lecture notes2231 scm

8/9/2019 Lecture Notes2231 scm

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Working-Capital

Management

Chapter 15


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Keown Martin Petty - Chapter 15 2

Learning Objectives1. Describe the risk-return tradeoff involved in

managing a firms working capital.

2. Explain the determinants of net working capital.3. Calculate the firms cash conversion cycle and

interpret its determinants.

4. Calculate the effective cost of short-term credit.

5. List and describe the basic sources of short-termcredit.

6. Describe the special problems encountered bymultinational firms in managing working capital.


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Slide Contents1. Principles Used in this Chapter

2. Working Capital

3. The Appropriate Level of Working Capital

4. Cash Conversion Cycle

5. Cost of Short-term Credit6. Multinational Working Capital Management


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1. Principles Used in this Chapter


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Principles Used in this Chapter

Principle 1: The Risk-Return Trade-Off We Wont

Take On Additional Risk Unless We Expectto Be Compensated with Additional Return.


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2. Working Capital


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Working Capital

Working capital The firms total investmentin current assets.

Net working capital The difference betweenthe firms current assets and its currentliabilities.

This chapter focuses on net working capital.


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Managing Net Working Capital Managing net working capital is

concerned with managing the firms

liquidity. This entails managing tworelated aspects of the firmsoperations:

1. Investment in current assets

2. Use of short-term or current liabilities


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Short-Term Sources of Financing

Includes current liabilities i.e. all forms offinancing that have maturities of 1 year orless.

Two issues to consider:

How much short-term financing should the firmuse?

What specific sources of short-term financingshould the firm select?


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How Much Short-Term Financing

Should a Firm Use?

This question is addressed by hedging

the principle of working-capitalmanagement.


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What Specific Sources of Short-Term

Financing Should the Firm Select? Three basic factors influence the decision:

The effective cost of credit

The availability of credit in the amount neededand for the period that financing is required

The influence of a particular credit source on

the cost and availability of other sources offinancing


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Current Assets A firms current assets are assets that are

expected to be converted to cash within a

period of a year or less, such as cash andmarketable securities, accounts receivable,inventories.


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Risk-Return Trade-off Holding more current assets will reduce the risk of

illiquidity.

However, liquid assets like cash and marketablesecurities earn relatively less compared to otherassets. Thus larger amount liquid investments willreduce overall rate of return

The Trade-off: Increased liquidity must be traded-offagainst the firms reduction in return on investment.


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Use of Current versus

Long-term Debt Other things remaining the same, the greater the

firms reliance on short-term debt or current liabilities

in financing its assets, the greater the risk ofilliquidity.

Trade-off: A firm can reduce its risk of illiquiditythrough the use of long-term debt at the expense of

a reduction in its return on invested funds. Trade-offinvolves an increased risk of illiquidity versusincreased profitability.


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Advantages of Current Liabilities:

Return

Flexibility

Current liabilities can be used to match the timingof a firms needs for short-term financing.Example: Obtaining seasonal financing versuslong-term financing for short-term needs.

Interest Cost

Interest rates on short-term debt are lower thanon long-term debt.


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Disadvantages of Current

Liabilities: Risk

Risk of illiquidity increases due to:

Short-term debt must be repaid or rolled overmore often

Uncertainty of interest costs from year to year


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3. The Appropriate Level ofWorking Capital


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Appropriate Level of

Working Capital

Managing working capital involvesinterrelated decisions regardinginvestments in current assets and use ofcurrent liabilities.

Hedging Principle or Principle of Self-

Liquidating Debt provides a guide to themaintenance of appropriate level ofliquidity.


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Hedging Principle Involves matching the cash flow generating

characteristics of an asset with the maturity of the

source of financing used to finance its acquisition.

Thus a seasonal need for inventories should befinanced with a short-term loan or current liability.

On the other hand, investment in equipment expectedto last for a long time should be financed with long-term debt.


