FINANCIAL MANAGEMENT

LECTURE HANDOUT ______ ______

WORKING CAPITAL MANAGEMENT

At the end of this topic, the student should be able to:

● Know the basic concepts and significance of working capital management
● Understand the factors affecting the level of current assets that a business firm should maintain
● Know the advantages of having adequate working capital and the disadvantages of excessive and inadequate working capital
● State and explain the alternative current asset investment and financing policies
● Understand the objective of current asset management
● Know the concept of cash conversion cycle
● Explain the objectives of managing : (1) Cash; (2) Marketable securities; (3) Accounts receivable and (4) Inventory
● Know the tools and techniques in determining the optimum level of: (1) Cash; (2) Marketable Securities; (3) Accounts receivable and (4)
Inventory
● Enumerate the cost associated with investment in or holding: (1) Cash; (2) Marketable securities; (3) Accounts receivable and
(4)Inventory
● Understand the techniques used in evaluating a firm’s efficiency in managing current assets
● Understand the nature of problems encountered in the management of the use of short-term financing
● Know the factors in selecting a source of short-term fund
● Enumerate and explain the sources of short-term funds
● Apply the techniques in estimating the cost of short-term credit

Working capital (gross working capital) – simple referred to as current assets

Permanent (normal) working capital – constitutes the minimum current assets required to conduct the
business
regardless of seasonal requirements

Variable (seasonal) working capital – additional working capital needed by the enterprise during the more
active
business seasons of the year

Net working capital – excess of current assets over current liabilities

Net operating working capital – defines as current assets minus non-interest bearing current liabilities.
More specifically, it is often expressed as cash and marketable securities, accounts receivable and inventories,
less accounts payable and accrued liabilities.

current assets minus non-interest bearing current liabilities

(C+MS+AR+I)-(AP+AL)

Zero working capital – has its own definition of working capital: Inventories + Receivables – Payables. The
rationale is that inventories and receivables are the keys to making sales, and that inventories can be financed by suppliers
through accounts payable.

Inventories + Receivables – Payables

Working capital management – involves the determination of the level, quality and maturity of each major current
assets and current liability. It also refers to the administration and control of current assets and current liabilities to insure
that they are adequate and used effectively for business purposes. It involves both setting working capital policy
and carrying out that policy in day-to-day operations. It could be viewed collectively or individually, understanding the
components of the working capital would lead to cash management, short-term securities management, receivables management, inventory
management, and short-term financing management.

Sources of working capital (current assets)

1) Income from current operations, adjusted for noncash expenses such as depreciation
2) Gain on sale of marketable securities
3) Proceeds from the sale of non-current assets
4) Proceeds from long-term borrowings
5) Investments from owners

Uses of working capital

1. Operations (deducted from sources)
2. Purchase of non-current assets
3. Retirement/ payment of long-term debt
4. Return of capital to owners through: (1) dividend payments; (2) retirement of capital stock and (3) withdrawals

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Significance of working capital management

1) Working capital represents the margin of safety for short-term creditors

Current assets are likely to yield a higher percentage of their book value on liquidation than do fixed assets.
Hence, short-term creditors look to the current asset as a source of repayment of their claims. The
working capital also indicates the amount by which the value of current assets could drop from their book values and
still cover the claims of short-term creditors without loss

2) The amount of working capital represents the extent to which current assets are financed from long-term sources
Although current assets are turned over within relatively short periods, they always represent some percentage of
sales. In this sense, a portion of current assets must be owned by the firm permanently. Consequently, it is
appropriate that a portion of current assets be financed from permanent sources.

Factors affecting level of current assets:

a) General nature of the business and product – trading and manufacturing companies usually require higher proportions
of current assets than service and utility companies do.
b) Effect of sales pattern – working capital needs will be affected by the nature of the change in sales or business activity.

If sales are brought about by cyclical (seasonal) changes, periodic build-up of receivables and inventory is temporary and financing
need is considered short-term. This is because the conversion of these investments into cash will come in the normal course of
operation. If the change in sales is due to secular (permanent) changes, the incremental working capital required is permanent and
will require long-term financing

c) Length of manufacturing process – the longer the period of time required to manufacture the products of the company,
the higher the level of working capital requirement is

d) Industry practices – industry or line of business with greater proportion of assets readily convertible to cash can afford
to have a lower working capital investment and a higher level of current liabilities

e) Terms of purchases and sales – the longer the credit period granted by suppliers of merchandise is, the lower the
requirement for permanent working capital is. Meanwhile, the longer the credit period given to customer of the firm
is, the higher the requirement for working capital is

Advantages of having an adequate working capital Disadvantages of having an

1. Company can settle its debts promptly thereby enabling it to ● INADEQUATE WORKING CAPITAL
maintain its good credit standing
2. Credit may be extended to customers thereby increasing the 1) Risk of business failure is increased
sales volume of the firm 2) Company may not be able to pursue its objectives
because of lack of funds

3. Inventories can be easily replenished ● EXCESSIVE WORKING CAPITAL

4. Current operating expenses are paid promptly
5. Management and employee morale is enhanced 1) Management may become inefficient and complacent
6. Profitable opportunities can be taken advantage of 2) Management may be tempted to speculate
3) Unnecessary expense and extravagance may result
4) Resources are not optimally employed

The management of working capital as a cluster of assets is important because the overall profitability and liquidity risk of the firm is affected by
the total amounts, as well as the types of working capital utilized. The level of working capital can be varied relative to the productive output that
affects the risk of insolvency as well as the potential profitability of the firm.

Working capital policy – refers to the firm’s policy regarding (1) target levels for each category of current assets and (2)
how assets will be financed.

ALTERNATIVE CURRENT ASSET INVESTMENT POLICIES

1. Conservative (relaxed) current asset investment policy (“fat cat”) – a policy under which relative large amounts of cash,
marketable securities and inventories are carried and under which sales are stimulated by a liberal credit policy,
resulting in a high level of receivables. This policy generally provides the lowest expected return on
investment because capital tied up in current assets either does not earn any substantial income at all
or a minimal income if any, but it entails the lowest risk
2. Restricted (aggressive) current asset investment policy (“lean and mean”) – a policy under which holding of cash,
securities, inventories and receivables are minimized. In this policy, the firm has fewer liquid assets with which to
prevent a possible financial failure. Holdings in cash, securities, investors and receivables are minimized. While risk of
financial failure is high because of the small amount of total capital requirement, the profitability rate measured by the
rate of return as total assets however is higher.

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3. Moderate current asset investment policy – a policy that is between relaxed and restricted policy.

Capital
Relaxed current asset policy

Moderate current asst policy

Restricted current asset policy

Permanent current assets – current assets that a firm must carry even at the trough of its cycles
Temporary current assets – current assets that fluctuate with seasonal (cyclical) variations in sales

ALTERNATIVE CURRENT ASSET FINANCING POLICIES

1) Maturity matching (self-liquidating) approach – a moderate approach to current asset financing involves matching to the
extent possible the maturities of assets and liabilities, so that temporary current assets are financed with are financed
with short-term nonspontaneous debt and permanent current assets and fixed assets are financed with long-term debt
or equity, plus spontaneous debt. It is a financing policy that matches asset and liability maturities.

