Chapter 15. Working Capital Management Chapter Objectives Managing current assets and current...
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Transcript of Chapter 15. Working Capital Management Chapter Objectives Managing current assets and current...
![Page 1: Chapter 15. Working Capital Management Chapter Objectives Managing current assets and current liabilities Appropriate level of working capital Estimating.](https://reader030.fdocuments.in/reader030/viewer/2022033017/56649cc95503460f94990bdc/html5/thumbnails/1.jpg)
Chapter 15Chapter 15
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Working Capital ManagementWorking Capital Management
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Chapter ObjectivesChapter Objectives
Managing current assets and current liabilities
Appropriate level of working capitalEstimating the cost of short-term creditSources of short-term creditMultinational working-capital management
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Working CapitalWorking Capital
Working Capital Traditionally is the firm’s total investment
in current assetsNet working capitalDifference between the firm’s current assets
and its current liabilitiesNet working capital = Current assets –
current liabilities
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Managing Net Working CapitalManaging Net Working Capital
Equals managing liquidityEntails two aspects of operations:
– Investment in current assets– Use of short-term or current liabilities
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Short-term Sources of Short-term Sources of FinancingFinancing
Include all forms of financing that have maturities of 1 year of less or current liabilities
Two issues:How much short-term financing should the
firm use?What specific sources of short-term
financing should the firm select?
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How Much Short-term How Much Short-term Financing Should a Firm use?Financing Should a Firm use?
Hedging principle of working-capital management
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What Specific Sources of What Specific Sources of Short-term Financing Should Short-term Financing Should
the Firm Select?the Firm Select?
Three factors influence the decision:The effective cost of creditThe availability of creditThe influence of a particular credit source
on other sources of financing
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Risk-Return Trade-offRisk-Return Trade-off
Holding liquid investments reduces overall rate of return
Increased liquidity must be traded-off against the firm’s reduction in return on investment
Managing this trade-off is an important theme of working-capital management
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Liquidity RiskLiquidity Risk
Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
A firm can reduce its risk of illiquidity through the use of long-term debt at the expense of a reduction in its return on invested funds
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Advantages of Current Advantages of Current LiabilitiesLiabilities
Flexibility– Can be used to match the timing of a firm’s
needs for short-term financing
Interest Cost– Interest rates on short-term debt are lower than
on long-term debt
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Disadvantages of Current Disadvantages of Current LiabilitiesLiabilities
Risk– Short-term debt must be repaid or rolled over
more often
Uncertainty– Uncertainty of interest costs from year to year
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Appropriate Level of Working Appropriate Level of Working CapitalCapital
Involves interrelated decisions Can be a significant problemCan utilize a type of benchmark
– Hedging Principle or Principle of self-liquidating debt
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Hedging PrincipleHedging Principle
Also known as Principle of Self-liquidating debt
Involves matching the cash flow generating characteristics of an asset with the maturity of the source of financing used to finance its acquisition
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Permanent and Temporary Permanent and Temporary AssetsAssets
Permanent investments – Investments that the firm expects to hold for a
period longer than 1 year
Temporary Investments– Current assets that will be liquidated and not
replaced within the current year
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Temporary, Permanent and Temporary, Permanent and Spontaneous Sources of Spontaneous Sources of
FinancingFinancing Temporary sources of financing
– Current liabilities or short-term notes payable, unsecured bank loans, commercial paper, loans secured by accounts receivable and inventories
Permanent Sources of financing– Intermediate-term loans, long-term debt, preferred stock and
common equity Spontaneous Sources of financing
– Arise in the firm’s day-to-day operation– Trade credit is often made available spontaneously or on demand
from the firms supplies when the firm orders its supplies or inventory
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Hedging PrincipleHedging Principle
Asset needs of the firm not financed by spontaneous sources should be financed in accordance with this rule:
Permanent-asset investments are financed with permanent sources, and temporary investments are financed with temporary sources
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Cost of Short-term CreditCost of Short-term Credit
Interest = principal X rate X timeCost of short-term financing = APR or
annual percentage rateAPR = interest/(principal X time)
orAPR = (interest/principal) X (1/time)
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APRAPR
A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000 principal amount plus $30 interest. What is the APR?
