Quiz 5

Working Capital
Policy
1
Learning Objectives
 Understand the importance of working
capital.
 The liquidity-profitability trade-off.
 Determining the optimal level of
current assets.
 The risk and return implications of
alternative approaches to working
capital financing policy.
2
The Importance of Managing and
Accumulating Working Capital
 Working capital is the amount of the
firm’s current assets: cash, accounts
receivable, marketable securities,
inventory and prepaid expenses.
 Managing the level and financing of
working capital is necessary:
– to keep costs under control (e.g. storage of
inventory)
– to keep risk levels at an appropriate level
(e.g. liquidity)
3
Managing Current Assets
& Liabilities
 Net Working Capital
= Current Assets - Current Liabilities
 Determining the “Correct” level of Working
Capital
– Balance Risk & Return
– Benefits of Working Capital
 Higher Liquidity (Lowers Risk)
– Costs of Working Capital
 Lower Returns - $$ invested in lower returning
securities rather than production.
4
Example: Risk-Return Trade-off
Compare the 2 following companies
Firm 1 Firm 1
Marketable Securities 0 ST Debt 100
Other Current Assets 200
Fixed Assets 800 LT Debt 400
Total Assets 1000
Common Stock 500
Firm 1 Total Liabilities&Equity 1000

Operating Earnings 150 Current Ratio = Current Assets
Interest Earned 0 Current Liabilities
EBT 150
Taxes (40%) -60 = 200
Net Income 90 100
Current Ratio 2 = 2
5
Firm 1 Firm 1
Marketable Securities 0 ST Debt 100
Other Current Assets 200
Fixed Assets 800 LT Debt 400
Total Assets 1000
Common Stock 500
Firm 1 Total Liabilities&Equity 1000

Operating Earnings 150 Net Income
Return on Assets = Assets
Interest Earned 0
EBT 150 90
=
Taxes (40%) -60 1000
Net Income 90
= .09 = 9%
Current Ratio 2
ROA 9% 6
Firm 1 Firm 2 Firm 1 Firm 2
Marketable Securities 0 200 ST Debt 100 100
Other Current Assets 200 200 LT Debt 400 400
Fixed Assets 800 800 Common Stock 500 700
Total Assets 1000 1200 Total Liabilities&Equity 1000 1200
Firm 1 Firm 2 Firm 2:

Operating Earnings 150 150
Interest Earned 0 8 $200 Marketable Securities
EBT 150 158 Financed with Common Stock
Taxes (40%) -60 -63
Net Income 90 95 200 x 4% = $8 interest earned
Current Ratio 2
ROA 9% 7
Firm 1 Firm 2
Interest Earned 0 8 Current Ratio = CA
EBT 150 158 CL
Taxes (40%) -60 -63 400
Net Income 90 95 =
100
Current Ratio 2 4 =4
ROA 9% 8
Firm 1 Firm 2
Operating Earnings 150 150 NI
Interest Earned 0 8 Return on Assets = Assets
EBT 150 158
Taxes (40%) -60 -63 = 95
Net Income 90 95 1200
Current Ratio 2 4
=.079 = 7.9%
ROA 9% 7.9% 9
Firm 1 Firm 2
Interest Earned 0 8 Firm 1 Firm 2
EBT 150 158 Higher ROA Lower ROA
Taxes (40%) -60 -63 Less Liquid More Liquid
Net Income 90 95 Riskier Less Risky
Current Ratio 2 4
ROA 9% 7.9% 10
Variation in assets over time
Total Assets
$5M
}
Time
Fixed
Assets
Assume ZERO Long-term Growth 11