This policy is also known as hedging policy call for the use of permanent financing (long-term debt and equity) to finance permanent assets
(fixed assets and permanent working capital) and then use of short-term financing to cover seasonal and/ or cyclical temporary assets. This
strategy minimizes the risk that the firm ill be unable to pay off its maturing obligations.

2) Aggressive approach – in this approach, a firm finances all of its fixed assets with long-term capital but part of its
permanent current assets is financed with short-term nonspontaneous credit. This happens because to acquire long-
term funds, the firm must generally go to the capital markets with a stock or bonds offering or muse negotiate long-
term obligations with insurance companies and so on. Many small businesses do not have access to such long-term
capital. It is in this approach wherein some permanent current assets, and perhaps even some fixed assets are
financed with short-term debt.

A relatively high aggressive firm would be very much subject to dangers from using interest rates as well as loan renewal problems. Although
short-term debt is often cheaper than long-term debt, some firms are willing to sacrifice safety for the chance of higher profits.

3) Conservative approach – this approach uses permanent or long-term financing source to finance all permanent assets
and also part of the temporary current assets and then hold temporary surplus of funds as marketable securities at the
trough of the cycle. Here, the amount of permanent, or long term capital exceeds the level of permanent assets.
Conservative approach would be to use long-term capital to finance all permanent assets and some temporary current
assets.

Trade of between risk and return

Conservative Aggressive
Level of working capital High Low
Level of long-term financing High Low
Liquidity risk Low High
Profitability returns Low High

Notes:6
● High level of current asset = LOW LIQUIDITY RISK
● More reliance on long-term financing = LOW RETURNS
● Substantial level of working capital entails high reliance on long-term financing, which would lead to greater liquidity but
lower returns (profit) because of higher explicit costs
● Liquidity of current assets will affect the terms and availability of short-term credit. Short term credit, in turn, affects the
amount of cash balance held by the firm
● Holding more current than long term assets results into reduced liquidity risk. However, the rate of return will be less than
with the current assets than with long term assets. This is because long-term assets generally earn greater than current assets.

Illustrative problem no. 1A: (working capital). Given the following information of Wapak Company:
Cash P10,000 Accrued expenses P 5,000
Accounts receivable 20,000 Taxes payable 3,000
Inventory 42,000 Accounts payable 12,000
Machinery 90,000 Bonds payable 82,000

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Bonds payable will mature in 10 years. All amounts are correctly stated to their proper values
Compute for the following:
● Net working capital
● Current ratio
● Acid test ratio
● New current ratio (assuming all accrued expenses
are paid)
● New current ratio (assuming a 5,000 short term
loan is obtained from a bank)

Illustrative problem no.1B: (working capital policies) Bolts and Associates is developing an asset financing plan.
Bolts have P500,000 in current assets, of which 15 percent are permanent and P700,000 in fixed assets. The current long-
term rates is 11 percent and the current short-term rate is 8.5 percent. Bolts’ tax rate is 40 percent.
Required:
1. Construct two financing plans – one conservative, with 80 percent of assets financed by long-term sources and the
other aggressive, with only 60 percent of assets financed by long-term sources.
2. If Bolts’ earnings before interest and taxes are P325,000, calculate net income under each alternative

Solution:
1) Financing plans Plan A (conservative) Plan B (aggressive)
● Short-term
Plan A (20%)
Plan B (40%)
● Long-term
Plan A (80%)
Plan B (60%)
Total
2) Net income Plan A (conservative) Plan B (aggressive)
Earnings before interest and taxes P 325,000 P 325,000
Interest:
● Short-term (8.5 percent)

● Long-term (11 percent)

Earnings before interest

Taxes (40 percent)
Net income

OBJECTIVE OF CURRENT ASSET MANAGEMENT

1. The total amount of liquidity necessary to avoid the risk of insolvency
2. The amount of cash versus near-cash (marketable securities) to have in the liquidity mix for transaction purposes

Cash conversion cycle – the average length of time involved – from the payment of raw materials to the collections of
accounts receivable.

Formula:
Cash Conversion Cycle = Inventory conversion period + Receivable collection period – Payable deferral period

Inventory conversion period = Inventory / Sales per day

Receivables collection period = Receivables / (sales / # of days in a year)
Payables deferral period = Payables / Purchases per day

Illustrative problem no. 2. John Company has an inventory conversion period of sixty days, a receivables conversion
period of forty-five days and a payments cycle of thirty days. What is the length of the firm’s cash conversion cycle?

CASH MANAGEMENT

Cash is a commodity it is not an investment. It has to be invested to produce wealth. Theoretically, cash represents
an idle resource. However, cash balance is maintained to meet loan conditions, contractual requirements, deposit
arrangements or petty cash contingencies. Managing cash is a treasurer’s domain. Cash balance should be at its optimum
and cash flows ( inflows and outflows) should be synchronized.

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Cash management involves the maintenance of a cash and marketable securities investment level which will enable the
company to meet its cash requirements and at the same time optimize the income on idle funds.

Objective of Cash Management:

1) To meet the cash disbursements needs
2) To minimize the funds committed to transactions and precautionary balances
3) To avoid misappropriation and handling losses in the normal course of business

Reasons of holding cash:

1. Transaction motive – cash is needed to facilitate the normal transactions of the business, that is, to carry out its
purchases and sales activities
2. Precautionary motive – cash may be held beyond its normal operating requirement level in order to provide for a
buffer against contingencies such as unexpected slow-down in accounts receivable collection, strike or increase in
cash beyond management’s original projections
3. Speculative motive – cash is held ready for profit-making or investment opportunities that may come up such as a
block of raw materials inventory offered at a discounted prices or a merger proposal
4. Contractual motive – a company may be required by a bank to maintain a certain compensating balance in its
demand deposit account as a condition of a loan extended to it.

MANAGING CASH FLOWS

Synchronized cash flows – a situation in which inflows coincide with outflows, thereby permitting a firm to hold low
transactions balances.

Determining the cash needs:

1) Cash budget – a schedule showing projected cash inflows and outflows over some period. It is used to predict cash
surpluses and deficits, and it is the primary cash management planning tool.

2) Cash breakeven chart – shows the relationship between the company’s cash needs and cash sources. It indicates the
minimum amount of cash that should be maintained to enable the company to meet its obligations.

3) Optimal cash balance model (Baumol Model) – in most medium or large-sized corporations, liquidity management has
assumed a greater role over the past decade. Since cash is needed for both transaction and precautionary needs in all
companies, it must be available in some form (cash, marketable securities, borrowing capacity) all of the time. The
liquidity managers must utilize some formal models or techniques to maintain the optimal amount at each moment in
time because too much liquidity brings down the rate of return on total assets employed and too little liquidity
jeopardizes the very existence of the firm itself. In managing the level of cash (currency plus demand deposits) for
transaction purposes versus near cash (marketable securities), the following costs must be considered: (1) Fixed and
variable brokerage fees and (2) Opportunity costs such as interest foregone by holding cash instead of near cash. This model
balances the opportunity cost of holding cash against the transaction costs associated with replenishing the cash
account by selling off marketable securities or by borrowing.

