working capital policy.pptx

7/29/2019 working capital policy.pptx

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Learning Objectives

Understand the importance of workingcapital.

The liquidity-profitability trade-off. Determining the optimal level of

current assets.

The risk and return implications ofalternative approaches to workingcapital financing policy.


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The Importance of Managing and

Accumulating Working Capital

Working capital is the amount of thefirms current assets: cash, accounts

receivable, marketable securities,inventory and prepaid expenses.

Managing the level and financing ofworking capital is necessary:

to keep costs under control (e.g. storage ofinventory)

to keep risk levels at an appropriate level(e.g. liquidity)


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Managing Current Assets

& Liabilities Net Working Capital

= Current Assets - Current Liabilities

Determining the Correct level of WorkingCapital 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.


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Firm 1

ST Debt 100LT Debt 400Common Stock 500Total Liabilities&Equity 1000

Firm 1Marketable Securities 0Other Current Assets 200

Fixed Assets 800Total Assets 1000

Firm 1Operating Earnings 150

Interest Earned 0EBT 150Taxes (40%) -60Net Income 90

Example: Risk-Return Trade-off

Compare the 2 following companies

Current Assets

Current Liabilities

Current Ratio =

200100

=

= 2Current Ratio 2


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Firm 1

ST Debt 100LT Debt 400Common Stock 500Total Liabilities&Equity 1000

Firm 1Marketable Securities 0Other Current Assets 200

Fixed Assets 800Total Assets 1000

Firm 1Operating Earnings 150

Interest Earned 0EBT 150Taxes (40%) -60Net Income 90

Current Ratio 2

Return on Assets =Net Income

Assets

901000

=



= .09 = 9%

ROA 9%


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Firm 2:

$200 Marketable SecuritiesFinanced with Common Stock

200 x 4% = $8 interest earned

Firm 1 Firm 2

Marketable Securities 0 200Other Current Assets 200 200

Fixed Assets 800 800Total Assets 1000 1200

Firm 1 Firm 2

ST Debt 100 100LT Debt 400 400

Common Stock 500 700Total Liabilities&Equity 1000 1200

Firm 1 Firm 2Operating Earnings 150 150

Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95

Current Ratio 2

ROA 9%




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Firm 1 Firm 2



Firm 1 Firm 2





Current Ratio 2

ROA 9%

400100

=

Current Ratio = CA

CL



= 44


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Firm 1 Firm 2



Firm 1 Firm 2





Current Ratio 2 4

ROA 9%

951200

=



=.079 = 7.9%

7.9%

Return on Assets =NI

Assets


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Firm 1Higher ROALess LiquidRiskier

Firm 2Lower ROAMore LiquidLess Risky



Firm 1 Firm 2



Firm 1 Firm 2





Current Ratio 2 4

ROA 9% 7.9%


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Time

Total Assets

Assume ZERO Long-term Growth

$5M

Variation in assets over time

FixedAssets

}


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Time

Total Assets

FixedAssets

Permanent

Current Assets}

}$5M

$7M



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Temporary Current Assets


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}

$5M

$7M

$10M


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Different Approaches to Financing

Conservative Approach

Finance all fixed assets, permanent current assets,

and some temporary with LT debt or equity. STfinancing is used for the remaining temp. currentassets.

Lower risk, lower return


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Financing Current Assets:

Conservative Approach


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}

$5M

$7M

$10M


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}

$5M

$7M

$10M

Short-term

Sources

Long-term

Sources


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Different Approaches to

Financing Conservative Approach

Finance all fixed assets, permanent current assets,and some temporary with LT debt or equity. STfinancing is used for the remaining temp. currentassets.


Moderate Approach (Maturity Matching) Finance fixed assets and permanent current assetswith LT funds and temporary current assets withST funds.

Moderate risk, moderate return


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Moderate Approach


Time

Total Assets

FixedAssets

Permanent

Current Assets}

}$5M

$7M

$10M


Time

Total Assets

FixedAssets

Permanent

Current Assets}

}$5M

$7M

$10M

Long-term

Sources


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Moderate ApproachShort-term

Sources


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}$5M

$7M

$10M


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}$5M

$7M

$10M

Long-term

Sources


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Different Approaches to

Financing Conservative Approach

Finance all fixed assets, permanent current assets, and sometemporary with LT debt or equity. ST financing is used forthe 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 isused for the remaining fixed assets.

