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CFA Exam Level –I Corporate Finance Module

W ki Capital
Working C it l Management
M t

Dr. C. Bulent Aybar

Professor of International Finance
Net Working Capital

• Working Capital includes a firm

firm’ss current assets
which consist of cash and marketable securities in
addition to accounts receivable and inventories.
• It also consists of current liabilities, including
accounts payable (trade credit), notes payable (bank
loans), and accrued liabilities.
• Net Workingg Capitalp is defined as total current
assets less total current liabilities.

© Dr. C. Bulent Aybar

The Tradeoff Between Profitability & Risk

Positive Net Working Capital (low return

return, low risk)

Current Current
Liabilities low
low cost
Net Working
return Capital > 0
Debt high

Fi ed
high Assets
return Equity
The Tradeoff Between Profitability & Risk

N ti Net
Negative N t Working
W ki Capital
C it l (high
(hi h return
t andd high
hi h risk)
i k)

low Current Assets Current

return Liabilities low
Net Working cost
Capital < 0

Fixed Assets Long-Term

high D bt
Debt high
return cost

q y
© Dr. C. Bulent Aybar
Effects of Changing Ratios on Profits and Risk
The Cash Conversion Cycle

• Short-term financial management—managing current

assets and current liabilities—is one of the financial
manager’s most important and time-consuming activities.
• The goal of short-term financial management is to
g each of the firms’ current assets and liabilities to
achieve a balance between profitability and risk that
contributes positively to overall firm value.

© Dr. C. Bulent Aybar

Effective Working Capital Management

• Ensures that the company has adequate ready access to the

funds necessary to handle its day to day operations
• Makes sure that company
p y assets are invested in the most
productive way!
• Achieving these objectives require:
– Maintaining adequate levels of cash
– Converting short term assets into cash and
– Controlling outgoing payments to vendors, employees or others

© Dr. C. Bulent Aybar

Working Capital Management-Multifaceted
• Effective WCM requires multidimensional effectiveness in
– Managing Short Term Investments
– Granting credit to customers and managing Collections
– Managing Inventory
– Managing Payables
– Reliable cash flow forecasts
– Effective monitoring of transactions and bank balances

• Its scope ranges from transactions, to effective relationships

with financial institutions, clients and suppliers (trading
partners) to analysis to develop appropriate strategies.

© Dr. C. Bulent Aybar

Definition of Liquidity

• Liquidity is defined as the ability to meet short term

obligations without disruption of business.
• Liquidity
q y management
g refers to the abilityy of an organization
to generate cash when and where it is needed.
• In general we associate liquidity with short term assets and
short term liabilities.
• Effective liquidity management requires maintaining a
productive balance between short term assets and liabilities,
as well as efficient management of key sources of liquidity.

© Dr. C. Bulent Aybar

Drags and Pulls on Liquidity

• Uncollected • Making payments early

• Reduced credit limits
• Obsolete Inventory imposed by suppliers
• Tight Credit • Limits on short term
lines of credit imposed
by financial institutions
• Low liquidity positions
Measuring Liquidity

• Liquidity Ratios measure a company

company’ss ability to meet short
term obligations to creditors. This measure of liquidity
focuses on the relationships between current assets and
currentt liabilities
li biliti andd relies
li on the
th rapidity
idit with
ith which
hi h
receivables and inventories can be converted in to cash
– Current Ratio (Current Assets/Total Current Liabilities)

• In most situations, inventory is the least liquid of the current

assets,, therefore exclusion of inventoryy pprovides more
powerful measure of liquidity:
– Quick Ratio (Current Assets-Inventory/Total Current

© Dr. C. Bulent Aybar

A Word of Caution

• It is often said that the larger

g the current ratio,, the more liquid
q the firm is.
However, a firm’s current ratio can be increased by:
• Having clients pay their bills as late as possible
• Maximizing
Ma imi ing inventories
in entories
• Paying the firm’s suppliers in a hurry
• Although the quick ratio is an improvement over the current ratio, it still
emphasizes a liquidation view of the firm
• Furthermore, a firm’s inventories (which are excluded from the quick ratio on the
assumption that they are less liquid than receivables) are often as liquid as the
firm's receivables

