Ch. 18:

Management

and Short-Term Financing 2002, Prentice Hall, Inc.

Working-Capital ManagementCurrent Assetscash, marketable securities, inventory, accounts receivableLong-Term Assetsequipment, buildings, land

Which earn higher rates of return?Which help avoid risk of illiquidity?

Working-Capital ManagementCurrent Assetscash, marketable securities, inventory, accounts receivableLong-Term Assetsequipment, buildings, land

Risk-Return Trade-off: Current assets earn low returns, but help reduce the risk of illiquidity.

Working-Capital ManagementCurrent Liabilitiesshort-term notes, accrued expenses, accounts payableLong-Term Debt and Equitybonds, preferred stock, common stock

Which are more expensive for the firm?Which help avoid risk of illiquidity?

Working-Capital ManagementCurrent Liabilitiesshort-term notes, accrued expenses, accounts payableLong-Term Debt and Equitybonds, preferred stock, common stock

Risk-Return Trade-off: Current liabilities are less expensive, but increase the risk of illiquidity.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

To illustrate, lets finance all current assets with current liabilities,

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

To illustrate, lets finance all current assets with current liabilities,

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

To illustrate, lets finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

To illustrate, lets finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use long-term financing to finance some of our current assets.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use long-term financing to finance some of our current assets.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use current liabilities to finance some of our fixed assets.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use current liabilities to finance some of our fixed assets.

Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt Preferred Stock Common Stock

Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!

The Hedging PrinciplePermanent 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.

Balance Sheet

TemporaryCurrent Assets

Balance Sheet

Temporary TemporaryCurrent Assets Short-term financing

Balance Sheet

Temporary TemporaryCurrent Assets Short-term financing

PermanentFixed Assets

Balance Sheet

Temporary TemporaryCurrent Assets Short-term financing

Permanent Permanent Fixed Assets Financingand Spontaneous Financing

The Hedging PrinciplePermanent Financingintermediate-term loans, long-term debt, preferred stock, common stockSpontaneous Financingaccounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes)Short-term financingunsecured bank loans, commercial paper, loans secured by A/R or inventory

Cost of Short-Term CreditInterest = 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

Cost of Short-Term CreditWe can use this simple relationship:Interest = principal x rate x timeto solve for rate, and get the

Cost of Short-Term CreditWe can use this simple relationship:Interest = principal x rate x timeto solve for rate, and get theAnnual Percentage Rate (APR)

Cost of Short-Term CreditWe can use this simple relationship:Interest = principal x rate x timeto solve for rate, and get theAnnual Percentage Rate (APR)

interest 1 principal time

Cost of Short-Term Credit

Cost of Short-Term Credit interest 1 principal time

Cost of Short-Term Credit interest 1 principal time

example: If you pay $637.50 in interest on $10,000 principal for 9 months:

Cost of Short-Term Credit interest 1 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

Cost of Short-Term CreditAnnual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

Cost of Short-Term CreditAnnual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

i m m

Cost of Short-Term CreditAnnual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

i m m

i = the nominal rate of interestm = the # of compounding periods per year

Cost of Short-Term CreditWhat is the (APY) of a 9% loan with monthly payments?

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

= 9.38%

Sources of Short-term CreditUnsecured

Sources of Short-term CreditUnsecuredaccrued wages and taxes

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade credit

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade creditbank credit

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade creditbank creditcommercial paper

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade creditbank creditcommercial paperSecured

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade creditbank creditcommercial paperSecuredaccounts receivable loans

Sources of Short-term CreditUnsecuredaccrued wages and taxestrade creditbank creditcommercial paperSecuredaccounts receivable loansinventory loans