Higher risk, higher return


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Long-term Sources


Aggressive Approach


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}$5M

$7M

$10M


Time

Total Assets

Fixed

Assets

Permanent

Current Assets}

}$5M

$7M

$10M

Short-term

Sources


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Managing (WARM, SOFT) Cash


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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 thatis necessary.(Maximum balance)


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The size of the minimum

cash balance depends on: How quickly and cheaply a firm can

raise cash when needed.

How accurately managers can predictcash requirements.

How much precautionary cash the

managers need for emergencies.

Link to Dun & Bradstreet
http://www.dnb.com/http://www.dnb.com/


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The firms 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 andmaking an investment

Link to Bureau of Economic Analysis
http://www.bea.doc.gov/http://www.bea.doc.gov/http://www.bea.doc.gov/http://www.bea.doc.gov/


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Choosing the Optimum CashBalance

Days of the Month

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Cash Balances in a Typical Month


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The Miller - Orr Model

The Miller-Orr Model provides a formula fordetermining the optimum cash balance, the

point at which to sell securities (lower limit)and when to invest excess cash (upperlimit).

Depends on:

transaction costs of buying or selling securities

variability of daily cash

return on short-term investments


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The Miller-Orr Model- Target Cash Balance (Z)

3 x TC x V

4 x rZ = + L

3

where: TC = transaction cost of buyingor selling securities

V = variance of daily cash flowsr = return on short-term

investmentsL = minimum cash requirement


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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).



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Example

3 x 50 x 100,0004 x .05/365

Z = + $1,000

= $3,014 + $1,000 = $4,014

3


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The Miller-Orr Mode

- Upper Limit The upper limit for the cash account (H) is

determined by the equation:

H = 3Z - 2Lwhere:Z = Target cash balanceL = Lower limit

In the previous example:H = 3 ($4,014) - 2($1,000) = $10,042


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Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has thefollowing information:

Previous Sales November 2007 130,000December 2007 125,000

Forecast SalesJanuary 2008 120,000February 2008 260,000March 2008 140,000

April 2008 140,000


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Rocky Mountain Climbing, Inc. (RMC) has thefollowing information:Previous Sales: November 2007 130,000

December 2007 125,000Forecast sales for: January 2008 120,000

February 2008 260,000March 2008 140,000

April 2008 140,000Collections : 30% of customers pay cash

50% pay in month after sale20% pay 2 months after sale


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Other information for RMC Cash Budget:

Purchases of inventory are 75% of sales

and are made 2 months before saleand are paid for 1 month after delivery

Other expenses $14,000 per month

Taxes $10,000 due in March

Cash Balance (Dec. 31, 2007) = $28,000Minimum balance required by bank = $25,000(ST borrowing rate = 6% annually)


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Steps in the Cash Budget

Forecast of monthly collections andother cash inflows

Forecast of purchases and other cashoutflows

Summarize the effect on net monthly

cash flows and determine borrowingneeds or surpluses.


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Cash Budget - Collections

In each month RMC will collect cash from sales thathave occurred in that month and in the precedingtwo 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


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Sales made in January will not be fullycollected 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 x .30

60,000

120,000 x .50


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Sales made in January will not be fullycollected 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 x .30

60,000

120,000 x .50

24,000

120,000 x .20


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Calculate collections for other months.


Cash Budget

RMC, Inc.

Sales 130,000 125,000 120,000 260,000 140,000Collections:Month of Sale (30%) 36,000 78,000 42,000

First Month (50%) 62,500 60,000 130,0002nd Month (20%) 26,000 25,000 24,000Total Collections 124,500 163,000 196,000

Nov Dec Jan Feb Mar


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Payments for January Purchases

Nov Dec Jan Feb Mar

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

75% of January Sales Purchased inNovember

Purchases are made 2 months prior tosale and are paid for 1 month later.