© Dr. C. Bulent Aybar

Operating Cycle

• The Operating
p g Cycle
y ((OC)) is the time between orderingg
materials and collecting cash from receivables.
• A long operating cycle is a drag on liquidity. If it takes too
long to convert inventory to sales, and it takes too long to
collect cash from sales on credit, company’s ability to
generate cash declines.
• These two potential drags can be measured by using several
ratios such as Accounts Receivable Turnover and Inventoryy

© Dr. C. Bulent Aybar

A Quick Review of Key Short Term Asset Management Ratios

• Accounts Receivable Ratios:

• Accounts Receivable Turnover =Credit Sales/Average Receivables
• Number of Days of Receivables =365/ART
• Number of Days of Receivables =Accounts Receivables/Average Daily Credit
• Inventory Ratios:
• Inventory Turnover Ratio=Cost of Goods Sold/Average Inventory
• Number of Days in Inventory =365/Inventory Turnover Ratio
• Number of Days in Inventory =Average Inventory/Daily Cost of Goods Sold
• Accounts Payable Ratios:
• Number of Days of Payables: Average Accounts Payable/Daily Purchases

© Dr. C. Bulent Aybar

Operating Cycle

– OC
Number of Days in Inventory + Number of Days in Receivables
– Number of Days in Inventory=Average Age of Inventory
– Number of Days in Receivables=Average Collection Period
– As we indicated earlier the Operating Cycle (OC) is the time between
ordering materials and collecting cash from receivables. The longer
the OC,, the longer
g the cash is tied upp in operations.
– However, in order to accurately account for cash conversion we also
need to incorporate payment cycle. This brings us to Net Operating

© Dr. C. Bulent Aybar

Net Operating Cycle or Cash Conversion Cycle

• The Cash Conversion Cycle (CCC) is the time between

when a firm pays it’s suppliers (payables) for inventory and
collecting cash from the sale of the finished product.
– CCC=Number of Days in Inventory-Number of Days in Receivables
–Number of days of Payables Average

© Dr. C. Bulent Aybar

Example: Max’s Cash Conversion Cycle
MAX Company, a producer of paper dinnerware, has annual sales of $10 million, cost
of goods sold of 75% of sales,
sales and purchases that are 65% of cost of goods sold
sold. MAX
has an average age of inventory (AAI) of 60 days, an average collection period (ACP)
of 40 days, and an average payment period (APP) of 35 days.

U i ththe values
l ffor th
these variables,
i bl th
the operating
ti cycle
l ffor MAX iis
60 + 40=100 days. Cash Conversion or Net Operating Cycle is
100-35=65 days.
XYZ Inc.

• XYZ is a Southern California furniture manufacturer in a niche market.

• Company is in the process of reviewing its cash management practice.
Treasurer gathers facts and identifies the following:
– Company purchases on open account, there are volume discounts (due to its
order size), Suppliers also do not offer any cash discounts , currently
company buys on net 30 terms. Its average payment period (APP) is 30
days This is shorter than industry average of 39 days.
days. days
– Average days in inventory for the firm is 110 days. This is well above the
industry average of 83 days.
– Company sales are on net 60 basis which is the industry standard. Average
days in receivables is 75 days. If company used cash discounts (eg 3/10 net
60) ADR (or Average collection period) could be reduced by 40%.
– XYZ’s’ operating
i cycle
l investment
i is
i currently
l $26.5m.
$26 This
hi isi the
h minimum
i i
projected disbursement until 2010 and opportunity cost of this investment is
about 15%.
© Dr. C. Bulent Aybar
• Analyze the current operating cycle,
cycle cash conversion cycle
and resource investment need. Assuming a constant rate of
purchases calculate OC and NOC.
• If the company optimized its operations according to
industry standards, what will be its operating cycle ( OC),
cash conversion cycle ( CCC),
CCC) and resource investment
• In terms of resource investment requirements,
requirements what is the
cost of operational inefficiency?