Formula:
1) Total cost of cash balance = Holding costs + Transaction costs

Holding costs = Average cash balance x Opportunity cost

Transaction costs = Number of transactions x Cost per transaction

Total cash balance = (C/ 2) (K) + (T/C) (F)

Where:
C = amount of cash raised by selling marketable securities or by borrowing
C* = optimal amount of cash to be raised by selling marketable securities or by borrowing
C/2 = average cash balance
C*/2 = optimal average cash balance
F = fixed costs of making a securities trade or of obtaining a loan
T = total amount of net new cash needed for transactions during the period (usually a year)
k = opportunity cost of holding cash, net equal to the rate of return foregone on marketable securities or the cost
of borrowing to hold cash.

2) Optimal cash balance (C*)

2 (total amount of net new cash required) (fixed costs of trading securities or cost of borrowing)
Opportunity cost of holding cash

Note: The optimum cash balance computation resembles that of the economic order quantity

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Illustrative problem no. 3: (optimal cash balance) Fake Gold Corporation expects to make monthly cash payments
of P160,000, evenly during the month. The average return on money market placements is 8 percent per annum and it
expects P250 per cash transfer. Determine the following: (1) Optimum cash balance; (2) Average cash balance; (3)
Number of cash transfer per year; (4) Total relevant cost at the optimum cash balance; (5) Total relevant cash costs at the
following cash orders: (a) P50,000 and (b) P400,000.

SOLUTION:
1) Optimum cash balance
Annual cash demand
Optimum cash balance
2) Average cash balance
3) Number of cash transfer
4) Total relevant cost:

5) Total relevant cost @ P50,000 @ P400,000

Transaction costs:
@50,000
@400,000
Carrying costs:
@50,000
@400,000
Total

Techniques for lessening Cash needs:

1. Accelerating collections – any method that accelerates collection lessens the firm’s need for cash. This may be
accomplished through:
a) High standards on credit approval . Reliable collection pattern is greatly related to the quality of credit customers.
Customers who have shown their capability, ability and commitments to meet credit payments in the past are
expected to continue their paying practices in the coming periods.

b) Shorter trade discount and credit period . If the competitive environment suggests, granting trade credit facilities
on a shorter period is a more comfortable way of managing cash collections from customers

c) Efficient and effective billing system. Collections are also dependent on the efficiency of the organization’s billing
system. Accurate, prompt and service-oriented billing policies give a serious signal to customers that records
are kept completely and intact and commitments are expected to be met as they fall due.

Cost-effective collection systems such as:

1) Frequency of collection follow-up. Friendly, tactful and frequent notices of collections through calls, other
electronic means or personal visitation are tested practices in making an effective collection

2) Visibility of collection personnel. Maintaining an effective field collection personnel group is also a successful
technique most commonly applied by small and medium size distribution and financing companies

3) Use of specialized postal system (i.e. lockbox system). Collections through a postal system, either government-
operated or privately-owned postal company, are found to be cost-effective in other places.

Lockbox plan – a procedure used to speed up collections and reduce floats through the use of post office boxes
in payer’s local areas.

4) Electronic fund transfer. The advent of electronic technology has already seeped its way to the banking sector
where transfers of funds are made anywhere and everywhere thereby scraping off several traditional
bottlenecks in collections such as the problem of distance, timing and costs.

5) Concentration banking. Collections could be facilitated by banks through a bank-to-bank transfer scheme. It is
the method of collections through banking facilities, where the depository bank of the seller is given authority
to receive transfer of funds from the buyer through its depository bank which has been authorized to transfer
of funds.

2. Slowing disbursements – any action on the part of the finance officer which shows the disbursement of funds lessens
the use for cash balance. This can be done by:
a) Use of checks and drafts. Disbursements must be made in checks or drafts unless it is impractical to do so. the
use of check signifies that the cash payment is authorized after all the accounting verification processes. The
use of check makes use of the “cash float”.

Play the float – involves taking advantage of the time it takes for the company’s check to clear the banking system.

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Float – the difference between the balance shown in the firm’s (or individual) checkbook and the balance on
the bank’s record.

● Cash float – number of days from the date of the check to the date the money is withdrawn.
● Disbursement float – value of the checks that were written but are still being processed and thus have not
been deducted from the account balance by the bank
● Collections float – amount of checks that we have received but have not yet been credited to our account
● Net float – difference between our checkbook balance and the balance shown on the bank’s account

Check clearing – the process of converting a check that has been written and mailed into cash in the payee’s
account.
For local checks to be cleared = takes two days
For regional checks to be cleared = takes normally five days

b) Voucher system. Transactions that need cash payments are recorded in a voucher register. Details of
transactions are entered to keep an accurate record of events and amounts. Additionally, liability due date and
credit terms is readily available for rightful management disposition. More importantly, before a check is
prepared, a journal voucher is processed and supported by documents showing the existence, accuracy, and
verifiability of the debt to be paid.
c) The 3:00 o’ clock habit. For a maximized use of float, checks are to be issued at or after 3:00 o’ clock in the
afternoon after the bank clearing time is closed. This makes the check good for deposit in the following
business day, at the earliest. This practice stretches the deposit by a day.
d) Thank God it’s Friday (TGIF) syndrome. If the checks are issued on a Fridays, deposit could be made the
incoming Monday, thereby, increasing the cash float by two more days (that is Saturday and Sunday)
e) Centralized processing of payables. This permits the finance manager to evaluate the payments coming due for
the entire firm and to schedule the availability of funds to meet these needs on a company-wide basis. It also
results to more efficient monitoring of payables and float balances. Care, however, should be taken so as not
to create ill will among suppliers of goods and services or raise the company’s cost if bills are not paid on time.
f) Zero balance accounts (ZBA). These are special disbursement accounts having a zero peso balance on which
checks are written. As checks are presented to a ZBA for payment, funds are automatically transferred from a
master account.
g) Delaying payment. If one is not going to take advantage of any offered trade discount for early payment, pay on
the last day of the credit period.
h) Less frequent payroll. Instead of paying the workers weekly, they may just be paid semi-monthly

Illustrative problem no. 4: (acceleration of cash receipts). Ek-Ekan Fashion designs is evaluating a special
processing system as a cash receipts acceleration device. In a typical year, this firm receives remittances totalling P7
million by check. The firm will record and process 4,000 checks over the same time period. First Provincial Bank has
informed the management of Ek-Ekan fashion designs that it will process checks and associated documents through the
special processing system for a unit cost of P0.25 per check. Ek-Ekan’s financial manager has projected that cash freed by
adoption of the system can be invested in a portfolio of near-cash assets that will yield an annual before tax return of 8
percent. Ek-Ekan fashion Designs’ financial analysts use a 365 day year in their procedures.
Required:
1. What reduction in check collection is necessary for Ek-Ekan fashion Designs to be neither better nor worse off for
having adopted the proposed system?
2. How would your solution to (1) be affected if Ek-Ekan fashion Designs could invest the freed cash balances only at
an expected annual return of 5.5 percent?