Total Assets
$7M
$5M
} Permanent
Current Assets
}
Time
Fixed
Assets
12
Total Assets
$10M
Temporary Current Assets
$7M
$5M
} Permanent
Current Assets
} Time
Fixed
Assets
13
Different Approaches to Financing
 Conservative Approach
– Finance all fixed assets, permanent current assets,
and some temporary with LT debt or equity. ST
financing is used for the remaining temp. current
assets.
– Lower risk, lower return
14
Financing Current Assets:
Conservative Approach
Total Assets
Short-term
Sources
$10M
$7M
} Permanent
Long-term
Sources
Current Assets
$5M
}
Time
Fixed
Assets
15
Different Approaches to
Financing
– Finance all fixed assets, permanent current assets,
and some temporary with LT debt or equity. ST
financing is used for the remaining temp. current
assets.
 Moderate Approach (Maturity Matching)
– Finance fixed assets and permanent current assets
with LT funds and temporary current assets with
ST funds.
– Moderate risk, moderate return 16
Moderate Approach
Total Assets
$10M
$7M
} Permanent
Current Assets
Long-term
$5M
}
Sources
Fixed
Assets
Time
17
Moderate Approach
Total Assets
Short-term
Sources
$10M
$7M
} Permanent
Current Assets
Long-term
$5M
}
Sources
Fixed
Assets
Time
18
Different Approaches to
Financing
– Finance all fixed assets, permanent current assets, and some
temporary with LT debt or equity. ST financing is used for
the remaining temp. current assets.
 Moderate Approach (Maturity Matching)
– Finance fixed assets and permanent current assets with LT
funds and temporary current assets with ST funds.
– Moderate risk, moderate return
 Aggressive Approach
– Finance all temporary current assets, permanent current
assets, and some fixed assets with ST debt. LT financing is
used for the remaining fixed assets.
– Higher risk, higher return
19
Aggressive Approach
Total Assets
Short-term
Sources
$10M
$7M
$5M
} Permanent
Current Assets
Long-term Sources
}
Time
Fixed
Assets
20
Managing (WARM, SOFT) Cash
21
How much cash should a
firm keep on hand?
 Managers must keep enough cash to
make payments when needed.
(Minimum balance)
 But since cash is a non-earning asset,
managers should invest excess returns
and keep just the amount of cash that
is necessary.
(Maximum balance)
23
The size of the minimum
cash balance depends on:
 How quickly and cheaply a firm can
raise cash when needed.
 How accurately managers can predict
cash requirements.
 How much precautionary cash the
managers need for emergencies.
Link to Dun & Bradstreet

24
The firm’s maximum cash
balance depends on:
 Available (short-term) investment
opportunities
– e.g. money market funds, CDs, commercial
paper
 Expected return on investment opportunities
(opportunity cost)
– If high expected return, firms are quick to invest
excess cash
 Transaction cost of withdrawing cash and
making an investment
Link to Bureau of Economic Analysis

25
Choosing the Optimum Cash
Balance
Cash Balances in a Typical Month
Dollars in the Cash Account
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month 26
Balance
Invest Excess
Cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Balance
Sell Securities to
obtain cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
The Miller - Orr Model
 The Miller-Orr Model provides a formula for
determining the optimum cash balance, the
point at which to sell securities (lower limit)
and when to invest excess cash (upper
limit).
 Depends on:
– transaction costs of buying or selling securities
– variability of daily cash
– return on short-term investments
29
The Miller-Orr Model
- Target Cash Balance (Z)
3
3 x TC x V
Z= +L
4xr
where: TC = transaction cost of buying
or selling securities
V = variance of daily cash flows
r = return on short-term
investments
L = minimum cash requirement 30
Example: Suppose that short-term securities

yield 5% per year (r) and it costs the firm
$50 each time it buys or sells securities
(TC). The variance of cash flows is $100,000
(V) and your bank requires $1,000 minimum
checking account balance (L).
31
 Example
3
Z = 3 x 50 x 100,000
+ $1,000
4 x .05/365
= $3,014 + $1,000 = $4,014
32
The Miller-Orr Mode
- Upper Limit
 The upper limit for the cash account (H) is
determined by the equation:
H = 3Z - 2L
where:
Z = Target cash balance
L = Lower limit
 In the previous example:
H = 3 ($4,014) - 2($1,000) = $10,042
33
Forecasting Cash Needs
- Cash Budget
 Used to determine monthly needs and
surpluses for cash during the planning
period
 Examines timing of cash inflows and
outflows i.e. when checks are written and
when deposits are made.
 Payments to suppliers are typically made
some time after shipment is received.
 Receipts from credit customers are received
some time after sale is recorded. 34
Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has the