© Dr. C. Bulent Aybar

• Operating cycle (OC)=
(OC) average age of inventory + average collection
– = 110 days + 75 days = 185 days
• Cash conversion cycle(CCC)= OC - average payment period
– = 185 days - 30 days
– = 155 days
• Investment Tied-up= (Total Operating Cycle Outlays/365) x CCC
= ((26,500,000/365)
, , ) x 155
= $11,253,425

© Dr. C. Bulent Aybar

OC, CCC and Resource Need at Industry Standards

• Industryy OC= 83 days

y + 75 days
= 158 days
• Industry CCC= 158 days - 39 days
= 119 days
• Resources needed if CCC were at industry standard 119 days
– (26,500,000/365)x119= $8,639,726

• Overinvestment in Operations=$11,253,425-8,639,726
= $2,613,699
• Cost of inefficiency=$2,613,699 x 0.15 = $392,055
© Dr. C. Bulent Aybar
Offering 3/10 net 60 to Clients
• Reduction in collection period =75 days  (1 - 0.4)=45 days
• OC = 110 days + 45 days = 155 days
• CCC =155 days - 39 days
• =116 days
• Resources needed = (26,500.000/365)x116=$8,421,917
• Additional savings =$ = $11,253,425 - $8,421,917 =
=$2,831,507  0.15 = $424,126

© Dr. C. Bulent Aybar

Credit Policy Changes and Trade-offs

• Note that this savings occur at a cost.

cost A more specific
assessment of the credit policy changes require assessment
of costs and benefits:
• The major cost is often the discount offered to the client,
which reduces the revenues
• There are two typical benefits:
– A Reduction in investment in A/R
– A reduction in bad debt

• The adaptation of policy requires careful analysis of these

t andd benefits.
b fit

© Dr. C. Bulent Aybar


The following slides (24-28) will not be covered in the review,

and also are not co
ered in the preparation materials
materials, ho
e er it would
o ld be
useful to put the preceding consideration into a perspective.
Discount and Reduction in Sales

• If the firms sales ( all on credit) are $ 40,000,000

40 000 000 and 45% of
the customers are expected to take the cash discount, by how
much will the firms annual revenues be reduced as a result of
th discount?
the di t?
– Reduction in sales: $40,000,000  0.45  0.03 = $540,000

© Dr. C. Bulent Aybar

• ( 3)) If the firms variable cost of the $ 40,000,000
, , in sales is 80%,, determine the
reduction in the average investment in accounts receivable and the annual
savings that will result from this reduced investment, assuming that sales remain
– Average investment in accounts receivable assuming cash discount:
– New average collection period = 45 days
– ($40,000,000  0.80)  (365  45) = $3,945,205
– Average investment in accounts receivable assuming no cash discount:
– (40,000,000  0.80)  (365  75) = $6,575,342
– Reduction in investment in accounts receivable:
– $
$6,575,342 - $3,945,205
$ = $2,630,137
– Annual savings: $2,630,137  0.15= $ 394,521

© Dr. C. Bulent Aybar

• ( 4) If the firms bad- debts expenses decline from 2% to 1.5% of sales,
what annual savings will result, assuming that sales remain constant?
– Reduction in bad debt expense:
– $40,000,000
$  (0.02
( - 0.015)=
) $ 200,000
• ( 5) Use your findings in parts ( 2) through ( 4) to assess whether offering
the cash discount can be jjustified financially.
y Explain
p whyy or whyy not.
– Cost of offering cash discount ($ 540,000)
– Annual savings from reduction in investment in accounts receivable 394,521
– Annual savings from reduction in bad debt expense: 200 000
– Savings due to cash discount $ 54,521

