking down trade credit:
◼ If the firm decides to take the discount and pays on the
10th day – its payables will become
◼ Payables = $8,219.18 (10) = $82,192

Thus, the firm will receive 82,192 of credit from the

supplier.

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 Breaking down trade credit:
◼ Now , suppose the firm decides not to take the
discount and will now pay on the 40th day, its
accounts payable will increase and will become:

Payables = $8,219.18 (40) = $328,767

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 Breaking down trade credit:
◼ Note: the firm now will have additional credit
($328,767 - $82,192) = 246,575, which would use to
build up cash accounts or pay off debt.
◼ But this additional trade has a cost – the cost of
foregoing discount .

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 Breaking down trade credit:
◼ Based on the previous discussion, the total credit can
be divided into two components:
1) Free trade credit: it involves credit received during
the discount period .

2) Costly trade credit: involves credit in excess of the

free trade credit and whose cost is based on the forgone
discount.

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 Breaking down trade credit:
Credit breakdown

Total trade credit $328,767

Free trade credit - 82,192
Costly trade credit $246,575

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 Breaking down trade credit:
Firms should always use the free component, but they should use
the costly component after analyzing the cost of this component
to make sure that it is less than the cost of funds that could be
obtained from other sources.

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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
◼ Compensating Balances
◼ Discount interest with 10% compensating
balance
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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

Effective Rate = 8,000/92,000 = 8.696

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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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 Compensating Balances
◼ The compensating balance is 10%
◼ Compensating Balance= 0.1 (100,000)

= 10,000
Usable Funds = 100,000 – 10,000 = 90,000
Effective Rate = 8,000 / 90,000 = 8.88%
Amount to be borrowed = 100,000/0.9
= 111,111
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 Discount interest loan with a
10% compensating balance
◼ Discount Interest = 8,000
◼ Compensating Balance = 10,000
◼ Usable funds = 100,000 – 18,000 = 82,000
◼ Effective cost = 8,000 / 82,000 = 9.756.
◼ Amount Borrowed = 100,000/(1-.18)
= 121,951.22

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