2005, Pearson Prentice Hall

Chapter 18 – Chapter 18 – Working-Capital Working-Capital Management and Short-term Management and Short-term

FinancingFinancing

Working-Capital ManagementWorking-Capital Management

Current AssetsCurrent Assets Cash, marketable securities, inventory, Cash, marketable securities, inventory,

accounts receivable.accounts receivable.

Long-Term AssetsLong-Term Assets Equipment, buildings, land.Equipment, buildings, land.

Which earn Which earn higher rates of returnhigher rates of return?? Which help avoid risk of Which help avoid risk of illiquidityilliquidity??

Working-Capital ManagementWorking-Capital Management

CurrentCurrent AssetsAssets Cash, marketable securities, inventory, Cash, marketable securities, inventory,

accounts receivable.accounts receivable.

Long-TermLong-Term AssetsAssets Equipment, buildings, land.Equipment, buildings, land.

Risk-Return Trade-off:Risk-Return Trade-off: Current assets earn low returns, but Current assets earn low returns, but

help reduce thehelp reduce the risk of illiquidity. risk of illiquidity.

Working-Capital ManagementWorking-Capital Management

Current LiabilitiesCurrent Liabilities Short-term notes, accrued expenses, Short-term notes, accrued expenses,

accounts payable.accounts payable.

Long-Term Debt and EquityLong-Term Debt and Equity Bonds, preferred stock, common stock.Bonds, preferred stock, common stock.

Which are more Which are more expensiveexpensive for the firm? for the firm? Which help avoid risk of Which help avoid risk of illiquidityilliquidity??

Working-Capital ManagementWorking-Capital Management

CurrentCurrent LiabilitiesLiabilities Short-term notes, accrued expenses, Short-term notes, accrued expenses,

accounts payable.accounts payable.

Long-Term Debt and EquityLong-Term Debt and Equity Bonds, preferred stock, common stock.Bonds, preferred stock, common stock.

Risk-Return Trade-off:Risk-Return Trade-off: Current liabilities are less expensive, Current liabilities are less expensive,

but increase thebut increase the risk of illiquidity. risk of illiquidity.

Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

To illustrate, let’s To illustrate, let’s finance all current assets finance all current assets with current liabilitieswith current liabilities, ,

Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

To illustrate, let’s finance all To illustrate, let’s finance all current assetscurrent assets with with current liabilitiescurrent liabilities, and , and finance all finance all fixed assets with long-term financingfixed assets with long-term financing..

Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

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

Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

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

This strategy would be This strategy would be less riskyless risky, but , but more more expensive!expensive!

Balance SheetBalance Sheet

Current Assets Current LiabilitiesCurrent Assets Current Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

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

Balance SheetBalance Sheet

Current Assets Current Assets Current LiabilitiesCurrent Liabilities

Fixed AssetsFixed Assets Long-Term Debt Long-Term Debt

Preferred StockPreferred Stock

Common StockCommon Stock

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

This strategy would be This strategy would be less expensiveless expensive, but , but more riskymore risky!!

The Hedging PrincipleThe Hedging Principle

PermanentPermanent AssetsAssets (those held (those held >> 1 year) 1 year) Should be financed with permanent and Should be financed with permanent and

spontaneous sources of financing.spontaneous sources of financing.

TemporaryTemporary AssetsAssets (those held (those held << 1 year) 1 year) Should be financed with temporary Should be financed with temporary

sources of financing.sources of financing.

Balance SheetBalance Sheet

TemporaryTemporary Temporary Temporary

Current Assets Current Assets Short-term financing Short-term financing

PermanentPermanent PermanentPermanent

Fixed AssetsFixed Assets FinancingFinancing

andand

SpontaneousSpontaneous

FinancingFinancing

The Hedging PrincipleThe Hedging Principle

Permanent FinancingPermanent Financing Intermediate-term loans, long-term debt, Intermediate-term loans, long-term debt,

preferred stock, common stock.preferred stock, common stock.

Spontaneous FinancingSpontaneous Financing Accounts payable that arise spontaneously Accounts payable that arise spontaneously

in day-to-day operations (trade credit, in day-to-day operations (trade credit, wages payable, accrued interest and taxes).wages payable, accrued interest and taxes).

Short-term financingShort-term financing Unsecured bank loans, commercial paper, Unsecured bank loans, commercial paper,

loans secured by A/R or inventory.loans secured by A/R or inventory.

Cost of Short-Term CreditCost of Short-Term Credit

Interest Interest == principal principal xx rate rate xx time time

ExampleExample: Borrow : Borrow $10,000$10,000 at at 8.5%8.5% for for 9 9 months.months.

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

== $637.50 $637.50

APR = x

We can use this simple relationship:We can use this simple relationship:

Interest = principal Interest = principal xx rate rate xx time timeto solve for to solve for raterate, and get the, and get the

Annual Percentage Rate (APR)Annual Percentage Rate (APR)

interest 1interest 1

principal timeprincipal time

Cost of Short-Term CreditCost of Short-Term Credit

APR = x interest 1interest 1

principal timeprincipal time

ExampleExample: If you pay : If you pay $637.50$637.50 in in interest on interest on $10,000$10,000 principal for principal for 99 months:months:

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

= = 8.5% APR8.5% APR

Cost of Short-Term CreditCost of Short-Term Credit

APY = ( 1 + ) - 1

Annual Percentage YieldAnnual Percentage Yield (APY) (APY) is is similar to APR, except that it similar to APR, except that it accounts for compound interest:accounts for compound interest:

i i mm

mm

i = the nominal rate of interesti = the nominal rate of interest

m = the # of compounding periods per yearm = the # of compounding periods per year

Cost of Short-Term CreditCost of Short-Term Credit

Cost of Short-Term CreditCost of Short-Term Credit

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

APYAPY = ( 1 + ( .09 / 12 ) = ( 1 + ( .09 / 12 ) 1212 -1 ) = .0938 -1 ) = .0938

= = 9.38%9.38%

Sources of Short-term CreditSources of Short-term Credit

UnsecuredUnsecured Accrued wages and taxes.Accrued wages and taxes. Trade credit.Trade credit. Bank credit.Bank credit. Commercial paper.Commercial paper.

SecuredSecured Accounts receivable loans.Accounts receivable loans. Inventory loans.Inventory loans.