Solution:
1) Average check size
Daily opportunity cost of carrying cash
Days saved in the collection process: Added costs = Added benefits
P=DxSxI

2) Daily opportunity cost of carrying cash

Days saved in the collection process:

Illustrative problem no. 5: (valuing float reduction). Next year, Jackson Motors expects its gross revenues from
sales to be P80 million. The firm’s treasurer has projected that its marketable securities portfolio will earn 6.50 percent
over the coming budget year. What is the value of one day’s float reduction to the company? Jackson Motors uses a 365-
day year in all of its financial analysis procedures.

Solution:

Value of one day’s float reduction: Page 7 of 19

FINANCIAL MANAGEMENT
LECTURE HANDOUT ______ ______

Internal control for cash

1) The cash department should be under the supervision of the treasurer
2) The cash department should be separated from the accounting and other departments that keep records of
transactions and events
3) All cash transactions must be supported by available proof of accuracy. All cash receipts must be issued pre-numbered
official receipts. All official receipts must be multi-copied and preferably machine validated. All check issuances must
be supported by delivery receipts, sales invoices, receiving reports, board resolutions or official receipts
4) All cash receipts must be deposited intact in the designated depository on the day of collection or in the following
business day
5) Bank deposit slips must always be on file, complete and available
6) Periodic reconciliation of bank and book records must be done
7) Cash count should always be done and with an element of surprise
8) All checks must be properly signed and approved by at least two signatories
9) Cash personnel must be properly selected and trained
10) Cashiers must be bonded
11) Cashiers should be rotated, periodically or surprisingly
12) A cashier’s manual must be made available
13) Use of mechanical or electronic equipment in issuing checks and official receipts
14) Preparation and verification of daily cash report

MARKETABLE SECURITIES MANAGEMENT

Marketable securities – securities that can be sold on short notice

Objective of marketable securities management

The firm may hold excess funds in anticipation of a cash outlay. When funds are being held for other than immediate
transaction purposes, they should be converted from cash into interest-bearing marketable securities. Marketable securities which
should be of highest investment grade usually consists of treasury bills, commercial paper, certification of time deposits from
commercial banks.

Realistically, management of cash and marketable securities cannot be separated. Management of one implies management
of the other.

Reasons for holding marketable securities

“Firms can reduce their cash balances by holding marketable securities, which can be sold on short notice at close on their quoted
prices. They serve both as a substitute for cash and as a temporary investment for funds that will be needed in the near future .”

1. They serve as substitutes for cash balances. Many firms prefer to hold marketable securities as a substitute for
transaction balances, precautionary balances, for speculative balances or for all three. In most cases, however, the
securities are held primarily for precautionary purposes or as a guard against a possible shortage of bank credit
2. They are held as temporary investment where a return us earned while funds are temporary idle
3. They are built up to meet known financial requirements such as tax payments, maturity bond issue etc...

Factors Influencing the Choice of Marketable Securities

1) Risks

a) Default risk – risk that the issuer of the security cannot pay the principal or interest at due dates
b) Interest rate risk – risk of declines in market values of the security due to rising interest dates
c) Inflation risk – the risk that inflation will reduce the “real” value of the investment. In periods of rising prices,
inflation risk is lower on investments (e.g. common stocks) whose returns tend to rise inflation than on
investments whose returns are fixed

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2) Maturity. Marketable securities held should mature or can be sold at the same time cost is required

3) Yield (returns on securities). Generally, the higher a security’s risk, the higher its required return. Corporate investors,
like other investors must make a trade-off between risk and return when choosing marketable securities. Because
these securities are generally held either for a specific known need or for use in emergencies, the portfolio should
consist of highly liquid short-term securities issued by the government or very strong corporation. Treasurers should
not sacrifice safety fir higher rates of return.

4) Marketability (liquidity) risk. Refers to the risk that securities cannot be sold at close to the quoted market price and is
closely associated with liquidity risk.

Illustrative problem no. 6: (buying and selling marketable securities). Peace Inc. has P2 million in excess of
cash that it might invest in marketable securities. In order to buy and sell the securities, however, the firm must pay a
transaction fee of P45,000.
Required:
a. Would you recommend purchasing the securities if they yield 12 percent annually and are held for:
1) One month
2) Two months
3) Three months
4) Six months
b. What minimum yield would the securities have to return for the firm to hold them for three months (what is the
breakeven yield for a 3-month holding period)?

Solution:
a. Recommendation;
Recommendations:
● 1 month
● 2 months
● 3 months
● Six months

b. Break even yield:

RECEIVABLES MANAGEMENT

Objective of Receivable management

“To encourage sales and gain additional customers by extending credit.” It is therefore the responsibility of the finance
officer to evaluate the pertinent costs and benefits related to credit extension, to finance the firm’s investment in accounts receivable,
implement the firm’s chosen credit policy and to enforce collection.

Credit management – strategically defines the quality of accounts receivable collections.

Credit and collection have a direct relationship. If credit standards are high, the rate of collection is expected to be high and vice-versa.

Credit management Credit policy Effects to

variables Collection Receivable Receivable Collection
balance turnover period
High Faster Decrease Increase Shorter
Discount rate Low Slower Increase Decrease Longer

Short/Strict Faster Decrease Increase Shorter

Discount time Long / lax Slower Increase Decrease Longer

Short/ strict Faster Decrease Increase Shorter

Credit period Long/ lax Slower Increase Decrease Longer

High / strict Faster Decrease Increase Shorter

Credit cap/ credit limit Long/ lax Slower Increase Decrease Longer

Low risk/ strict Faster Decrease Increase Shorter

Credit class High risk/ lax Slower Increase Decrease Longer

Credit policy – set of decisions that include a firm’s credit period, credit standards, collection procedures and discounts
offered

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Collection policy – procedures that a firm follows to collect accounts receivable.

Credit cap/ credit limit – the limitation of credit line in terms of amount set or imposed by the seller to a given
customer depending on his capability to meet trade payments.

Credit block – policy of non-delivery of merchandise to customers once their accounts become past due.

Credit class – pertains to group of customers to whom merchandise shall be delivered. Customers may be classified
according to their income level, place of residence, gender, age, geographical location, civil status, and other matters of
social demographics. Credit limits and other credit terms are determined for each credit class.

Factors in determining Accounts Receivable policy

1. Credit standards. Credit policy can have a significant influence upon sales. If credit policy is relaxed, while sales may
increase, the quality of accounts receivable may suffer. This may result into longer average collection period. An
optimal credit policy would involve extending trade credit more liberally until the marginal profitability on additional
sales equals the required return on the additional investment in receivables. Or it is a trade-off between the profits on
sales that give rise to receivables on one hand and the cost of carrying these receivables plus bad debt losses on the
other. These are standards that stipulate the required financial strength that an applicant must demonstrate to be granted credit.

2. Credit terms. It involves both the length of the credit period and the discount given. Although the customs of the
industry frequently dictate the terms given, the credit period if lengthened generally results to an increased product
demand and vice versa. It is a statement of the credit period and any discounts offered (e.g. 2/10, net 30)

Credit period – length of time for which credit is granted.