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Permanent and Temporary

Assets

Permanent investments

Investments that the firm expects to holdfor a period longer than one year

Temporary Investments

Current assets that will be liquidated andnot replaced within the current year


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Sources of Financing Total assets will equal the sum of

temporary, permanent and spontaneoussources of financing.


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Temporary & Permanent Source Temporary sources of financing consist of

current liabilities such as short-term secured

and unsecured notes payable.

Permanent sources of financing include:intermediate-term loans, long-term debt,

preferred stock common equity


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Spontaneous Sources of

Financing Spontaneous sources of financing arise

spontaneously in the firms day-to-day

operations. Trade credit is often made available spontaneously or

on demand from the firms supplies when the firmorders its supplies or more inventory of products to

sell. Trade credit appears on a balance sheet as accounts payable.

Wages and salaries payable, accrued interest and accruedtaxes also provide valuable sources of spontaneous financing.


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Also see table 15-1


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Hedging Principle Summary

Asset needs of the firm not financed by

spontaneous sources should be financedin accordance with this rule:

Permanent-asset investments are financedwith permanent sources, and temporaryinvestments are financed with temporarysources.


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4. Cash Conversion Cycle


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Cash Conversion Cycle A firm can minimize its working capital by

speeding up collection on sales, increasing

inventory turns, and slowing down thedisbursement of cash.

Cash Conversion cycle (CCC) captures the

above. CCC = days of sales outstanding + days of

sales in inventory days of payablesoutstanding.


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Figure 15-2 shows that both Dell and Applehave been effective in reducing their CCC.

CCC is below zero due to effectivemanagement of inventories and being able toreceive favorable credit terms.

See table 15-2 for Dells CCC.

Cash Conversion Cycle


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5. Cost of Short-term Credit


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Cost of Short-term Credit Interest = principal x rate x time

Cost of short-term financing = APR orannual percentage rate

APR = (interest / principal) * (1 / time)


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APR exampleA company plans to borrow $1,000 for 180

days. At maturity, the company will repay

the $1,000 principal amount plus $40interest. What is the APR?

APR = ($40/$1,000) X [1/(180/360)]

= .04 X (180/90)

= .08 or 8%


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Annual Percentage Yield (APY) APR does not consider compound interest. To

account for the influence of compounding, must

calculate APY or annual percentage yield. APY = (1 + i/m)m 1

Where:

i is the nominal rate of interest per year; m is number of compounding period within a year.


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APY example In the previous example,

# of compounding periods 360/180 = 2

Rate = 8%

APY = (1 + .08/2)21

= .0816 or 8.16%


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APR or APY?

Because the differences between APR

and APY are usually small, we can usethe simple interest values of APR tocompute the cost of short-term credit.


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5. Sources of Short-term Credit


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Sources of Short-term Credit Short-term credit sources can be

classified into two basic groups:

Unsecured

Secured


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Unsecured Loans Unsecured loans include all of those sources

that have as their security only the lenders

faith in the ability of the borrower to repaythe funds when due.

Major sources:

Accrued wages and taxes, trade credit, unsecuredbank loans, and commercial paper


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Secured Loans Involve the pledge of specific assets as

collateral in the event that the borrower

defaults in payment of principal or interest.

Primary Suppliers:

Commercial banks, finance companies, and factors

Principal sources of collateral:

Accounts receivable and inventories


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Unsecured Source:

Accrued wages and taxes Since employees are paid periodically

(biweekly or monthly), firms accrue a wage

payable account that is, in essence, a loanfrom their employees.

Similarly, if taxes are deferred or paid

periodically, the firm has the use of the taxmoney.


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Unsecured Source:

Trade Credit Trade credit arises spontaneously with the

firms purchases. Often, the credit terms

offered with trade credit involve a cashdiscount for early payment.

Terms such as 2/10 net 30 means a 2%discount is offered for payment within 10days, or the full amount is due in 30 days

A 2% penalty is involved for not payingwithin 10 days.