© Dr. C. Bulent Aybar

End of Extra Material
Investing Short Term Funds

• Short term Working Capital Portfolios consist of highly

liquid, less risky and shorter maturity securities.
– US Treasury Bills
– Federal Agency Securities (Fannie Mae, FHLB etc.)
– Bank CDs/Bank Sweep Services
– Banker’s Acceptances (BA)
– Eurodollar Time Deposits
– Repos
– Commercial Papers
– Money Market Funds
– Adjustable Rate Preferred Stocks
© Dr. C. Bulent Aybar
Yield Calculations-A Quick Review

  
Face Value-Purchase Price 360
Money Market Yield=   
  Number of days to maturity 
 Purchase Price  

  
Face Value-Purchase Price 365
Bond Equivalent Yield=   
  Number of days to maturity 
 Purchase Price  

  
Face Value-Purchase Price 360
Discount Basis Yield=   
   Number of days to maturity 
 Face Value  

© Dr. C. Bulent Aybar

Example: Money Market and Bond Equivalent Yield

• A 91 day $100
000 US Treasury is sold at a discounted rate
of 2.5%. Calculate the money market and bond equivalent
– Step-1: Calculate the Purchase Price
– 100,000-[0.025 x (91/360)x$100,000]=99,368.06
– Step-2: Use MMY and BEY formulas
– MMY (100,000-99,368.06/99,368.06)x(360/91)

– BEY  (100,000-99,368.06/99,368.06)x(365/91)

© Dr. C. Bulent Aybar
Managing Accounts Receivables

• The second component of the cash conversion cycle is the

average collection period – the average length of time from a
sale on credit until the payment becomes usable funds to the
• The collection period consists of two parts:
– the time period from the sale until the customer mails payment, and
– the time from when the payment is mailed until the firm collects
u ds in itss ba
bank accou

© Dr. C. Bulent Aybar

Average Collection Period

• Average Collection Period can be reduced by changing the credit terms

and encouraging shorter pay periods through discounts.
• ACP can also reduced by increasing effectiveness of the collections by
reducing collection float
• Collection float is the delay between the time when a payer deducts a
payment from its checking account ledger and the time when the payee
actually receives the funds in spendable form. There are three
components of the collection float:
– Mail float is the delay between the time when a payer places payment in the mail and
h time
i when h it i is
i received
i d by
b the
h payee.
– Processing float is the delay between the receipt of a check by the payee and the
deposit of it in the firm’s account.
– Cl
i float
fl is i the
h delay
d l between
b the
h deposit
d i off a check
h k by
b the
h payee andd the
h actuall
availability of the funds which results from the time required for a check to clear the
banking system.
© Dr. C. Bulent Aybar
Float and Float Factor

• The Float is the amount of money in transit between

payments made by customers and the funds usable by the
• Float Factor measures the time it takes for the deposited
checks to clear, not the time it takes to receive the checks,
deposit them and have them clear!
• Float Factor=Average Daily Float/Average Daily Deposits

© Dr. C. Bulent Aybar

Inventory Management

• Inventoryy is considered as an investment since managers

must purchase the raw materials and make expenditures for
the production of the product such as paying labor costs.
Until cash is received through the sale of the finished goods,
the cash expended for inventory, in any of its forms, is an
investment by the firm.
• Classification of inventories:
– Raw materials: items purchased for use in the manufacture of a
finished product
– Work-in-progress: all items that are currently in production
– Finished
Fi i h d goods:
d items
it that
th t have
h been
b produced
d d but
b t nott yett sold

© Dr. C. Bulent Aybar

Inventory Management: Differing Views About Inventory

• The different departments within a firm (finance,

(finance production,
marketing, etc.) often have differing views about what is an
“appropriate” level of inventory.
• Financial managers would like to keep inventory levels low
to ensure that funds are wisely invested.
• Marketing managers would like to keep inventory levels
high to ensure orders could be quickly filled.
• Manufacturing managers would like to keep raw materials
levels high to avoid production delays and to make larger,
more economical pproduction runs.