following information:
Previous Sales
November 2007 130,000
December 2007 125,000
Forecast Sales
January 2008 120,000
February 2008 260,000
March 2008 140,000
April 2008 140,000
35
Rocky Mountain Climbing, Inc. (RMC) has the

following information:
Previous Sales: November 2007 130,000
December 2007 125,000
Forecast sales for: January 2008 120,000
February 2008 260,000
March 2008 140,000
April 2008 140,000
Collections : 30% of customers pay cash
50% pay in month after sale
20% pay 2 months after sale
36
Other information for RMC Cash Budget:
Purchases of inventory are 75% of sales

and are made 2 months before sale
and are paid for 1 month after delivery
Other expenses $14,000 per month

Taxes $10,000 due in March
Cash Balance (Dec. 31, 2007) = $28,000

Minimum balance required by bank = $25,000
(ST borrowing rate = 6% annually) 37
Steps in the Cash Budget
 Forecast of monthly collections and

other cash inflows
 Forecast of purchases and other cash
outflows
 Summarize the effect on net monthly
cash flows and determine borrowing
needs or surpluses.
38
Cash Budget - Collections
 In each month RMC will collect cash from sales that
have occurred in that month and in the preceding
two months.
 In January, sales are 120,000
 Collections:
– 30% x $120,000 (January sales) = 36,000
– 50% x $125,000 (December sales) = 62,500
– 20% x $130,000 (November sales) = 26,000
 Total cash collected in January =$124,500
39
Sales made in January will not be fully
collected until March.
Collection of January Sales
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000

36,000
120,000
120,000xx.30
.30
40

Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000

36,000 60,000
120,000
120,000xx.30
.30 120,000
120,000xx.50
.50
41

Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000

36,000 60,000 24,000
120,000
120,000xx.30
.30 120,000
120,000xx.50
.50 120,000
120,000xx.20
.20
42
Calculate collections for other months.
Cash Budget
RMC, Inc.
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
Collections:
Month of Sale (30%) 36,000 78,000 42,000
First Month (50%) 62,500 60,000 130,000
2nd Month (20%) 26,000 25,000 24,000
Total Collections 124,500 163,000 196,000
43
Cash Budget -
Purchases/Payments
Purchases are made 2 months prior to
sale and are paid for 1 month later.
Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000

90,000
75%
75%of
ofJanuary
JanuarySales
SalesPurchased
Purchasedinin
November
November
44
Cash Budget -
Purchases/Payments
Purchases are made 2 months prior to
sale and are paid for 1 month later.
Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000