3. Collection period. Credit analysis is instrumental in determining the amount of credit risk to be accepted. In turn, the
amount of risk accepted affects the slowness of receivables and the resulting investment in receivables, as well as the
amount of bad debt losses. Collection procedures affect these factors. Within a reasonable range, the lower the
proportion of bad debt losses and the shorter the average collection period, all other things remaining the same

4. Delinquency and default. Whatever credit policies a business firm may adopt, there will be some customers who will
delay and others who will default entirely, thereby increasing the total accounts receivable costs. Again, the optimal
credit policy that should be adopted is the one that provides the greatest marginal benefit

Costs associated with accounts receivable

a) Credit analysis, accounting and collection costs. If the firm is extending credit in anticipation of attracting more
business, it incurs cost of hiring a credit manager plus assistants and bookkeepers within the finance department; of
acquiring credit information sources and of generally maintaining and operating a credit and collection department.

b) Capital costs. Once the firm extends credit, it must raise funds in order to finance it. The interest to be paid if the funds
are borrowed or the opportunity cost if equity capital will constitute the cost of funds that will be tied up in the
receivables.

c) Delinquency costs. These are incurred when the customer is late in paying. This delay adds collection costs above those
associated with a normal collection. Delinquency also creates an opportunity cost for any additional time the funds are
tied up after the normal collection period

d) Default costs (Bad debts). The firm incurs default costs when a customer fails to pay at all. In addition to the collection
costs, capital costs and delinquency costs incurred up to this point, the firm loses the cost of goods sold not paid for. It
has to write off the entire sales once it decides the delinquent account has defaulted and is no longer collectible.

Illustrative problem no. 7: (average investment of accounts receivable). AH1N1 Corporation sells on terms of
2/10, net 30. 70 percent of the customers normally avails the discount. Annual sales are P900,000, 80 percent of which is
made on credit. Cost is approximately 75 percent of sales.
Required:
1) Average balance of accounts receivable
2) Average investment in accounts receivable

Solution:
1. Average balance of AR:

2. Average investment of AR:

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Summary of trade-offs in Credit and Collection policies

Trade offs
Benefits Costs
● Relaxation of credit standards ✔ Increase in sales and total � Increase in:
contribution margin 1) Credit processing costs
2) Collection costs
� High default costs or bad debts
� Higher capital costs

● Lengthening of credit period ✔ Increase in sales and total � Higher capital costs (opportunity
contribution margin cost of higher investment in
receivables)

● Granting cash discounts ✔ Increase in sales and total � Lesser profit

contribution margin
✔ Opportunity income on lower
investment in receivable

● Intensified collection efforts ✔ Lower default costs or bad debts � Higher collection expenses
✔ Lower opportunity cost or capital � Lower sales
costs

MARGINAL/ INCREMENTAL ANALYSIS IF CREDIT POLICIES

IF: Change in credit policy?

� Incremental profit contribution > incremental cost Accept
� Incremental profit contribution = incremental cost Be indifferent
� Incremental profit contribution < incremental cost Reject

Illustrative problem no.8A: (relaxation of credit policy). Alphabet Corp.’s products sells for P10 a unit of which
P7 represents variable costs before taxes including credit department costs. Current annual credit sales are P2.4 million.
The firm is considering a more liberal extension of credit, which will result in a slowing in the average collection period
from one month to two months. The relaxation in credit standards is expected to produce a 25 percent increase in sales.
Assume that the firm’s required rate of return on investment is 20 percent before taxes. Bad debts losses will be 5 percent
of incremental sales and collection expenses will increase by P20,000. Required: Should the company liberalize its credit
policy?

Solution:
Incremental CM from additional units
Bad debts
Collection expenses
Incremental profit (loss)

Required return on add’l investment:

Present level of receivables
Level of receivables after the change in
credit policy
Additional receivables

Additional investment in receivables

Required return
Required return on additional investment

DECISION:

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Illustrative problem no. 8B: (change in credit terms). The Centurions Shades Co. has 12 percent opportunity cost
of capital and currently sells on terms n/20. It has current annual sales of P10 million, 80 percent of which are on credit.
Current average collection period is sixty days. It is now considering to offer terms of 2/10, net/30 in order to reduce the
collection period. It expects 60 percent of its customers to take advantage of the discount and the collection period to be
reduced to forty days. Required: should the company change its terms from n/20 to 2/10, net/ 30?

Solution:
Present Proposed
Opportunity cost:
Present
Proposed
Sales discount:
Proposed
Total

Decision:

Trade discount/ Credit discounts - given to encourage credit customers to pay their accounts earlier.

This win-win situation between the seller and the buyer speaks of the benefits that could be derived by the buyer in terms of reduction in
the amount to be paid and the benefit on the part of the seller for the opportunity to use the money to generate additional earnings. The bait is “the
higher the discount rate, the more attractive it is for the buyer to pay at an earlier date”. However, the cost-benefit trade off should be considered, that
is, the cost of offering the discount rate should be compared with the benefit of using the money.

Cash discounts –reduction in the price of goods given to encourage early payment.

Effective discount rate – discount rate adjusted on an annual basis.

Formula: Effective discount rate: (Days in a year / remaining credit time) x [Discount rate / (100% - discount rate)]
Effective discount rate: Discount time turnover x adjusted discount rate per discount time

SELLER BUYER
� EDR < ROI of money collected in advance Offer trade discount
� EDR > ROI if money is used Ignore trade discount
� EDR < cost of money (e.g. interest rate) Ignore trade discount
� EDR > ROI of money collected in advance Do not offer trade discount
� EDR < ROI if money is used Avail trade discount
� EDR > cost of money Avail trade discount

Seasonal dating – used to induce customers to buy early by not requiring payment until the purchaser’s selling season,
regardless of when the goods are shipped.

Illustrative problem no. 9: (effective discount rate) If a firm is given a trade credit terms of 2/10, net 30, then the
cost to the firm failing to take the discount is: (use 360-days) _______________________

Solution:

Receivable portfolio analysis (receivable spread) – refers to the strategy of spreading investments in receivables over a
customer base. It gives an impression of whether the management is strict or lax in imposing its receivable policies and
whether the management is conservative or aggressive in its receivable investments.

INVENTORY MANAGEMENT

Objective of inventory management

Inventory is the stockpile of the product the firm is offering for sale and the components that make up the product. It is the
responsibility of the financial officer to maintain a sufficient amount of inventory to insure the smooth operation of the firm’s
production and marketing functions and at the same time avoid tying up funds in excessive and slow-moving inventory.

Functions of inventories

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1. Pipeline (transit) inventories. These are inventories which are being moved or transported from one location to another
and they fill the supply pipelines between stages of the entire production-distribution system

2. Organizational (decoupling) inventories. These are inventories that are maintained to provide each link in the
production-distribution chain a certain degree of independence from the others. These will also take care of random
fluctuations in demand and/or supply

3. Seasonal (anticipation) stock. These are built up in anticipation of the heavy selling season or in anticipation of price
increase or as part of promotional sales campaign

4. Batch (lot-size) inventories. These are inventories that are maintained whenever the user makes or buys material in
larger lots than are needed for his immediate purposes

5. Safety (buffer) stock. These inventories are maintained to protect the company from uncertainties such as unexpected
customer demand, delays in delivery goods ordered etc..

