Chapter15 working capital policy and short term financing
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Transcript of Chapter15 working capital policy and short term financing
CONTEMPORARY FINANCIAL MANAGEMENT
Chapter 15:
Working Capital Policy and Short Term Financing
INTRODUCTION This chapter deals with the management of working capital,
which involves decisions about the optimal overall level of current assets and the optimal mix of short-term funds used to finance the company’s assets.
It also deals with the financing of the current assets that make up the working capital.
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WORKING CAPITAL Working capital is the firm’s total investment in current assets
Net working capital equals current assets minus current liabilities
Working capital represents assets that flow through the firm Turned over at a rapid rate Usually recovered during the operating cycle when inventory sells and
receivables collected
Working capital is needed because of the time lag between cash disbursements and cash receipts
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WORKING CAPITAL POLICY
Involves many decisions about a firm’s current assets and current liabilities
What they consist of How they are used How their mix affects the risk-return characteristics of the
company
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OPERATING CYCLE
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PurchaseRaw Materials
Pay forRaw Materials
SellFinished Goods
on Credit
CollectReceivables
Operating CycleInventory Conversion PeriodReceivables Conversion PeriodPayables Deferral PeriodCash Conversion Cycle
OPERATING CYCLE ANALYSIS
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OperatingCycle =
InventoryConversion
Period+
ReceivablesConversion
Period
InventoryConversion
Period=
Average Inventory
Cost of Sales/ 365
ReceivablesConversion
Period= Accounts Receivable
Annual Credit Sales/ 365
OPERATING CYCLE ANALYSIS CONTINUED
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Cash Conversion
Cycle=
OperatingCycle +
PayablesDeferralPeriod
PayablesDeferralPeriod
=
Accounts Payable +
Salaries, Benefits& Payroll Taxes
Payable
Cost ofSales – Selling, Gen,
Admin Exp( /365)
SIZE AND NATURE OF CURRENT ASSETS
Depends on:
Type of product manufactured or distributed
Length of operating cycle
Optimal amount of Inventory
Optimal amount of safety stock
Credit policies
Efficiency of current asset management
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APPROPRIATE LEVEL OF WORKING CAPITAL
More conservative policies often result in lost sales due to restrictive credit policies.
Optimal level of working capital investment is the level which is expected to maximize shareholder wealth.
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Conservative Aggressive
Current Assets More LessProfitability Lower HigherRisk Lower Higher
OPTIMAL MIX OF ST AND LT DEBT
Impact of term structure of interest rates Long rates usually higher than short rates Thus the interest cost of short-term debt usually cheaper than
long-term debt
Borrower incurs higher risk with short term debt Must refinance frequently Short term interest rates are highly volatile
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PROFITABILITY VERSUS RISK
Need for financing equal to the sum of: Current assets Fixed assets
Current assets may be: Permanent - Are not affected by seasonal or cyclical demand Fluctuating - Are affected by seasonal or cyclical demand
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FINANCING STRATEGIES
Matching
Match the maturity of all assets & liabilities Reduces liquidity risk Hard to implement in practice
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FINANCING STRATEGIES
Conservative Approach
High proportion of long term debt Less profitable, since LT debt usually more expensive
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FINANCING STRATEGIES
Aggressive Approach
High proportion of short term debt More profitable (short term debt cheaper) but also more risky
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AN OPTIMAL FINANCING STRATEGY?
No one strategy is “right” for all firms
The mix between ST and LT debt must also consider: Industry norms Variability of sales Variability of cash flows
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COST OF SHORT TERM CREDIT
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APR = Interest + Fees
Usable funds× 365
Maturity (Days)
Simple interest
Compound interestm
[ Interest + fees
Usable funds ] – 1 1 +EAR =
APR = Annual percentage rateEAR = Equivalent annual returnm = number of compounding periods per year
SOURCES OF SHORT-TERM FINANCING Trade credit
Accrual expenses and deferred income
Loans from commercial banks
Commercial paper
Borrowing against Account Receivables
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TRADE CREDIT Seller provides financing as part of the sales inducement
Spontaneous source of financing
Cost of trade credit is captured in the purchase price
Trade credit is never free. The cost of foregoing a cash discount is:
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APR = % discount
100% – % discount
365
Credit – Disc period×
EXAMPLE: COST OF FOREGOING A DISCOUNT A vendor offers a discount of 2% if payment is made within
ten days. If the discount is not taken, full payment is due in 30 days. What is the annual cost of not accepting the 2% discount?