90,000 90,000
75%
75%of
ofJanuary
JanuarySales
SalesPurchased
Purchasedinin
November,
November,Paid
Paidfor
forininDecember
December
45
Cash Budget -
Purchases/Payments
Calculate payments for all months.
Note that in order to do a cash budget,
you will need forecasts of sales for April.
Cash Budget
RMC, Inc.
Nov Dec Jan Feb Mar Apr
Sales 130,000 125,000 120,000 260,000 140,000 140,000
Purchases 195,000 105,000 105,000
Payments 195,000 105,000 105,000
46
Cash Budget
RMC, Inc.
Jan Feb Mar
Cash Collections 124,500 163,000 196,000
Material Payments 195,000 105,000 105,000
Summary
Summary of
ofPrevious
Previous Calculations
Calculations
47
Cash Budget
RMC, Inc.
Jan Feb Mar
Other Payments:
Other Expenses 14,000 14,000 14,000
Tax Payments 0 0 10,000
Remaining
RemainingCash
CashOutflows
Outflows
48
Cash Budget
RMC, Inc.
Jan Feb Mar
Other Payments:
Rent 2,000 2,000 2,000
Other Expenses 12,000 12,000 12,000
Tax Payments 0 0 10,000
Net Monthly Change (84,500) 44,000 67,000
49
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan Feb Mar
Beginning Cash Balance 28,000
Ending Cash (No Borrow)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Cumulative Borrowing
50
Cash Budget
RMC, Inc.
Jan Feb Mar
Ending Cash (No Borrow) (56,500)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
51
Cash Budget
RMC, Inc.
Jan Feb Mar
Needed (Borrowing)
Loan Repayment Target
TargetEnding
EndingBalance
Balance
Interest Cost
Ending Cash Balance 25,000
52
Cash Budget
RMC, Inc.
Jan Feb Mar
Needed (Borrowing) 81,500
Loan Repayment 0
Interest Cost 0
Ending Cash Balance 25,000 Borrowing
BorrowingRequired
Requiredto
to
Cumulative Borrowing cover
coverMinimum
MinimumBalance
Balance
and
andDeficit
Deficit
56,500+25,000
53
Cash Budget
RMC, Inc.
Jan Feb Mar
Loan Repayment 0
Interest Cost 0
Cumulative Borrowing 81,500
54
Cash Budget
RMC, Inc.
Jan Feb Mar
Beginning Cash Balance 28,000 25,000
Ending Cash (No Borrow) (56,500) 69,000
Loan Repayment 0
Interest Cost 0
55
Cash Budget
RMC, Inc.
Jan Feb Mar
Needed (Borrowing) 81,500 0
Loan Repayment 0
Interest Cost 0 408
Ending Cash Balance 25,000 25,000
Interest
InterestIncurred
Incurredon
onPrior
Prior
Month
MonthBorrowing
Borrowing
81,500 x .005 56
Cash Budget
RMC, Inc.
Jan Feb Mar
Loan Repayment 0 43,592
Interest Cost 0 408
Amount
Amountthat
thatcan
canbe
berepaid
repaidfrom
from
monthly
monthly surplus
surplus
69,000 - 408 - 25,000=$43,592 57
Cash Budget
RMC, Inc.
Jan Feb Mar
Interest Cost 0 408
Cumulative Borrowing 81,500 37,908
New
NewLoan
LoanBalance
Balance
81,500 - 43,592=$37,908
58
Cash Budget
RMC, Inc.
Jan Feb Mar
Beginning Cash Balance 28,000 25,000 25,000
Ending Cash (No Borrow) (56,500) 69,000 92,000
Interest Cost 0 408
59
Cash Budget
RMC, Inc.
Jan Feb Mar
Needed (Borrowing) 81,500 0 0
Interest Cost 0 408 190
Interest
InterestIncurred
Incurredon
onPrior
Prior
Month
MonthBorrowing
Borrowing
37,908 x .005
60
Cash Budget
RMC, Inc.
Jan Feb Mar
Loan Repayment 0 43,592 37,908
Repay
RepayOutstanding
OutstandingLoan
Loan
Balance
Balance
61
Cash Budget
RMC, Inc.
Jan Feb Mar
Loan Repayment 0 43,592 37,908
Ending Cash Balance 25,000 25,000 53,902
Cumulative Borrowing 81,500 37,908 0
Ending
EndingCash
CashBalance
Balance
$53,902-$25,000=$28,902 Surplus 62
Cash Budget
RMC, Inc.
Jan Feb Mar
Ending Cash Balance 25,000 25,000 53,902
Cumulative Borrowing 81,500 37,908 0
RMC needs to raise $81,500 in short-term debt in

January, would probably take out a short-term bank
loan. In March RMC has a 28,902 surplus. It would
probably invest in marketable securities at this point
in time.
63
Managing Cash Inflows and
Outflows
 Generally managers try to increase the
amount of cash flowing into a business
during any given time period.
 They also try to slow down cash
outflows.
 Collect early and Pay late (but not too
late).
64
Managing Cash Flows
 Can increase cash inflows (or speed them
up) by:
– Increasing cash sales
– Increasing credit sales collections
 Can decrease cash outflows (or slow them
down) by:
– Cutting costs
– Taking full advantage of time allowed to pay
obligations
65
Managing Cash Flows
 Can speed up inflows by:
– Tightening up credit policy (as long as savings
from reduced bad debts and collection costs
exceed sales that may be lost)
– Obtaining computerized fund transfers from
customers
– Using collection centers
– Using a lockbox system
 Can slow down cash outflows by:
– Delaying the payment of bills
– Using remote disbursement banks
66
Accounts Receivable
and Inventory
67
Learning Objectives
 How and why firms manage accounts