Inventory management – directly linked to the operating goal of giving the best service to customers.

Basic comparison between traditional and modern management models

Criteria Traditional Inventory management Modern Inventory management

● Objective Deliver sales on time at the lowest possible Delivers sales on time at the most reasonable
cost price

● Primary strategy Maintain adequate inventory holdings of Efficient scheduling of production process (i.e.
materials and finished goods input, throughput and output) through the use
of technology and linkages to suppliers

● Business environment ● Production is labor-intensive ● Production is technology-oriented

● Use of mechanical equipment and ● Use of electronic and mechanical
machineries equipment and machineries
● Product-oriented; functional in nature ● Process-oriented
● Emphasis on company-customer ● Emphasis on suppliers-company-customer
relations relations
● Less investment in capital expenditures ● Heavy investments in capital expenditures
● Generally, lesser cost of production in the ● Generally, lower cost of doing business in
short-run the long-run

● Inventory models ● Economic order quantity model ● Just-in-time (JIT)

● Reorder point ● Flexible manufacturing system
● Order cycling method ● Computer integrated manufacturing
● Two-bin system ● Materials requirements planning (MRP)
● Min-max model ● Manufacturing resource planning (MRP-II)
● ABC classification ● Enterprise resource planning

INVENTORY MANAGEMENT TECHNIQUES

1) Inventory planning. It involves the determination of what inventory quality, quantity, timing and location should be in
order to meet future business requirements.
a. Economic order quantity (EOQ) – refers to the units of materials that should be purchased to minimize total relevant
inventory costs.
Formula:
Economic Order Quantity:

In units:
__________________________________________________________
√ (2 x Annual demand x Cost per order) / Carrying cost per unit

In pesos:
________________________________________________________________
√ (2 x Annual demand in pesos x Cost per order) / Carrying cost ratio

Total relevant inventory costs – sum of ordering costs and carrying costs
Formula: Total ordering costs + Total carrying costs

Note: At Economic Order Quantity (EOQ), total ordering cost is EQUAL to total carrying cost.

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Ordering costs – include those spent in placing an order, waiting for an order, inspection and receiving costs,
setup costs and quantity discounts lost. Its total cost is taken from the historical records of the organization.
Formula:
● Total ordering costs: Cost per order x number of orders
● Cost per order: Total ordering costs / number of orders
● Number of orders: Annual demand / Order size

Carrying costs – those spent in holding, maintaining or warehousing inventories such as warehousing and
storage costs, handling and clerical costs, property taxes and insurance, deterioration and shrinkage of stocks,
obsolescence of stocks, interest and return on investment (e.g. lost return on investment tied up in inventory).
Formula:
● Carrying cost per unit: Total carrying cost / Average inventory
or Unit cost x Carrying cost ratio
● Carrying cost ratio: carrying cost per unit / Unit cost
● Average inventory: Order (lot) size / 2
● Total carrying costs: Carrying cost per unit x Average inventory

Relationship between order size, ordering costs and carrying costs

Order size Ordering costs Carrying costs

Increase Decrease Increase
Decrease Increase Decrease

b. Economic Production Run (economic production quantity; optimum production run; optimum lot size) . It refers to the size
of production where the total cost of materials will be at minimum. The EOQ formula can be used in determining
the optimum production run. This is the economic order quantity model for manufacturing firms, particularly in
terms of producing products.
Formula:
Economic Production Run
_______________________________________________
√ (2 x Annual demand x Set up cost) / Carrying cost per unit

c. Economic Order Quantity with “back orders”.

Back orders – sale made when the item is not in stock.
Formula:
Economic order quantity with back orders:
___________________________________________________________________
√ (2 x annual demand x cost per order)
[carrying cost per unit x (Cost of back orders / (Cost of back orders – Carrying cost per unit)]

d. Reorder point (ROP). It refers to the inventory level where a purchase order should be placed. It is the sum of lead
time quantity and safety stock quantity.
Formula:
Reorder point: Lead time quantity + Safety stock quantity

Lead time. Refers to the waiting time from the date the order is placed until the date the delivery is received.

Lead time quantity. It represents the normal usage during the lead time period.
Formula: Lead time quantity: Normal usage x Normal lead time

Normal usage. It means the average usage of inventory during a period (i.e. annual demand / working days in a
year)

Safety stock. It is set to serve as a margin in case of variations in normal usage and normal lead time. Hence, it
is a safety stock for variations in usage and a safety stock for variations in time.
Formulas:
Safety stock: Safety stock (usage) + Safety stock (time)
Safety stock (usage): (Maximum usage – Normal usage) x Normal lead time
Safety stock (time): (Maximum lead time – Normal lead time) x Normal usage

Maximum inventory level. It is the sum of the safety stock quantity and order size. The minimum quantity is
the safety stock quantity.
Formula: Safety stock quantity + Order size

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e. Stock out costs. Inadequate inventory levels carried by a business have the following costs: (1) extra purchasing,
handling and transportation costs; (2) lost sales and of customer goodwill; (3) additional clerical costs due to
keeping customer-back order records; (4) inflation-oriented increases in prices when inventory purchases are
deferred; (5) frequent stock-out costs leading to disruptions of production schedules, overtime and extra set-up
time; (6) higher price due to small quantities (e.g. extra purchasing on transportation costs); (7) foregone
suppliers’ discount. Stock out costs has two costs, the carrying costs of safety stock and costs of the stockout
occurrences.
Formula
● Total stockout costs: Cost of carrying costs of safety stock quantity + Cost of stockout occurrences
● Cost of carrying Safety stock quantity: Safety stock quantity x Carrying cost per unit
● Stockout cost per occurrence: Stockout cost per unit x Stockout units
● Cost of stockout occurrences:
Stockout cost per occurrence x Probability of occurrence x Number of occurrences

2) Inventory control systems

Inventory control – the regulation of inventory within predetermined limits

Effective inventory management should provide adequate stocks to meet the requirements of the business, while at the same
time keeping the required investment to a minimum.

a) Fixed order quantity system. It is a system wherein each time the inventory goes down to a predetermined level
(known as reorder point), an order for a fixed quantity is placed. It requires the use of perpetual inventory records
or the continuous monitoring of the inventory level.
� Min-max model – sets definable limits in inventory balances. Here the minimum inventory level serves as
the reorder point. It includes normal quantity to be used from the time an order is placed up to the time
the materials are received. The safety stock quantity to minimize the occurrence of stockout is also
included. The maximum inventory level is the sum of the stockout quantity and the order size.
� Two-bin system – reorder is placed when the contents of the first bin are used up. It is an inventory control
procedure in which an order is placed when one of two inventory-stocked items is empty
� Red-line method – an inventory control procedure in which a red line is drawn around the inside of an
inventory stocked bin to indicate the reorder point level.
� Computerized inventory control system – a system of inventory control in which a computer is used to
determine reorder points and to adjust inventory balances

b) Fixed reorder cycle system. It is also known as the periodic review or the replacement system where orders are made
after a review of inventory levels has been done at regular intervals. An order is placed if at the time of the review
the inventory level had gone down since the preceding review. The quantity ordered under this system is variable
depending on usage or demand during the review period.
Formula in getting the replenishment level:
M = B + D(R-L)
Where: M = replenishment level in units; B = buffer stock in units; D = average demand per day;
R = time interval in days, between reviews; L = lead time in days