÷ ÷ ÷ ÷
Percentage Discount 365APR =
100 - %Discount Credit Period - Discount Period
2 365=
100 - 2 30 -10
= 37.24%
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ACCRUED EXPENSES & DEFERRED INCOME
Any accrued but unpaid expense is a form of short term financing
Stretching payables extends the financing period but can result in a poor credit rating
Deferred income consists of payments received for goods & services to be delivered in the future Are shown on the Balance Sheet as a liability called Deferred
Income
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SHORT TERM BANK CREDIT
Single loans for specific financial needs Line of credit
Agreement to borrow up to predetermined limit at any time
Revolving credit Legally commits the bank Usually secured Requires a commitment fee
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APR =
Interestcosts
Usable funds
+Commitmentfee × 365
Maturity ( days )
COMMERCIAL PAPER
Short-term unsecured promissory notes
Issued by large well-known corporations
Maturities from a few days to 9 months
Sold at a discount
Purchasers include corporations, banks, insurance
companies, pension funds, etc
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Maturity ( days )
Interest costs +
Placement fee
Usable funds× 365
APR =
ACCOUNTS RECEIVABLE LOANS
Receivables make excellent collateral: Fairly liquid Easy to recover in the event of default
Problems with receivables includes: Subject to fraud High administrative costs
Two common forms of receivables lending Pledging–Firm retains title Factoring–Sale of A/R With recourse Without recourse
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BORROWING AGAINST INVENTORY
Inventory may make a good form of collateral, depending on the following characteristics:
Perishability Identifiability Marketability Price stability
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BORROWING AGAINST INVENTORY
When lending against inventory, the lender must decide who will hold the collateral (inventory)
If borrower holds inventory, the lender may use: Floating lien: floating charge over all current and future
acquired inventory Trust receipt: inventory and sale proceeds are held “in trust”
for the lender
A third party holds the inventory in a: Terminal warehouse: inventory is stored in a bonded
warehouse Field warehouse: secured inventory is segregated on site and
managed by a field warehouse company25
CHARACTERISTICS OF TERM LOANS
Granted by a bank or other lending institution
Maturity – initial maturity of 1 to 10 years
Less expensive than a public offering
Repayment may include: Equal periodic payments of interest plus principal (amortized) Equal principal payments plus interest on the outstanding
balance Periodic payments plus a large [balloon] payment at the
maturity date One large payment on the maturity date (bullet payment) 26
CHARACTERISTICS OF TERM LOANS
Interest rate varies, depending on: General level of rates in the market Size of the loan Maturity of the loan Borrower’s credit rating
Interest may be charged as a: Fixed rate Variable rate (Prime plus ___%)
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CHARACTERISTICS OF TERM LOANS Security Provisions
Protect the lender in case of borrower default May include:
Assignment of monies due under a contract Assignment of receivables or inventory Floating lien or debenture on firm assets Pledge of marketable securities Mortgage on fixed assets Assignment of the cash surrender value on a life insurance policy
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CHARACTERISTICS OF TERM LOANS
Affirmative Covenants Things the borrower will do
Provide periodic Financial statements Carry insurance Maintain minimum net working capital
Negative Covenants Things the borrower will not do
Not to pledge certain assets as security Not to merge or consolidate Not to make or guarantee loans to others
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SOURCES OF TERM LOANS Banks
Insurance companies
Pension funds
Government agencies
Equipment suppliers Conditional sales contracts
Chattel mortgages
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MAJOR POINTS
Working capital consists of the current assets carried on the Balance Sheet and the current liabilities used to fund them.
Current assets require an investment, similar to that of a fixed asset.
Current assets are low return; therefore the firm wants to carry the minimum amount necessary.
There are many forms of short-term funding available, but each of them has a cost attached. 31