© prentice hall, 2004 22 corporate financial management 3e emery finnerty stowe liquidity...
TRANSCRIPT
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© Prentice Hall, 2004
2222
Corporate Financial Management 3e
Emery Finnerty Stowe
Liquidity Management
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Working Capital Management
Working capital = current assets – current liabilities
Working capital management refers to choosing the levels and mix of: cash, marketable securities, receivables and
inventories. different types of short-term financing.
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Considerations in Working Capital Management
Sales impact
Liquidity
Relations with stakeholders suppliers customers
Short-term financing mix profitability risk considerations
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Working Capital Management
Maturity matching approach
Conservative approach
Aggressive approach
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Maturity Matching Approach
Hedge risk by matching the maturities of assets and liabilities.
Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-term financing.
There are no excess funds.
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Maturity Matching Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed AssetsLong Term
Financing
Short Term Financing
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Conservative Approach
Long-term funds are used to finance both permanent as well as some temporary short-term assets.
When there are excess funds, they are invested in marketable securities.
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Conservative Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed Assets
Marketable securitiesLong Term
Financing
Short Term Financing
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Aggressive Approach
Use less long-term and more short-term financing than the conservative approach.
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Aggressive Approach
Temporary Current Assets
Time
$
Permanent Current Assets
Fixed Assets Long Term
Financing
Short Term Financing
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Cost and Risk Considerations
Yield curve is usually upward sloping.
Short-term rates are more volatile than long-term rates.
Firm's ability to obtain needed short-term financing.
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Cash Conversion Cycle
The cash conversion cycle is the length of time between payment of accounts payable and the receipt of cash from accounts receivable.
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Cash Conversion Cycle
Purchase Inventory
Sale on Credit
Collect Acct. Receivable
Payment of Accts. Payable
Inventory Conversion Period
Cash Conversion Cycle
Time
Payables Deferral Period
Receivables Collection Period
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Cash Conversion Cycle
period
deferral
Payables
period
collection
sReceivable
period
conversion
Inventory
cycle
conversion
Cash
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Inventory Conversion Period
The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.
turnoverInventory
365
Sales/365 ofCost
Inventory
period
conversion
Inventory
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Receivables Collection Period
The receivables collection period is the average number of days it takes to collect on accounts receivable. Equal to days sales outstanding (DSO)
turnoversReceivable
365
Sales/365
sReceivable
period
collection
sReceivable
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Payables Deferral Period
The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same.
365expenses)/ tiveadministra and general Selling,sales of(Cost
payable taxespayroll benefits,Wages,payable Accounts
period
deferral
Payables
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Cash Conversion Cycle
Given the following information about Vision Opticals, compute the firm’s cash conversion cycle.
InventoryAccounts ReceivableAccounts PayableWages, Benefits, Payroll Taxes
SalesCost of SalesSelling & Other Expenses
$19,000$21,000
$5,600$9,000
$227,000$93,000$22,000
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Inventory Conversion Period
turnoverInventory
365
Sales/365 ofCost
Inventory
period
conversion
Inventory
days 74.575$93,000/36
$19,000
period
conversion
Inventory
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Receivables Collection Period
turnoversReceivable
365
Sales/365
sReceivable
period
collection
sReceivable
days 77.3365$227,000/3
$21,000
period
collection
sReceivable
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Payables Deferral Period
days 34.46365/)000,22$000,93($
000,9$600,5$
365expenses)/ tiveadministra and general Selling,sales of(Cost
payable taxespayroll benefits,Wages,payable Accounts
period
deferral
Payables
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Cash Conversion Cycle
period
deferral
Payables
period
collection
sReceivable
period
conversion
Inventory
cycle
conversion
Cash
days 34.46days 77.33days 57.74
cycle
conversion
Cash
days 62
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Cash Management
How much liquidity (cash plus marketable securities) should the firm have?
What should be the relative proportions of cash and marketable securities?
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Demands for Cash
Transactions demand
Precautionary demand
Speculative demand
Compensating balances
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Short-Term Investment Alternatives
U.S. Treasury securities T-bills, T-notes, and T-bonds
U.S. federal agency securities
Negotiable certificates of deposit
Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock
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Other Factors in Cash Management
Compensating balance requirements
Optimal amount of marketable securities transaction costs maturity risk yield
Special tax situations
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Float
Float is the difference between the available (or collected) balance at the bank and the firm’s book or ledger balance.
Disbursement float occurs when the firm writes a check but the check has not yet cleared the banking system.
Collection float occurs when a check has been deposited but the funds are not yet credited to the firm’s bank account.
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Float Management Techniques
Wire transfers
Zero balance accounts (ZBAs)
Controlled disbursing
Centralized processing of payables
Lockboxes
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Lockbox Systems
Discount Music Stores is evaluating a lockbox system which will reduce float by 3 days. The lockbox system costs $15,000 per year. The firm’s daily collections average $150,000, and its opportunity cost of funds is 6% per year.
Should the firm utilize this lockbox system?
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Lockbox Systems
Funds freed up due to a reduction in float = (3 days)($150,000 per day) or $450,000.
Annual value of float reduction = $450,000(6%) = $27,000.
After deducting the $15,000 cost of the lockbox system, the firm nets $12,000 before taxes.
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Short-Term Financing
Trade Credit
Secured and Unsecured Bank Loans
Commercial Paper
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Cost of Trade Credit
Discount Music Stores buys its inventory on “3/10, net 30” terms. What is the cost of not taking the discount?
