Introduction To Working Capital Management

Ch.
15:
Introduction to
Working Capital
Management
10/2/20 1
Working-Capital Management
 Current Assets
 cash, marketable securities, inventory,
accounts receivable
 Long-Term Assets
 equipment, buildings, land
 Which earn higher rates of return?

 Which help avoid risk of illiquidity?
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 Illiquidity
 Illiquid refers to the state of a stock, bond, or other assets that
cannot easily and readily be sold or exchanged for cash without a
substantial loss in value. ... Illiquidity occurs when a security or
other asset that cannot easily and quickly be sold or exchanged
for cash without a substantial loss in value.
 Examples of illiquid assets include penny stocks, microcap
stocks and nanocap stocks; ownership interests in private
companies; collectibles like art and antiques; partnership shares
in hedge funds and alternative investments; certain types of
options, futures and forward contracts; and some types of bonds
and debt ...
10/2/20 3
 Illiquidity Risk
 The illiquidity risk premium is an excess return paid to
investors for tying up capital. The premium compensates
the investor for forfeiting the options to contain mark-to-
market losses and to adapt positions to a changing
environment.
 Illiquidity and Insolvency
 Being illiquid means that you don't have resources
available to meet your current obligations. Figuring this
out is straightforward: either you can pay your bills or
you can't.
 Being insolvent means that you owe more than you
own.
10/2/20 4
 Current Assets
 cash, marketable securities, inventory,
accounts receivable
 Long-Term Assets
 equipment, buildings, land
 Risk-Return Trade-off:
Current assets earn low returns, but
help reduce the risk of illiquidity.
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 Current Liabilities
 short-term notes, accrued expenses,
accounts payable
 Long-Term Debt and Equity
 bonds, preferred stock, common stock
 Which are more expensive for the firm?

 Which help avoid risk of illiquidity?
10/2/20 6
 Current Liabilities
 short-term notes, accrued expenses,
accounts payable
 Long-Term Debt and Equity
 bonds, preferred stock, common stock
 Risk-Return Trade-off:
Current liabilities are less expensive,
but increase the risk of illiquidity.
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt

Preferred Stock
Common Stock
To illustrate, let’s finance all current assets

with current liabilities,
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Balance Sheet

Preferred Stock
Common Stock

with current liabilities,
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Balance Sheet

Preferred Stock
Common Stock

with current liabilities, and finance all
fixed assets with long-term financing.
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Balance Sheet

Preferred Stock
Common Stock

with current liabilities, and finance all
fixed assets with long-term financing.
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Balance Sheet

Preferred Stock
Common Stock
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Balance Sheet

Preferred Stock
Common Stock
Suppose we use long-term financing to

finance some of our current assets.
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Balance Sheet

Preferred Stock
Common Stock

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Balance Sheet

Preferred Stock
Common Stock

This strategy would be less risky, but more
expensive!
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Balance Sheet

Preferred Stock
Common Stock
10/2/20 16
Balance Sheet

Preferred Stock
Common Stock
Suppose we use current liabilities to

finance some of our fixed assets.
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Balance Sheet

Preferred Stock
Common Stock

10/2/20 18
Balance Sheet

Preferred Stock
Common Stock

This strategy would be less expensive, but
more
10/2/20 risky! 19
The Hedging Principle
 Permanent Assets (those held > 1 year)
 should be financed with permanent and
spontaneous sources of financing.
 Temporary Assets (those held < 1 year)
 should be financed with temporary
sources of financing.
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Balance Sheet
Temporary
Current Assets
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Balance Sheet
Temporary Temporary
Current Assets Short-term financing
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Balance Sheet
Temporary Temporary
Permanent
Fixed Assets
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Balance Sheet
Temporary Temporary
Permanent Permanent
Fixed Assets Financing
and
Spontaneous
Financing
10/2/20 24
The Hedging Principle
 Permanent Financing
 intermediate-term loans, long-term debt,
preferred stock, common stock
 Spontaneous Financing
 accounts payable that arise spontaneously
in day-to-day operations (trade credit,
wages payable, accrued interest and taxes)
 Short-term financing
 unsecured bank loans, commercial paper,
loans secured by A/R or inventory
10/2/20 25
Cost of Short-Term Credit
Interest = principal x rate x time
ex: borrow $10,000 at 8.5% for 9 months
Interest = $10,000 x .085 x 3/4 year

= $637.50
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We can use this simple relationship:

to solve for rate, and get the
10/2/20 27

Annual Percentage Rate (APR)
10/2/20 28

Annual Percentage Rate (APR)
interest 1
APR = x
principal time
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10/2/20 30
interest 1
APR = x
principal time
10/2/20 31
interest 1
APR = x
principal time
example: If you pay $637.50 in

interest on $10,000 principal for 9
months:
10/2/20 32
interest 1
APR = x
principal time
example: If you pay $637.50 in

interest on $10,000 principal for 9
months:
APR = 637.50/10,000 x 1/.75 = .085

= 8.5% APR
10/2/20 33
Annual Percentage Yield (APY) is

similar to APR, except that it
accounts for compound interest:
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APY = (i m
m 1 + ) - 1
10/2/20 35

APY = (i m
m 1 + ) - 1
i = the nominal rate of interest
m = the # of compounding periods per year36
10/2/20
What is the (APY) of a 9% loan with

monthly payments?
APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938
= 9.38%
10/2/20 37
Sources of Short-term Credit
 Unsecured
10/2/20 38
 Unsecured
 accrued wages and taxes
10/2/20 39
 Unsecured
 trade credit
10/2/20 40
 Unsecured
 trade credit
 bank credit
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 Unsecured
 trade credit
 bank credit
 commercial paper
10/2/20 42
 Unsecured
 trade credit
 bank credit
 Secured
10/2/20 43
 Unsecured
 trade credit
 bank credit
 Secured
 accounts receivable loans
10/2/20 44
 Unsecured
 trade credit
 bank credit
 Secured
 accounts receivable loans
 inventory loans
10/2/20 45

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Ch.

 Which earn higher rates of return?

 Which are more expensive for the firm?

Fixed Assets Long-Term Debt

To illustrate, let’s finance all current assets

Fixed Assets Long-Term Debt

To illustrate, let’s finance all current assets

Fixed Assets Long-Term Debt

To illustrate, let’s finance all current assets

Fixed Assets Long-Term Debt

To illustrate, let’s finance all current assets

Fixed Assets Long-Term Debt

Fixed Assets Long-Term Debt

Suppose we use long-term financing to

Fixed Assets Long-Term Debt

Suppose we use long-term financing to

Fixed Assets Long-Term Debt

Suppose we use long-term financing to

Fixed Assets Long-Term Debt

Fixed Assets Long-Term Debt

Suppose we use current liabilities to

Fixed Assets Long-Term Debt

Suppose we use current liabilities to

Fixed Assets Long-Term Debt

Suppose we use current liabilities to

Interest = principal x rate x time

ex: borrow $10,000 at 8.5% for 9 months

Interest = $10,000 x .085 x 3/4 year

We can use this simple relationship:

We can use this simple relationship:

We can use this simple relationship:

example: If you pay $637.50 in

example: If you pay $637.50 in

APR = 637.50/10,000 x 1/.75 = .085

Annual Percentage Yield (APY) is

Annual Percentage Yield (APY) is

Annual Percentage Yield (APY) is

What is the (APY) of a 9% loan with

APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938

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