Cash Budget -

Purchases/Payments

90,000


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Cash Budget -

Purchases/Payments

Payments for January Purchases

Nov Dec Jan Feb Mar

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

90,000 90,00075% of January Sales Purchased inNovember, Paid for in December

Purchases are made 2 months prior tosale and are paid for 1 month later.


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Calculate payments for all months.Note that in order to do a cash budget,

you will need forecasts of sales for April.

Cash Budget -

Purchases/Payments

Cash Budget

RMC, Inc.

Sales 130,000 125,000 120,000 260,000 140,000 140,000Purchases 195,000 105,000 105,000Payments 195,000 105,000 105,000

Nov Dec Jan Feb Mar Apr


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Jan Feb Mar

Cash Budget

RMC, Inc.

Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000

Summary of Previous Calculations


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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing

Analysis of Borrowing Needs


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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing



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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500



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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500


Interest Incurred on PriorMonth Borrowing

81,500 x .005


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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500

New Loan Balance

81,500 - 43,592=$37,908


37,908


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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908



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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908


Repay Outstanding LoanBalance

37,908


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Jan Feb Mar

Cash Budget

RMC, Inc.

Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592 37,908Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908 0


Ending Cash Balance

$53,902-$25,000=$28,902 Surplus

53,902


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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 toolate).


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Managing Cash Flows

Can increase cash inflows (or speed themup) by:

Increasing cash sales

Increasing credit sales collections

Can decrease cash outflows (or slow themdown) by:

Cutting costs Taking full advantage of time allowed to pay

obligations


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Accounts Receivable

and Inventory


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Learning Objectives

How and why firms manage accountsreceivable and inventory.

Computation of optimum levels ofaccounts receivable and inventory.

Alternative inventory management

approaches. How firms make credit decisions and

create collection policies.

Why do firms accumulate


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Why do firms accumulateaccounts receivable and

inventory? Given that accounts receivable and

inventory are assets that do not provide anexplicit rate of return, it is important to

understand why firms might still want tohave these investments.

Granting credit is often an essentialbusiness practice and can enhance sales.

(But also will increase costs.) Holding adequate inventory is necessary to

avoid loss of sales due to stock-outs.

Fi di th O ti L l


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Finding the Optimum Levelof Accounts Receivable

Firms managers must review the firmscredit policies and evaluate the impact ofany proposed changes in policies based onthe NPV of incremental cash flows due tothe change.

This is similar to the method we used in

determining the best capital budgetingprojects to undertake.

Link to Hoovers Online

A t R i bl
http://www.hoovers.com/http://www.hoovers.com/


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Accounts ReceivableManagement

The terms of sale are generally statedin the form X / Y, n Z

This means that the customer candeduct X percentage if the account ispaid withinYdays; otherwise, theaccount 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.

Eff t f Ti ht i


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Effects of TighteningCredit Policy Raise credit standards

Fewer credit customers (could reduce sales) Lower accounts receivable

Shorten net due period Fewer credit customers (could reduce sales)Accounts paid sooner Lower accounts receivable

Reduce discount percentage Fewer credit customers (could reduce sales) Fewer take the discount

Shorten discount period Same as above

A erage Collection Period


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Average Collection Period(ACP)

Old Policy; 2/10, n30 35% of customers pay in 10 days

62% of customers pay in 30 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

A l i f A t R i bl


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Analysis of Accts. ReceivableChanges

Develop pro forma financial statements foreach policy under consideration.

Use the pro formas to estimate incremental

cashflows by comparing forecasts tocurrent policy cash flows.

Use the incremental cash flows to estimatethe NPV of each policy change.

Choose the policy change that maximizesthe value of the firm (highest NPV).

Analysis of Accts


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Example:ABC Corporation is considering a credit policychange from offering no credit to offering 30days 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

Analysis of Accts.Receivable Changes


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Analysis of Accts


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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 creditpolicy change, assuming that the assumptions arevalid and that the projected cash flows areaccurate.

How Firms Make Credit


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How Firms Make CreditDecisions

The Five Cs of Credit:

Characteris the borrowers willingness to pay basedon past payment patterns.

Capacityis the borrowers ability to pay based onforecasts of future cash flows.