0 10 30
+$970,000 –$1,000,000
Suppose DMS buys $1,000,000 worth of inventory; if they forgo the 3% discount to pay on day 30 they are borrowing $970,000 for 20 days and paying $30,000 interest:
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Cost of Trade Credit: APY vs. APR
1%Discount %100
%Discount 1
PeriodDiscount Period Total
365
APY
PeriodDiscount -Period Total
365
%Discount %100
%Discount APR
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Cost of Trade Credit: APR
0 10 30
+$970,000 –$1,000,000
days 20
365
000,970$
$30,000APR
%44.56APR
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Cost of Trade Credit: APY
36520)1(
000,000,1$000,970$
r
970$
000,1$)1( 36520 r
%35.747435.01970$
000,1$ 20
365
r
0 10 30
+$970,000 –$1,000,000
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Effective Use of Trade Credit
Advantages: Readily available Informal Flexible Stretching payments
Disadvantages High cost of discounts foregone Stretching of payments can hurt reputation
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Bank Loans
Short-term unsecured loans Transaction loan Line of credit Revolving credit agreement
Term loans Bullet maturity Balloon payment
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Cost of Bank Loans
Prime rate + “spread”
LIBOR + “spread”
Compensating balances
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Compensating Balance Requirements
Let P = amount of loan f = loan term r = interest rate on loan B = incremental cash balance as a result of
compensating balance requirements y = interest earned (if any) on compensating balances
Interest charges = rPf
Interest received = yBf
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Compensating Balance Requirements
f-
-APR
1
balance ngcompensati amount Loan
receivedInterest chargesInterest
fBP
yBfrPf 1
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Compensating Balance Requirements
Custom Controls is considering a 1-year loan of $150,000 at an interest rate of 14%. Due to compensating balance requirements, Custom Controls will have to maintain a deposit balance of $20,000 which it would not have otherwise maintained at the lending bank. The deposit will earn 6% per year.
What is the APR of this loan?
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Compensating Balance Requirements
Without the 6% yield on the compensating balance, the APR = 16.15%
fBP
yBfrPfAPR
1
1
1
000,20$000,150$
000,20$06.0000,150$14.0APR
= 15.23%
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Discount Loans
The interest charge is deducted in advance for discount loans.
Let r = interest rate on the loan
f = the term of the loan
P = the principal amount
The APR of a discount loan is given by:
fr
r
frPfP
rPfAPR
1
1
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A Comparison of Single Payment Loans
Ole Tools Inc. needs to borrow $5,000 for 6 months. Four single payment loan alternatives are available as shown below. In each case, the interest rate is 15% per year. Compute the APR and APY of each alternative.
Loan Interest Payment CompensatingBalance
ABCD
in arrearsin arrears
in advancein advance
NoYes (10%)
NoYes (10%)
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A Comparison of Single Payment Loans
Interest charge on the loan is $5,000× (.15) ×(0.5 years) or $375.
For loans A & B, this amount is added to the repayment at loan maturity.
For discount loans (loans C & D), this amount is deducted from the loan amount at loan initiation.
Compensating balances (for loans B & D), is $5,000×0.10 = $500.
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A Comparison of Single Payment Loans
A
B
C
D
$5,000
$4,500
$4,625
$4,125
($5,375)
($4,875)
($5,000)
($4,500)
%22.165.
1
625,4$
375$
APR
Loan CF0 CF1 APR
%155.
1
000,5$
375
APR
%67.165.
1
500,4$
375
APR
%18.185.
1
125,4$
375$
APR
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A Comparison of Single Payment Loans
A
B
C
D
$5,000
$4,500
$4,625
$4,125
($5,375)
($4,875)
($5,000)
($4,500)
Loan CF0 CF1 APR
15.00%
16.67%
16.22%
18.18%
APY
15.56%
17.36%
16.87%
19.01%
1000,5$
375,5$2
1500,4$
875,4$2
1625,4$
000,5$2
1125,4$
500,4$2
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Discounted Installment Loans
Sheridan Systems borrows $12,000 for 3 months at 15%. The interest is paid in advance, and Sheridan will pay the loan in 3 monthly installments of $3,000 at the end of the first two months and $6,000 at the end of the third month.
Compute the APY and APR of this loan.
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Discounted Installment Loans
The interest cost of this loan is ($12,000)(15%)(3/12 years) or $450.
Since the interest is deducted in advance, Sheridan will get $12,000 - $450 or $11,550 at loan initiation.
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Discounted Installment Loans
0 1 3
–$6,000
32 )1(
000,6$
)1(
000,3$
1
000,3$550,11$
rrr
monthper %72.1r
2
–$3,000+$11,550 –$3,000
%6.200172.012 APR
%68.221)0172.1( 12 APY
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Commercial Paper
Commercial paper is a negotiable business IOU note.
It is sold by the largest, most creditworthy firms on a discount basis.
Maturity is set to less than 270 days. Registration with the SEC is not required.
40% of commercial paper is sold through dealers. Commission of about 0.125% on an annualized basis.
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Factors Affecting the Short-Term Financing Mix
Cost of each source of funds / incl’g options
Desired level of current assets
Seasonal component of current assets
Extent of maturity-matching
Flotation costs
Restricted access to long-term capital
Bankruptcy costs
Firm's choice of risk level