Chapter 10 Working-Capital Management and Short-term Financing

Working-Capital Management
Current Assets
Cash, marketable securities, inventory, accounts receivable.

Long-Term Assets
Equipment, buildings, land.

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

Working-Capital Management
Current Assets
Cash, marketable securities, inventory, accounts receivable.

Long-Term Assets
Equipment, buildings, land.

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

Working-Capital Management
Current Liabilities
Short-term notes, accrued expenses, accounts payable.

Long-Term Debt and Equity

Bonds, preferred stock, common stock.

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

Working-Capital Management
Current Liabilities
Short-term notes, accrued expenses, accounts payable.

Long-Term Debt and Equity

Bonds, 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 Principle

Permanent 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
Temporary Current Assets

Balance Sheet
Temporary Current Assets Temporary Short-term financing

Balance Sheet
Temporary Current Assets Permanent Fixed Assets Temporary Short-term financing

Balance Sheet
Temporary Current Assets Permanent Fixed Assets Temporary Short-term financing Permanent Financing and Spontaneous Financing

The Hedging Principle

Permanent Financing
Intermediate-term loans, long-term debt, preferred stock, common stock.

Spontaneous Financing
Accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes).

Short-term financing
Unsecured bank loans, commercial paper, loans secured by A/R or inventory.

Cost of Short-Term Credit

Interest = principal x rate x time
Example: Borrow $10,000 at 8.5% for 9 months.

Interest = $10,000 x .085 x 3/4 year = $637.50

Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x time

to solve for rate, and get the

Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x time

to solve for rate, and get the

Annual Percentage Rate (APR)

Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x time

to solve for rate, and get the

Annual Percentage Rate (APR)

APR =

interest principal

1 time

Cost of Short-Term Credit

Cost of Short-Term Credit APR =

interest principal

1 time

Cost of Short-Term Credit APR =

interest principal

1 time

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

Cost of Short-Term Credit APR =

interest principal

1 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 Credit

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

Cost of Short-Term Credit

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

APY =

(1+ )
i m

- 1

Cost of Short-Term Credit

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

APY =

(1+ )
i m

- 1

i = the nominal rate of interest m = the # of compounding periods per year

Cost of Short-Term Credit

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

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

9.38%

Sources of Short-term Credit

Unsecured

Sources of Short-term Credit

Unsecured
Accrued wages and taxes.

Sources of Short-term Credit

Unsecured
Accrued wages and taxes. Trade credit.

Sources of Short-term Credit

Unsecured
Accrued wages and taxes. Trade credit. Bank credit.

Sources of Short-term Credit

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

Sources of Short-term Credit

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

Secured

Sources of Short-term Credit

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

Secured
Accounts receivable loans.

Sources of Short-term Credit

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

Secured
Accounts receivable loans. Inventory loans.