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Effective Cost of Passing Up a

DiscountTerms 2/10 net 30

The equivalent APR of this discount is:

APR = $.02/$.98 X [1/(20/360)]

= .3673 or 36.73%

The effective cost of delaying payment for 20days is 36.73%


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Unsecured Source:

Bank Credit

Commercial banks provide unsecured

short-term credit in two forms: Lines of credit

Transaction loans (notes payable)


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Line of Credit Informal agreement between a borrower and a

bank about the maximum amount of credit the

bank will provide the borrower at any one time. There is no legal commitment on the part of the

bank to provide the stated credit.

Usually requires that the borrower maintain a

minimum balance in the bank throughout the loanperiod, called a compensating balance.

Interest rate on line of credit tends to be floating.


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Revolving Credit

Revolving credit is a variant of the line ofcredit form of financing.

A legal obligation is involved.


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Transaction Loans Transaction loan is made for a specific

purpose. This is the type of loan that mostindividuals associate with bank credit and isobtained by signing a promissory note.


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Commercial Paper The largest and most credit worthy companies are

able to use commercial paper a short-term promise

to pay that is sold in the market for short-term debtsecurities.

Maturity: Usually 6 months or less.

Interest Rate: Slightly lower ( to 1%) than theprime rate on commercial loans.

New issues of commercial paper are placed directly ordealer placed.


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Commercial Paper: Advantages Interest rates

Rates are generally lower than rates on bank loans.

Compensating-balance requirement

No minimum balance requirements are associated withcommercial paper.

Amount of credit

Offers the firm with very large credit needs a single source forall its short-term financing.

Prestige

Signifies credit status.


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Secured Sources of Loans Secured loans have assets of firm pledged as

collateral. If there is a default, the lender has firstclaim to the pledged assets. Because of its liquidity,

accounts receivable is regarded as the prime sourcefor collateral.

Accounts Receivable loans

Pledging Accounts Receivable Factoring Accounts Receivable

Inventory loans


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Pledging Accounts Receivable Borrower pledges accounts receivable as collateral for a loan

obtained from either a commercial bank or a finance company.

The amount of the loan is stated as a percentage of the face value

of the receivables pledged. If the firm pledges a general line, then all of the accounts are

pledged as security. (Simple and inexpensive)

If the firm pledges specific invoices each invoice must be evaluated

for creditworthiness. (more expensive) Credit Terms: Interest rate is 2-5% higher than the banks

prime rate. In addition, handling fee of 1-2% of the facevalue of receivables is charged.


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Factoring Accounts Receivable Factoring accounts receivable involves the

outright sale of a firms accounts to a

financial institution called a factor.

A factor is a firm (such as commercialfinancing firm or a commercial bank) thatacquires the receivables of other firms. Thefactor bears the risk of collection in exchangefor a fee of 1-3 % of the value of allreceivables factored.


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Inventory Loans These are loans secured by inventories

The amount of the loan that can be obtained dependson the marketability and perishability of the inventory

Types:

Floating lien agreement

Chattel Mortgage agreement Field warehouse-financing agreement

Terminal warehouse agreement


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Types of Inventory Loans Floating Lien Agreement

The borrower gives the lender a lienagainst all its inventories.

Chattel Mortgage Agreement

The inventory is identified and theborrower retains title to the inventory butcannot sell the items without the lendersconsent


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Types of Inventory Loans

Field warehouse-financing

agreement Inventories used as collateral are physically

separated from the firms other inventoriesand are placed under the control of a third-

party field-warehousing firm


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Types of Inventory Loans

Terminal warehouse agreement

Inventories pledged as collateral aretransported to a public warehouse that isphysically removed from the borrowerspremises.


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6. Multinational Working-Capital Management


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K M ti P tt Ch t 15 57

Multinational Working-Capital

Management The basic principle is the same for both

domestic and multinational corporations.

However, since multinationals spend andreceive money in different countries, it isexposed to exchange rate risk.

Exposed position (exposed assets-exposedliabilities) is of interest to the firm.

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