Capital is how much wealth the borrower has to fallback on.

Collateral is what the lender gets if the borrowerfails to pay.

Conditions faced by the borrower in the businessmarketplace are also considered.

Link to Credit Scoring

M th d f C ll ti
http://www.ftc.gov/bcp/conline/pubs/credit/scoring.htmhttp://www.ftc.gov/bcp/conline/pubs/credit/scoring.htm


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Methods of Collection

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.

Most firms use some of the following:


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Inventory Management

Typically, inventory accounts for about fourto five percent of a firm's assets.

In order to effectively manage theinvestment in inventory, two problems mustbe dealt with: how much to order and howoften to order.

The economic order quantity (EOQ) modelattempts to determine the order size thatwill minimize total inventory costs.


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Determining Optimal Inventory

Economic Order Quantity (EOQ)

Total

Inventory

Costs

=

Total

Carrying

Costs

Total

Ordering

Costs

+

Link to Bloomberg.com
http://www.bloomberg.com/http://www.bloomberg.com/


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=Total

InventoryCosts

( ) CC + ( ) OC

OQ2

SOQ

Where:

OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order

TotalInventory

Costs

=Total

Carrying

Costs

TotalOrdering

Costs

+


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Cost($)

Ordering Costs

= ( )OCS

OQ

Ordering Costs


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The economic order quantity that

minimizes the total costs of inventory.


EOQ =2 x S x OC

CC



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Economic Order Quantity (EOQ)Example:

Awesome Autos expects to sell 1,200 new automobiles

in the next year. It currently costs $26 per order placedwith the manufacturer. Carrying costs amount to $75 perauto. How many autos should they order each time theyplace an order?

=

= 28.84 29 cars

2(1200)2675


EOQ =2 x S x OC

CC



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Determining Optimal Inventory Economic Order Quantity (EOQ)

EOQ autos in each order

Place 1,200/ 29 = 41.4 orders each year

Example:Awesome Autos expects to sell 1,200 new automobiles

in the next year. It currently costs $26 per order placedwith the manufacturer. Carrying costs amount to $75 perauto. How many autos should they order each time theyplace an order?

Inventory Management with Safety


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y g yStock- Order before inventory is at

zero.

EOQ

Depleted Stock

During Delivery

Inventory Order Point

Actual Delivery Time

SafetyStock

Time

Inventory

Level

(units)


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ABC Inventory


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ABC InventoryClassification System Tool to reduce inventory carrying costs:

classify different types of inventoryaccording to value.

Example: Class A: Expensive items are assigned a serial

number and are checked daily. Replaced only assold.

Class B: Moderately priced items are assigned aserial number but are checked less often(monthly) and managed according to EOQ.

Class C: Small inexpensive items. Checkinventory annually and reorder by visual check.

Just In Time Inventory


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Just In Time InventoryControl (JIT)

Developed in Japan.

Reduce raw material inventory carryingcosts by making deals with suppliers thatrequire them to deliver the raw materials asneeded.

Carrying costs are passed on to suppliers.

Can result in higher costs if delivery isdelayed: shut down of whole productionline.


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Short Term

Financing


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Why Do Firms Need


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Why Do Firms NeedShort-term Financing?

Profits may not be sufficient to keep up withgrowth-related financing needs.

Firms may prefer to borrow now for their

needs rather than wait until they havesaved enough.

Short-term financing instead of long-termsources of financing due to: easier availability

usually lower cost

Sources of Short-term


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Sources of Short termFinancing

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.

Types of short-term


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Types of short termloans:

Promissory noteA 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 acquireassets that generate cash to repay the loan (e.g.inventory).

Types of short-term


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Types of short termloans:

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 withoverlapping payment periods.

Usually informal agreement and may changeover time

Revolving credit agreement

Formal agreement with bank to extend credit toa firm for a period of time (can be more thanone year).

T d C di


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Trade Credit

Trade credit is the act of obtaining funds bydelaying payment to suppliers.

Even though it is obtained by simply delayingpayment, it is not always free.

The cost of trade credit may be some interestcharge that the supplier charges on the unpaidbalance. More often, it is in the form of a lostdiscount that would be given to firms who payearlier.