receivable and inventory.
 Computation of optimum levels of
accounts receivable and inventory.
 Alternative inventory management
approaches.
 How firms make credit decisions and
create collection policies.
68
Why do firms accumulate
accounts receivable and
inventory?
 Given that accounts receivable and
inventory are assets that do not provide an
explicit rate of return, it is important to
understand why firms might still want to
have these investments.
 Granting credit is often an essential business
practice and can enhance sales. (But also
will increase costs.)
 Holding adequate inventory is necessary to
avoid loss of sales due to stock-outs.
69
Finding the Optimum Level
of Accounts Receivable
 Firm’s managers must review the firm’s
credit policies and evaluate the impact of
any proposed changes in policies based on
the NPV of incremental cash flows due to
the change.
 This is similar to the method we used in
determining the best capital budgeting
projects to undertake.
Link to Hoover’s Online
70
Accounts Receivable
Management
 The terms of sale are generally stated
in the form X / Y, n Z
 This means that the customer can
deduct X percentage if the account is
paid within Y days; otherwise, the
account must be paid within Z days.
Example: 2/10 n 30
– The company offers a 2% discount if
account paid in 10 days.
– Balance due in 30 days. 71
Effects of Tightening
Credit Policy
 Raise credit standards
– Fewer credit customers (could reduce sales)
– Lower accounts receivable
 Shorten net due period
– Accounts paid sooner
– Lower accounts receivable
 Reduce discount percentage
– Fewer take the discount
 Shorten discount period
– Same as above
72
Average Collection Period
(ACP)
 Old Policy; 2/10, n30
– 35% of customers pay in 10 days
– ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days
 New Policy; 2/10, n40
– 35%of customers pay in 10 days
– ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days
73
Analysis of Accts. Receivable
Changes
 Develop pro forma financial statements for
each policy under consideration.
 Use the pro formas to estimate incremental
cash flows by comparing forecasts to
current policy cash flows.
 Use the incremental cash flows to estimate
the NPV of each policy change.
 Choose the policy change that maximizes
the value of the firm (highest NPV).
74
Analysis of Accts.
Receivable Changes
 Example:
ABC Corporation is considering a credit policy
change from offering no credit to offering 30
days credit with no discount (n 30).
 Why might they do this?
-Increase sales
-Increase market share
 What costs will the firm incur as a result?
-Cost of carrying accounts receivable
-Potential increase in bad debts
-Credit analysis and collection costs
75
Analysis of Accts. Receivable
Changes
 Assume the Net Incremental Cash Flows
associated with ABC’s new credit policy are as
follows:
 External financing (Init. Investment) =
$28,000 t=0
– Increase in sales = $30,000
t=1,2...
– Increase in COGS = $15,000
– Increase in Bad Debts = $3,000
– increase in Other Expenses = $5,000
– Increase in Interest Expense = $500
– Increase in Taxes = $2,600
– Total Incr. Operating Cash Flow =
$3,900/yr. 76
Analysis of Accts.
Receivable Changes
 Calculate the NPV of the change (k = 12%):
 PV of the expected inflows of $3,900 per year
from t = 0 to infinity (perpetuity)
= $3,900 / .12
= $32,500
 NPV = PV of inflows - initial investment
= $32,500 - $28,000
= $4,500
 Since NPV > 0, ABC should undertake the credit
policy change, assuming that the assumptions are
valid and that the projected cash flows are
accurate.
77
How Firms Make Credit
Decisions
 The Five Cs of Credit:
 Character is the borrower’s willingness to pay based
on past payment patterns.
 Capacity is the borrower’s ability to pay based on
forecasts of future cash flows.
 Capital is how much wealth the borrower has to fall
back on.
 Collateral is what the lender gets if the borrower
fails to pay.
 Conditions faced by the borrower in the business
marketplace are also considered.
Link to Credit Scoring 78
Methods of Collection
Most firms use some of the following:

 Send reminder letters.
 Make telephone calls.
 Hire collection agencies.
 Sue the customer.
 Settle for a reduced amount.
 Write off the bill as a loss.
 Sell accounts receivable to factors. 79
Inventory Management
 Typically, inventory accounts for about four
to five percent of a firm's assets.
 In order to effectively manage the
investment in inventory, two problems must
be dealt with: how much to order and how
often to order.
 The economic order quantity (EOQ) model
attempts to determine the order size that
will minimize total inventory costs.
80
 Determining Optimal Inventory
– Economic Order Quantity (EOQ)
Total Total Total

Inventory = Carrying + Ordering
Costs Costs Costs
Link to Bloomberg.com
81
The EOQ Model assumes the firm
orders a fixed amount Q at equal
intervals.
Inventory
Level
(units)
Order
Quantity
Q
Time
82
The EOQ Model
Inventory
Level Order Quantity Q
(units) Average Inventory =
2 2
Order
Quantity
Q
Time
83
Total Total Total
Inventory = Carrying + Ordering
Costs Costs Costs
Total
OQ S
Inventory =
Costs
( 2
) CC + (
OQ
) OC
Where:
OQ = Order Size (order quantity)
S = Annual Sales Volume
CC= Carrying Cost per Unit
OC = Ordering Cost per Order 84
Ordering Costs = ( S )OC
OQ
Cost
Ordering Costs
($)
Order Size (units) 85

OQ
Carrying Costs = ( OQ ) CC
2
Cost
($) Carrying Costs
Order Size (units)

86
OQ
Carrying Costs = ( OQ ) CC
2
Total Costs = Carrying Costs + Order Costs
Cost
($)
Order Size (units) 87

 Determining Optimal Inventory
– The economic order quantity that
minimizes the total costs of inventory.
2 x S x OC
EOQ = CC
88
 Determining Optimal Inventory
Example:
Awesome Autos expects to sell 1,200 new automobiles in
the next year. It currently costs $26 per order placed with
the manufacturer. Carrying costs amount to $75 per auto.
How many autos should they order each time they place
an order?
2(1200)26
=
2 x S x OC 75
EOQ = CC
= 28.84  29 cars
89
 Determining Optimal Inventory
Example:
Awesome Autos expects to sell 1,200 new automobiles in
the next year. It currently costs $26 per order placed with
the manufacturer. Carrying costs amount to $75 per auto.
How many autos should they order each time they place
an order?
EOQ autos in each order

Place 1,200/ 29 = 41.4 orders each year
90
Inventory Management with Safety
Stock- Order before inventory is at
zero.
Inventory
Inventory Order Point
Level
(units)
EOQ
Depleted Stock
During Delivery
Safety
Stock
Actual Delivery Time Time 91