c) Optional replenishment system. This represents a combination of the important control mechanisms of the other two
systems.
Formula in getting the replenishment level:
P = B + D(L + R/2)
Where: P = reorder point in units; B = buffer stock in units; D= average daily demand in units;
L = lead time in days; R = time between review in days

d) ABC Classification system (selective control model). Under this system, segregation of materials for selective control
is made. Inventories are classified into “A” (high value items), “ B” (medium cost items) and “C” (low cost items).
Control may be exercised on these items as follows:
1. A items – highest possible controls, including most complete, accurate records, regular review by top
supervisor, blanket orders with frequent deliveries from vendor, close follow-up through the factory deliveries
from vendors; close follow-up through the factory to reduce lead time, etc. Careful accurate determination of
order quantities and order point with frequent review to reduce, if possible
2. B items – normal controls involving good records and regular attention; good analysis for EOQ and order point
but reviewed quarterly only or when major changes occur
3. C items – simplest possible controls such as periodic review of physical inventory with no records or only the
simplest notations that replenishment stocks have been ordered; no EOQ or order point calculations

Inventory class
A B C
Money value High Middle Low
Quality control Very strict Not too strict Strict

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Inventory movements Slow Relatively fast Fast

Level of safety stock Low Moderate High
Quality of personnel Best available Average Fair
Quality of records Error-free Highly reliable Reliable
Replacement time ASAP Normal Can be long
Inventory turnover Low Average high

Illustrative problem no. 10A: (ordering costs). Malaking Siyudad Corp. expects to use 10,000 units of material Eks
per month in 2009. Last year, the total ordering costs amounted to P200,000 for a total of forty orders. It is expected that
prices in 2010 would be 10 percent higher than that of last year. Determine the expected ordering costs in 2010 if the
company orders in a batch of 12,000 units or 24,000 units.

Illustrative problem no. 10B: (carrying costs). In 2011, Isukat Mo Co. incurred a total of P800,000 for inventory
carrying costs with an average inventory of 200,000 units. What would be the total carrying costs in 2012 if the order size
is 500,000 or 900,000 units, assuming the company does maintain safety stock quantity.

Illustrative problem no.11A: (economic order quantity). Assume that a foreign regalo shop is attempting to
determine how many sets of gin glass to order. The store feels it will sell approximately 800 sets in the next year at a price
of P18 per set. The wholesale price that the store pays per set is P12. Cost of carrying one set of gin glasses are estimated to
at P1.50 per year while ordering costs are estimated at P25.
Required:
1) Determine the economic order quantity for the set of gin glasses
2) Determine the annual inventory costs for the firm if it orders in this quantity

Solution:

Illustrative problem no.11B: (economic production run). Assume the annual materials needed is 40,000 units,
the setup cost per production is P625, the variable manufacturing costs is P20 and the carrying costs ratio is 10 percent.
Compute for the economic production run.

Solution:

Illustrative problem no. 12: (reorder point). Alissa Corporation has the following production data: annual
requirement 40,000 units; number of working days 320 days; normal lead time 10 days; maximum lead time 16 days;
maximum usage 150 units and economic order quantity 5,000 units. Determine the following: normal daily usage, lead
time quantity; safety stock quantities, reorder point and maximum inventory levels.

Solution:
1. Normal daily usage:
2. Lead time quantity:
3. Safety stock quantities:
a) In usage:
b) In time:
Total safety stock:
4. Reorder point:
5. Maximum inventory level:

Illustrative problem no. 13: (stockout costs)Assume a company uses an inventory where it places 12 orders per
year, the cost of the stockout is P200 per occurrence, the carrying cost per unit is P2 per year and the probabilities of
stockouts have been estimated for various levels of safety stock as follows:

Safety stock Probability Carrying cost Expected stockout per Cost of stockout per Total costs
(units) of stockout year occurrences
0 0.60
100 0.50
200 0.40
400 0.20
600 0.10

Determine the optimal safety stock level.

SHORT TERM FINANCING

Two basic problems encountered in managing the firm’s use of short-term financing:
a) Determining the level of short-term financing the firm should use
b) Selecting the source of short-term financing

Advantages and disadvantages of short term financing

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1) Speed. A short-term loan can be obtained much faster than long-term credit. Lenders will insist on a more thorough
financial examination before extending long-term credit, and the loan agreement will have to be spelled out in
considerable detail because a lot can happen during the life of a 10- to 20- year loan. Therefore, if funds are needed in
a hurry, the firm should look to the short-term markets.

2) Flexibility. If it needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for
three reasons: (1) flotation costs are higher for long-term debt than for short-term debt; (2) although long-term debt
can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be
expensive. According if a firm thinks its need for funds will diminish in the near future, it should choose short-term
debt; (3) long term loan agreements always contain provisions (or covenants) which constrain the firm’s future
actions. Short term credit agreements are generally less expensive.

Sources of short-term financing

1. Accrued liabilities. These are continually recurring short-term liabilities, especially accrued wages and accrued taxes.
These increase automatically (spontaneously) as a firm’s operations expand. Further, this type of debt is “free” in the
sense that no explicit interest is paid on funds raised through accrued liabilities.

2. Accounts payable (trade credits). These are debt arising from credit sales and recorded as accounts receivables by the
seller and as an account payable by the buyer. It is the largest single category of short-term debt, representing about
40 percent of the current liabilities of the average nonfinancial corporation. The percentage is somewhat larger for
smaller firms; because small companies often do not qualify for financing from other sources, they rely especially
heavily on trade credit. Trade credit is a “spontaneous” source of financing in the sense that it arises from ordinary business
transactions.

● Components of trade credit:

1) Free trade credit – credit received during the discount period
2) Costly trade credit – credit in excess of free trade credit, whose cost is equal to the discount lost.

Formula in getting the cost of trade credit:

Nominal Cost of trade credit: Discount percent x # of days in a year
( 100% - Discount percent) (Days credit outstanding – Discount period)

Effective cost of trade credit:

Discount rate [# of days in a year/ (days credit outstanding – discount period)]

(100% - Discount rate) -1

Stretching Account payable – the practice of deliberately paying late.

3. Bank loans. Commercial banks, whose loans generally appear on the balance sheets as notes payable, are second in
importance to trade credit as a source of short-term financing for non-financial corporations. The banks’ influence is
actually greater than it appears from the peso amounts because banks provide nonspontaneous funds. As a firm’s
financing need increase, it requests additional funds from its bank.

Key features of bank loan:

● Maturity. Although banks do make longer-term loans, the bulk of lending is on a short-term basis – about 2/3 of
all bank loans mature min a year or less. Bank loans to businesses are frequently written as 90-day notes, so the
loan must be repaid or renewed at the end of 90 days. Of course, if a borrower’s financial position has
deteriorated, the bank may refuse to renew the loan. This can mean serious trouble for the borrower.

● Promissory notes. It is a document specifying the terms and conditions of a loan, including the amount, interest
rate and repayment schedule.