© Dr. C. Bulent Aybar

Inventory Management Systems: Economic Order Quantity

• The EOQ looks at all of the various costs of inventory and

determines what order size minimizes total inventory cost.
• The model analyzes
y the tradeoff between order cost and
carrying cost and determines the order quantity that
minimizes the total inventory cost.
• The model Parameters:
– S= Usage in units per period
– O=Order Cost per Order
– C=Carrying Cost per unit per period
– Q=Order Quantity per Period

© Dr. C. Bulent Aybar

Determination of optimal order size

Total costs
s, dollars

Inventtory costs

Total order costs

Optimal Order size

order size
Economic Order Quantity

• Order Cost
O x (S/Q)
• Carrying Cost=C x (Q/2)
• Total
T t l Cost=Order
C t O d Cost
C t + Carrying
C i Cost
C t
• TC =[O x (S/Q)]+[ C x (Q/2)]
• Economic Order Quantity is the order quantity that
minimizes the total cost. Minimum point for TC is the point
where its slope is equal to zero.
• EOQ  dTC/dQ =0
© Dr. C. Bulent Aybar
Reorder Point

• Once a company has calculated its EOQ,

EOQ it must determine
when it should place its orders.
• More specifically,
specifically the reorder point must consider the lead
time needed to place and receive orders
• If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder point can be
determined by using the following equation:
– Reorder point = lead time in days x daily usage
– Daily Usage=Annual Usage/360

© Dr. C. Bulent Aybar

Example: RLB Inc. EOQ and Cost of Inventory

• Assume that RLB,, Inc.,, a manufacturer of electronic test

equipment, uses S=1,600 units of an item annually. Its order
cost is O=$50 per order, and the carrying cost is C=$1 per
unit per year.
• EOQ={(2x50x1,600)/1}1/2=400 units
• Assuming that company orders 400 units at a time the total
cost of inventory will be:
• TC=Order
TC O d Cost
C t +Carrying
+C i Cost
C t
• ={50 x(1,600/400)}+ {$1 x (400/2)}=$400

© Dr. C. Bulent Aybar

RIB Reorder Point

• Using the RIB example above,

above if they know that it requires
10 days to place and receive an order, and the annual usage
is 1,600 units per year, the reorder point can be determined
as follows:
f ll
• Daily Usage=1600/360=4.444
• Reorder Point=Lead Time x Daily Usage =10x 4.444
=44.44 or 45 units
• Thus, when RIB’s inventory level reaches 45 units, it should
place an order for 400 units. However, if RIB wishes to
i t i safety
f t stock
t k to
t protect
t t against
i t stock
t k outs,
t they
would order before inventory reached 45 units.
© Dr. C. Bulent Aybar
Accounts Payable Management

• The longer the number of days of payables,

payables the shorter the
cash conversion cycle. Therefore firms have an incentive to
delay payments. However, this effort should be managed
f ll as it may result
lt in
i deterioration
d t i ti off firm
fi credibility
and may have costly repercussions.
• While early payments should be avoided,
avoided and float factors
should be carefully accounted for, systematic delays should
be avoided and credit relationships should be carefully
managed with suppliers.
• An important consideration in A/P management is the
discountt offers.
ff Should
Sh ld the
th firm
fi take
t k discount
di t offers
ff andd pay
early? Or should the credit term be used fully?
© Dr. C. Bulent Aybar
Cash Discounts

• Taking the Cash Discount

– If a firm intends to take a cash discount, it should pay
on the last day of the discount period.
– There is no cost associated with taking a cash discount
• Giving
Gi i UpU the
th CCash
h Di
– If a firm chooses to give up the cash discount, it should
pay on the final day of the credit period.
– The cost of giving up a cash discount is the implied rate
of interest ppaid to delay
y ppayment
y of an account ppayable
for an additional number of days.
© Dr. C. Bulent Aybar

• Zoom Industries,
Industries operator of a small chain of video stores,
purchased $1,000 worth of merchandise on February 27
from a supplier extending terms of 2/10 net 30 EOM.
• If the firm takes the cash discount, it will have to pay $980
[$1,000 - (.02 x $1,000)] on March 10th saving $20.
• If Lawrence gives up the cash discount, payment can be
made on March 30th. To keep its money for an extra 20
days the firm must give up an opportunity to pay $980 for
its $1,000 purchase, thus costing $20 for an extra $20 days.