Inventory
Level
(units)
Order
Quantity
Q
Time
92
ABC Inventory
Classification System
 Tool to reduce inventory carrying costs:
classify different types of inventory
according to value.
Example:
– Class A: Expensive items are assigned a serial
number and are checked daily. Replaced only as
sold.
– Class B: Moderately priced items are assigned a
serial number but are checked less often
(monthly) and managed according to EOQ.
– Class C: Small inexpensive items. Check
inventory annually and reorder by visual check.
93
Just In Time Inventory
Control (JIT)
 Developed in Japan.
 Reduce raw material inventory carrying
costs by making deals with suppliers that
require them to deliver the raw materials as
needed.
 Carrying costs are passed on to suppliers.
 Can result in higher costs if delivery is
delayed: shut down of whole production
line.
94
Short Term
Financing
95
Learning Objectives
 The need for short-term financing.
 The advantages and disadvantages of short-
term financing.
 Three types of short-term financing.
 Computation of the cost of trade credit,
commercial paper, and bank loans.
 How to use accounts receivable and
inventory as collateral for short-term loans.
96
Why Do Firms Need
Short-term Financing?
 Profits may not be sufficient to keep up with
growth-related financing needs.
 Firms may prefer to borrow now for their
needs rather than wait until they have saved
enough.
 Short-term financing instead of long-term
sources of financing due to:
– easier availability
– usually lower cost
97
Sources of Short-term
Financing
 Short-term loans.
– borrowing from banks and other financial
institutions for one year or less.
 Trade credit.
– borrowing from suppliers
 Commercial paper.
– only available to large credit- worthy
businesses.
98
Types of short-term
loans:
 Promissory note
– A legal IOU that spells out the terms of the loan
agreement, usually the loan amount, the term of
the loan and the interest rate.
– Often requires that loan be repaid in full with
interest at the end of the loan period.
 Self-liquidating loan
– The proceeds of the loan are used to acquire
assets that generate cash to repay the loan (e.g.
inventory).
99
Types of short-term
loans:
 Line of Credit
– The borrowing limit that a bank sets for a firm.
– May include many promissory notes that the firm
has taken out at different times and with
overlapping payment periods.
– Usually informal agreement and may change
over time
 Revolving credit agreement
– Formal agreement with bank to extend credit to
a firm for a period of time (can be more than
one year).
100
Trade Credit
 Trade credit is the act of obtaining funds by
delaying payment to suppliers.
 Even though it is obtained by simply delaying
payment, it is not always free.
 The cost of trade credit may be some interest
charge that the supplier charges on the unpaid
balance. More often, it is in the form of a lost
discount that would be given to firms who pay
earlier.
 Credit has a cost. That cost may be passed along
to the customer as higher prices, borne by the
seller as lower profits, or some of both.
101
Estimation of Cost of
Short-Term Credit
 Calculation is easiest if the loan is for a one
year period:
 Effective Interest Rate is used to determine the
cost of the credit to be able to compare
differing terms.
Effective = Interest you pay

Interest Rate Amount you get to use
Example: You borrow $10,000 from a bank and must pay $1,000
interest at the end of the year
Your effective rate is the same as the stated rate
= $1,000/$10,000 = .10 = 10% 102
Variations in Loan Terms
 A discount loan requires that interest
be paid up front when the loan is
given.
 This changes the effective cost in the
previous example since you only get to
use:
($10,000 - $1,000) = $9,000.
 Effective cost = $1,000/$9,000 = .
1111 = 11.11%. 103
Variations in Loan Terms
 Sometimes lenders require that a minimum
amount, called a compensating balance be
kept in your bank account.
 If your compensating balance requirement
is $500, then the amount you can use is
reduced by that amount.
 Effective cost for a $10,000 simple interest
10% loan with a $500 compensating
balance = $1,000/($10,000-$500) = .1053
= 10.53%.
104
Cost of Short-Term Credit
For Periods Less Than One Year
 When loans are for less than one year, we must
convert the cost to annual terms for comparison.
 e.g. A 1 month $10,000 loan requires that interest
of $90 be paid:
the monthly rate = 90/10,000 = .0090 = .9%.
 Use the following formula to equate:
Effective (Periods/yr)
Annual =
Rate
(1 + $ Interest
$ you get
to use
) -1
105
 $10,000 loan for 1 month with monthly

interest equal to $90. What is the effective
annual interest rate?
 Effective annual rate = (1.009)12 - 1 = .1135
=11.35%
Link to CNNfn
106
 What if the loan is a discount loan? Must
pay the interest up front so that reduces the
dollars available to use.
 $10,000 loan with .9%monthly interest:
 Effective annual rate
12
90
(
K= 1+
10,000 - 90
) -1 = .1146
 k = 11.46%
107
Sources of Short Term
Credit
 Cost of Trade Credit
– Typically receive a discount if you pay
early.
– Stated as: 2/10, net 60
 Purchaser receives a 2% discount if payment
is made within 10 days of the invoice date,
otherwise payment is due within 60 days of
the invoice date.
– The cost is the form of the lost discount.
108
Cost of Trade Credit 2/10
net 60
 Assume your purchase is $100 list.
 If you take the discount, you pay $98.
If you don’t take the discount, you pay
$100.
 Therefore, you are paying $2 for the
privilege of borrowing $98 for the
additional 50 days. (Note: the first 10
days are free in this example).
109
Cost of Trade Credit 2/10 net 60
 The formula for cost of trade credit is similar to