Credit has a cost. That cost may be passed alongto the customer as higher prices, borne by theseller as lower profits, or some of both.

Estimation of Cost of


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Estimation of Cost ofShort-Term Credit Calculation is easiest if the loan is for a one

year period:

Effective Interest Rate is used to determine thecost of the credit to be able to comparediffering terms.

Effective

Interest RateInterest you pay

Amount you get to use=

Example: You borrow $10,000 from a bank and must pay $1,000interest at the end of the year

Your effective rate is the same as the stated rate= $1,000/$10,000 = .10 = 10%


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V i ti i L T


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Variations in Loan Terms

Sometimes lenders require that a minimumamount, called a compensating balance bekept in your bank account.

If your compensating balance requirementis $500, then the amount you can use isreduced by that amount.

Effective cost for a $10,000 simple interest

10% loan with a $500 compensatingbalance = $1,000/($10,000-$500) = .1053= 10.53%.

Cost of Short-Term Credit


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Cost of Short Term CreditFor Periods Less Than One Year

When loans are for less than one year, we mustconvert 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

Annual =

Rate1 + -1

$ Interest$ you get

to use

(Periods/yr)( )


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Cost of Short-Term Credit


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Cost of Short Term CreditFor Periods Less Than One Year

What if the loan is a discount loan? Mustpay the interest up front so that reduces thedollars available to use.

$10,000 loan with .9%monthly interest:

K=(1+ 9010,000 - 90

)12

-1 = .1146

k = 11.46%

Effective annual rate

Sources of Short Term


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Sources of Short TermCredit

Cost of Trade Credit

Typically receive a discount if you pay

early. Stated as: 2/10, net 60

Purchaser receives a 2% discount if paymentis made within 10 days of the invoice date,

otherwise payment is due within 60 days ofthe invoice date.

The cost is the form of the lost discount.

Cost of Trade Credit 2/10


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Cost o ade C ed t / 0net 60

Assume your purchase is $100 list.

If you take the discount, you pay $98.

If you dont take the discount, you pay$100.

Therefore, you are paying $2 for the

privilege of borrowing $98 for theadditional 50 days. (Note: the first 10days are free in this example).

Cost of Trade Credit 2/10 net 60


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The formula for cost of trade credit is similar tothe previous equations.

The exponent is the number of times per yearthe firm can take 50 days of credit.

The cost of trade credit for this example:[1 +(2/98)])7.3 -1 = .1589 = 15.89%.

Cost of Trade Credit 2/10 net 60

Cost

of Credit

Discount %100-Discount%

1 + -1365

days to pay - disc. pd.( )=((

Computing the Cost of TradeC dit


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Credit

Another Example Effective Annual Cost, k, of Passing Up

a Discount; 2/10, n40

K =(1+ 2100 - 2 )( 36540 10 )

-1 = .2786

k = 27.86%

Commercial Paper


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Commercial Paper

Commercial paper is quoted on a discountbasis so discount yield must be converted toeffective annual interest rate forcomparison.

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

Cost of Commercial Paper


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pExample

$1 million issue of 90 day c.p. quoted at 4% discount yield.

Step 1:Calculate D = .04 x $1 mill. x 90360

= $10,000

Step 2:Calculate price= $1,000,000 - $10,000= $990,000

Step 3:Calculate effective rate

= (1,000,000 / 990,000)

(365/90)

-1= 4.16%

Accounts Receivable as


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Collateral

A pledge is a promise that the borrowingfirm will pay the lender any paymentsreceived from the accounts receivablecollateral in the event of default.

Since accounts receivable fluctuate overtime, the lender may require certainsafeguards to ensure that the value of thecollateral does not go below the balance of

the loan. Accounts receivable can also be sold

outright. This is known as factoring.


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Inventory as Collateral


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Inventory as Collateral

Blanket Lien: A general claim against theborrowers inventory if there is a default

Trust Receipt: A legal document thatidentifies specific inventory as security for aloan

Warehousing: Inventory pledged as

collateral is removed from the control of theborrower (either in an on-site or publicwarehouse)

working capital policy.pptx

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