APR = ($30/$1,000) X [1/(90/360)].12 or 12%
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APYAPY
APR does not consider compound interest. To account for the influence of compounding, must calculate APY or annual percentage yield
APY = (1 + i/m)m – 1Where: I is the nominal rate of interest
per year; m is number of compounding period within a year
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APY CalculationAPY Calculation
A company plans to borrow $1,000 for 90 days. At maturity, the company will repay the $1,000 principal amount plus $30 interest. What is the APY?
Number of compounding periods 360/90 = 4
Rate = 12% (previously calculated)APY = (1 + .12/4)4 –1 = .126 or 12.6%
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APR or APYAPR or APY
Because the differences between APR and APY are usually small, use the simple interest values of APR to compute the cost of short-term credit
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Sources of Short-term CreditSources of Short-term Credit
Short-term credit sources can be classified into two basic groups:
Secured Unsecured
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Secured LoansSecured Loans
Involve the pledge of specific assets as collateral in the event the borrower defaults in payment of principal or interest
Primary Suppliers:– Commercial banks, finance companies, and factors
The principal sources of collateral include accounts receivable and inventories
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Unsecured LoansUnsecured Loans
All sources that have as their security only the lender’s faith in the ability of the borrower to repay the funds when due
Major sources:– accrued wages and taxes, trade credit,
unsecured bank loans, and commercial paper
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Cash DiscountsCash Discounts
Often, the credit terms associated with trade credit involve a cash discount for early payment.
Terms such as 2/10 net 30 means a 2 percent discount is offered for payment within 10 days, or the full amount is due in 30 days
A 2 percent penalty is involved for not paying within 10 days.
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Effective Cost of Passing Up a Effective Cost of Passing Up a DiscountDiscount
Terms 2/10 net 30 Means a 2 percent discount is available for
payment in 10 days or full amount is due in 30 days.
The equivalent APR of this discount is:APR = .02/.98 X [1/(20/360)]The effective cost of delaying payment for
20 days is 36.73%
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Unsecured Sources of LoansUnsecured Sources of Loans
Bank Credit:– Lines of credit– Transaction loans (notes payable)
Commercial Paper
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Line of CreditLine of Credit
Line of Credit– Informal agreement between a borrower and a bank
about the maximum amount of credit the bank will provide the borrower at any one time.
– There is no legal commitment on the part of the bank to provide the stated credit
– Usually require that the borrower maintain a minimum balance in the bank through the loan period or a compensating balance
Revolving Credit– Variant of the line of credit form of financing– A legal obligation is involved
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Transaction LoansTransaction Loans
Transactions loans– Made for a specific purpose– The type of loan that most individuals associate
with bank credit and is obtained by signing a promissory note
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Commercial PaperCommercial Paper
The largest and most credit worthy companies are able to use commercial paper– a short-term promise to pay that is sold in the market for short-term debt securities
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Advantages of Commercial Advantages of Commercial PaperPaper
Interest rates– Rates are generally lower than rates on bank loans
Compensating-balance requirement– No minimum balance requirements are associated with
commercial paper Amount of credit
– Offers the firm with very large credit needs a single source for all its short-term financing
Prestige– Signifies credit status
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Secured Sources of LoansSecured Sources of Loans
Accounts Receivable loans– Pledging Accounts Receivable– Factoring Accounts Receivable
Inventory loans
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Pledging Accounts ReceivablePledging Accounts Receivable
Under pledging, the borrower simply pledges accounts receivable as collateral for a loan obtained from either a commercial bank or a finance company
The amount of the loan is stated as a percentage of the face value of the receivables pledged
Flexible source of financing Can be costly
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Factoring Accounts Factoring Accounts Receivable Receivable
Factoring accounts receivable involves the outright sale of a firm’s accounts to a financial institution called a factor
A factor is a firm that acquires the receivables of other firms
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Inventory LoansInventory Loans
Loans secured by inventories The amount of the loan depends on the
marketability and perishability of the inventory Types:
– Floating lien agreement– Chattel Mortgage agreement– Field warehouse-financing agreement– Terminal warehouse agreement
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Types of Inventory LoansTypes of Inventory Loans
Floating Lien Agreement– The borrower gives the lender a lien against all
its inventories.– The simplest but least-secure form
Chattel Mortgage Agreement– The inventory is identified and the borrower
retains title to the inventory but cannot sell the items without the lender’s consent
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Field warehouse-financing agreementInventories used as collateral are physically
separated from the firm’s other inventories and are placed under the control of a third-party field-warehousing firm
Terminal warehouse agreementThe inventories pledged as collateral are
transported to a public warehouse that is physically removed from the borrower’s premises.