© Dr. C. Bulent Aybar

Cost of Giving up Cash Discount

365/ N
 CD 
Annualized Cost of Giving up Discounts  1   1
 (100%  CD) 
365 / 20
 2% 
 1    1  44.59%
 (100%  2%) 
If the firm’s short term financing cost Is lower than implied interest or cost of
giving up cash discount, firm should take the discount
Cost of Giving Up Cash Discount

• Note that the cost of giving up cash discount increases with

the credit period. The longer the credit period, or the longer
the payment can be delayed, the lower the cost of cash
• In the previous example, the payment can be delayed 20
more days.
days If the credit term was 2/10 net 70,
70 payment could
be delayed 60 more days. In that case the cost of giving up
discount would be:
365/ 60
 2% 
 1    1  13.07%
 ((100%  2%)) 

© Dr. C. Bulent Aybar

Unsecured Sources of Short Term Loans

• The major type of loan made by banks to businesses is the

short-term, self-liquidating loan which are intended to
carry firms through seasonal peaks in financing needs.
• These loans are generally obtained as companies build up
inventory and experience growth in accounts receivable.
• As receivables and inventories are converted into cash, the
loans are then retired.
• These loans come in three basic forms: single-payment
notes, lines of credit, and revolving credit agreements.

© Dr. C. Bulent Aybar

Interest on Short Term Loans

• Most banks loans are based on the prime rate of interest which is the
lowest rate of interest charged by the nation’s leading banks on loans to
their most reliable business borrowers.
• Short term international bank loans are based on LIBOR
• Banks generally determine the rate to be charged to various borrowers by
adding a premium to the prime rate or LIBOR to adjust it for the
borrowers ““riskiness.”
i ki ”
• Interest rates may be fixed or floating:
– On a fixed-rate loan, the rate of interest is determined at a set increment
above the prime rate or LIBOR and remains at that rate until maturity.
– On a floating-rate loan, the increment above the prime rate is initially
established and is then allowed to float with prime or LIBOR until maturity

© Dr. C. Bulent Aybar

Method of Computing Interest Rates

• If interest is paid at maturity, the effective (true) rate of interest—

assuming the loan is outstanding for exactly one year—may be computed
as follows:
I t

Amount Borrowed
• If the interest is paid in advance,
advance it is deducted from the loan so that the
borrower actually receives less money than requested. Loans of this type
are called discount loans. The effective rate of interest on a discount
loan assuming g it is outstanding
g for exactly
y one yyear may
y be computed
p as

Amount Borrowed  Interest

© Dr. C. Bulent Aybar

Single Payment Notes

• ABC Inc. recently borrowed $100,000 from each of 2 banks banks—A A and B.
Loan A is a fixed rate note, and loan B is a floating rate note. Both loans
were 90-day notes with interest due at the end of 90 days. The rates were
set at 1.5% above prime for A and 1.0% above prime for B when prime
was 6%.
• Based on this information, the total interest cost on loan A is:
• $1,849 [$100,000 x (6% +1.5%)x (90/365)]=$1,849
• The effective cost is 1.85% or ($1,849/100,000) for 90 days. The
effective annual rate mayy be calculated as follows:
• EAR = (1 + periodic rate)m - 1 = (1+. 0185)4.06 - 1 = 7.73%

© Dr. C. Bulent Aybar

Line of Credit
– A line of credit is an agreement
g between a commercial bank and a business
specifying the amount of unsecured short-term borrowing the bank will
make available to the firm over a given period of time.
– It is usually made for a period of 1 year and often places various constraints
on borrowers.
borro ers
– Although not guaranteed, the amount of a LOC is the maximum amount the
firm can owe the bank at any point in time.
– The
Th interest
i rate on a LOC is
i normally
ll floating
fl i andd peggedd to prime.
– Both LOCs and revolving credit agreements often require the borrower to
maintain compensating balances.A compensating balance is simply a
t i checking
h ki accountt balance
b l equall to
t a certain
t i percentage
t off the
th amountt
borrowed (typically 10 to 20 percent).
– This requirement effectively increases the cost of the loan to the borrower.