the previous equations.
 The exponent is the number of times per year
the firm can take 50 days of credit.
 The cost of trade credit for this example:
[1 +(2/98)])7.3 -1 = .1589 = 15.89%.
365
( )
(
( days to pay - disc. pd.
Cost = 1+ Discount %
100-Discount%
-1
of Credit
110
Computing the Cost of Trade
Credit
Another Example
 Effective Annual Cost, k, of Passing Up
a Discount; 2/10, n40
2 ( 365
)
K = (1+ 100 - 2
40 – 10
) -1 = .2786
 k = 27.86%
111
Commercial Paper
 Commercial paper is quoted on a discount
basis so discount yield must be converted to
effective annual interest rate for
comparison.
 Compute the discount from face value (D)
– D = (Discount yield x par x DTG)/360
– DTG = days to go (to maturity)
 Compute the price = Par - D
 Compute Effective Annual Rate
= (par/price)(365/DTG) - 1
112
Cost of Commercial Paper
Example
 $1 million issue of 90 day c.p. quoted at 4% discount yield.
Step 1: Calculate D = .04 x $1 mill. x 90
360
= $10,000
Step 2: Calculate price

= $1,000,000 - $10,000
= $990,000
Step 3: Calculate effective rate (365/90)

= (1,000,000 / 990,000) -1
= 4.16%
113
Accounts Receivable as
Collateral
 A pledge is a promise that the borrowing
firm will pay the lender any payments
received from the accounts receivable
collateral in the event of default.
 Since accounts receivable fluctuate over
time, the lender may require certain
safeguards to ensure that the value of the
collateral does not go below the balance of
the loan.
 Accounts receivable can also be sold
outright. This is known as factoring.
114
Inventory as Collateral
 A major problem with inventory

financing is valuing the inventory.
 For this reason, lenders will generally
make a loan in the amount of only a
fraction of the value of the inventory.
The fraction will differ depending on
the type of inventory.
115
Inventory as Collateral
 Blanket Lien: A general claim against the
borrowers inventory if there is a default
 Trust Receipt: A legal document that
identifies specific inventory as security for a
loan
 Warehousing: Inventory pledged as
collateral is removed from the control of the
borrower (either in an on-site or public
warehouse)
116

Quiz 5

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Quiz 5

Uploaded by

Copyright:

Available Formats

Working Capital

Firm 1 Total Liabilities&Equity 1000

Firm 1 Total Liabilities&Equity 1000

Firm 1 Firm 2 Firm 2:

Assume ZERO Long-term Growth 11

Link to Dun & Bradstreet

Link to Bureau of Economic Analysis

Example: Suppose that short-term securities

Rocky Mountain Climbing, Inc. (RMC) has the

Rocky Mountain Climbing, Inc. (RMC) has the

Purchases of inventory are 75% of sales

Other expenses $14,000 per month

Cash Balance (Dec. 31, 2007) = $28,000

 Forecast of monthly collections and

 In January, sales are 120,000

 Total cash collected in January =$124,500

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Sales made in January will not be fully

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Sales made in January will not be fully

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Calculate collections for other months.

Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

RMC needs to raise $81,500 in short-term debt in

 How and why firms manage accounts

Most firms use some of the following:

Total Total Total

Order Size (units) 85

Order Size (units)

Order Size (units) 87

EOQ autos in each order

Actual Delivery Time Time 91

Effective = Interest you pay

 Use the following formula to equate:

 $10,000 loan for 1 month with monthly

 The formula for cost of trade credit is similar to

Step 2: Calculate price

Step 3: Calculate effective rate (365/90)

 A major problem with inventory

You might also like