Key elements contained in promissory notes:

a) Interest only versus amortized. Loans are either interest-only, meaning that only interest is paid during the
life of the loan, and the principal is repaid when the loan matures, or amortized, meaning that some of the
principal is repaid on each payment date. Amortized loans are called instalment loans.
b) Collateral. If a short-term loan is secured by some specific collateral generally accounts receivable or
inventories, this fact is indicated in the note.
c) Loan guarantees. If the borrower is a small corporation, its bank will probably insist that the larger
stockholders personally guarantee the loan. Banks have often seen a troubled company’s divert assets from
the company to some other entity he or she owned, so banks protect themselves by insisting on personal
guarantees. However, stockholder guarantees are virtually impossible to get in the case of larger

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corporations that have many stockholders. Also, guarantees are unnecessary for proprietorships or
partnerships because here the owners are already personally liable for the business’ s debts.
d) Nominal (stated) interest rate. The interest rate can be wither fixed or floating. If it floats, it is generally
indexed to the bank’s prime rate, to the T-bill rate or to the London Inter-Bank Offer rate (LIBOR). Most
loans of any size ($25,000 and up) have floating rates if their maturities are greater than 50 days. The note
will also indicate whether the bank uses 360 – or 365 day year for purposes of calculating interest

Prime rate – a published interest rate charged by commercial banks to large, strong borrowers

e) Frequency of interest payments. If the note is on an interest-only basis, it will indicate how frequently
interest must be paid. Interest is typically calculated on a daily basis but paid monthly.
f) Maturity. Long-term loans always have specific maturity dates. A short-term loan may or may not have a
specified maturity. Banks never call demand notes unless the borrower’s creditworthiness deteriorates, so
some “short-term loans” remain outstanding for years, with the interest rate floating with rates in the
economy.
g) Discount interest. Most loans call for interest to be paid after it has been earned, but discount loans require
that interest must be paid in advance. If the loan is on a discount basis, the borrower actually receives less
than the face amount of the loan and this increases the loan’s effective cost. It is an interest that is calculated
on the face amount of a loan but is paid in advance.
h) Add-on basis instalment loans. Auto loans and other types of consumer instalment loans are generally setup
on an “add-on basis”, which means the interest charges over the life of the loan are calculated and then
added to the face amount of the loan. Thus, the borrower signs a note for the funds received plus the
interest. The add-on feature also raises the effective cost of a loan.

Add on interest – interest that is calculated and added to funds received to determine the face amount of an
instalment loan.

Formula in computing
Effective annual rate add-on: (1+kd) – 1.0
n
●
● Annual percentage rate (APR): Periods per year x Rate per period

i) Other cost elements. Some loans require compensating balances, and revolving credit agreements often
require commitment fees. Both of these conditions will be spelled out in the loan agreement, and both raise
the effective cost of a loan above its stated nominal rate.

● Compensating balances. A minimum checking account balances that a firm must maintain with a commercial
bank, generally equal to 10 to 20 percent of the amount of loans outstanding.

● Informal Line of credit. It is an informal agreement between bank and a borrower indicating the maximum
credit the bank will extend to the borrower.

● Revolving credit agreement. It is a formal line of credit extended by a bank or other lending institutions. The
bank has a legal obligation to honor a revolving credit agreement and it receives a commitment fee. Neither the
legal obligation nor the fee exists under the informal line of credit.
Often a line of credit will have clean-up clause that requires the borrower to reduce the loan balance to zero at least
once a year. Keep in mind that a line of credit typically is designed to help finance negative operating cash flows that are
incurred.

Criteria in choosing a bank:

a) Willingness to assume risks e) Maximum loan size
b) Advice and counsel f) Merchant banking
c) Loyalty to customers g) Other services (e.g. management services)
d) Specialization

Cost of Bank loans (Effective Annual Rate)

Without compensating balance With compensating balance

● Not discounted Cost = Interest Cost = Interest

Amount received (Face value – Compensating balance)
● Discounted Cost = Interest Cost = interest
(face value – interest) (face value – Interest- Compensating balance)

4. Commercial paper. Unsecured, short-term promissory notes of large firms, usually issued in denominations of
$100,000 or more and having an interest rate somewhat below the prime rate.

Cost of commercial paper:

[(interest + issue cost) / (Face value – Interest – Issue cost)] x [ # of days in a year / term]

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Illustrative problem no. 14: (current asset financing). Vanderheiden Press Inc. and the Herrenhouse Publishing
Company had the following balance sheets as of December 31, 2010 (in thousands of dollars):

Vanderheiden press Herenhouse publishing

Current assets P 100,000 P 80,000
Fixed assets (net) 100,000 120,000
Total assets P 200,000 P 200,000
Current liabilities P 20,000 P 80,000
Long-term debt 80,000 20,000
Common stock 50,000 50,000
Retained earnings 50,000 50,000
Total liabilities and equity P 200,000 P 200,000

Earnings before interest and taxes for both firms are P30 million and the effective tax rate is 40 percent.
a) What is the return on equity for each firm if the interest rate on current liabilities is 10 percent?
b) Assume that the short term rate rises to 20 percent. While the rate on new long-term debt rises to 16 percent. The
rate on existing long-term debt remains unchanged. What would be the return on equity for Vanderheiden Press
and Herrenhouse Publishing under these conditions?

Solution:
Income statements for the year ended 12/31/2010 (thousands of pesos)
Vanderheiden press Herrenhouse publishing
a) b) a) b)
EBIT P 30,000 P 30,000 P 30,000 P 30,000
INTEREST
TAXABLE INCOME
TAXES (40%)
NET INCOME
EQUITY P 100,000 P 100,000 P 100,000 P 100,000
RETURN ON EQUITY

Illustrative problem no. 15: (cost of trade credit). What is the nominal and effective cost of trade credit (on a 365-
day basis) under the credit terms 3/15, net 30?

Solution:
Nominal cost of trade credit
Effective cost of trade credit

Illustrative problem no. 16: (cost of bank loans). Alpha Trading Company was granted P200,000 bank loan with
12 percent stated interest.
Required: The effective annual rate, under the following cases:

a. The company receives the entire amount

b. The company was granted a discounted
loan
c. The company required to maintain a
compensating balance of P10,000 under
the non-discounted loan
d. The company is required to maintain a
compensating balance of 10 percent under
a discounted loan

Illustrative problem no. 17: (cost of commercial paper). Beta Company plans to sell P100 million in 180-day
maturity paper, which it expects to pay discounted interest at an annual rate of 12 percent per annum due to this
commercial paper, Beta Company expects to incur P100,000 in dealer placement fees and paper issuance costs. The
effective cost of Beta’s credit is: ______________________

Illustrative problem no. 18: (c0st of factoring receivables). DEF Trading has P200,000 in receivable that carries
360-day credit term, 2 percent factor’s fee, 6 percent holdback reserve and an interest of 12 percent per annum on
advances.
Required:
a) Cash proceeds from factoring DEF’s receivables
b) Effective annual financing cost of factoring the receivable
Formula: [(Factor’s fee + Interest) / Proceeds] x (# of days in a year / term

END OF LECTURE

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