© Dr. C. Bulent Aybar

Revolving Credit Agreement

• A RCA is nothing more than a guaranteed line

of credit.
• Because the bank guarantees the funds will be available, they
t i ll charge
typically h a commitment
it t fee
f which
hi h applies
li to
t the
unused portion of the borrowers credit line.
• A typical fee is around 0.5% of the average unused portion
of the funds.
• Although more expensive than the LOC, the RCA is less
i k from
f th borrowers
the b perspective.

© Dr. C. Bulent Aybar


• REH Company has a $2 million RCA.RCA Its average borrowing

under the agreement for the past year was $1.5 million.
• The bank charges
g a commitment fee of 0.5% % As a result,,
they had to pay 0.5% on the unused balance of $500,000 or
• In addition, REH paid $112,500 in interest on the $1.5
million it actually used.
• As a result, the effective annual cost of the RCA was 7.67%
[($112,500 + $2500)/$1,500,000].

© Dr. C. Bulent Aybar

Commercial Paper

• Commercial paper is a short-term,

short-term unsecured promissory
note issued by a firm with a high credit standing.
• Generallyy onlyy large
g firms in excellent financial condition
can issue commercial paper.
• Most commercial paper has maturities ranging from 3 to 270
days, is issued in multiples of $100,000 or more, and is sold
at a discount form par value.
• Commercial paper is traded in the money market and is
commonly held as a marketable security investment.

© Dr. C. Bulent Aybar

Cost of Commercial Paper

• XYZ Corporation has just issued $1 million worth of 90

day commercial
paper at $990,000.
• At the end of 90 days, XYZ will pay the purchaser the full $1 million.
• The cost to XYZ is therefore 1.01% ($10,000/$990,000) for 90 days.
• The effective annual rate of interest can be calculated as follows:
– EAR = (1 + periodic rate)m - 1 = (1+.0101)4.06
4 06 - 1 = 8.41%

© Dr. C. Bulent Aybar

Secured Loans-A/R and Inventory as Collaterals

• Although it may reduce the loss in the case of default,

default from
the viewpoint of lenders, collateral does not reduce the
riskiness of default on a loan.
• When collateral is used, lenders prefer to match the maturity
of the collateral with the life of the loan.
• As a result, for short-term loans, lenders prefer to use
accounts receivable and inventory as a source of collateral.

© Dr. C. Bulent Aybar

A/R as Collateral

• Pledging accounts receivable occurs when accounts

receivable is used as collateral for a loan.
• After investigating the desirability and liquidity of
the receivables, banks will normally lend between
50 and 90 percent of the face value of acceptable
• In addition,, to pprotect its interests,, the lender files a
lien on the collateral and is made on a non-
notification basis (the customer is not notified).

© Dr. C. Bulent Aybar

Inventory as Collateral

– The most important characteristic of inventory as collateral is its

– Perishable items such as fruits or vegetables may be marketable, but
since the cost of handling and storage is relatively high,
high they are
generally not considered to be a good form of collateral.
– Specialized items with limited sources of buyers are also not
d i bl collateral.
desirable ll t l
– A floating inventory lien is a lender’s claim on the borrower’s
general inventory as collateral.
• This is most desirable when the level of inventory is stable and it
consists of a diversified group of relatively inexpensive items.
• Because it is difficult to verify the presence of the inventory, lenders
generally advance less than 50% of the book value of the average
inventory and charge 3 to 5 percent above prime for such loans.

© Dr. C. Bulent Aybar