Working Capital Working Capital ManagementManagement

Chapter 15 Chapter 15

Chapter ObjectivesChapter Objectives

Managing current assets and current Managing current assets and current liabilitiesliabilities

Appropriate level of working capitalAppropriate level of working capital Estimating the cost of short-term creditEstimating the cost of short-term credit Sources of short-term creditSources of short-term credit Multinational working-capital Multinational working-capital

managementmanagement

Working CapitalWorking Capital

Working Capital Working Capital Traditionally is the firm’s total investment in Traditionally is the firm’s total investment in

current assetscurrent assets

Net working capitalNet working capital Difference between the firm’s current assets Difference between the firm’s current assets

and its current liabilitiesand its current liabilities Net working capital = Current assets – Net working capital = Current assets –

current liabilitiescurrent liabilities

Managing Net Working Managing Net Working CapitalCapital

Equals managing liquidityEquals managing liquidity Entails two aspects of operations:Entails two aspects of operations:

Investment in current assetsInvestment in current assets Use of short-term or current liabilitiesUse of short-term or current liabilities

Risk-Return Trade-offRisk-Return Trade-off

Holding liquid investments reduces Holding liquid investments reduces overall rate of returnoverall rate of return

Increased liquidity must be traded-off Increased liquidity must be traded-off against the firm’s reduction in return on against the firm’s reduction in return on investmentinvestment

Managing this trade-off is an important Managing this trade-off is an important theme of working-capital managementtheme of working-capital management

Liquidity RiskLiquidity Risk

Other things remaining the same, the Other things remaining the same, the greater the firm’s reliance on short-term greater the firm’s reliance on short-term debt or current liabilities in financing its debt or current liabilities in financing its assets, the greater the risk of illiquidityassets, the greater the risk of illiquidity

A firm can reduce its risk of illiquidity A firm can reduce its risk of illiquidity through the use of long-term debt at the through the use of long-term debt at the expense of a reduction in its return on expense of a reduction in its return on invested fundsinvested funds

Advantages of Current Advantages of Current LiabilitiesLiabilities

FlexibilityFlexibility Can be used to match the timing of a firm’s Can be used to match the timing of a firm’s

needs for short-term financingneeds for short-term financing

Interest CostInterest Cost Interest rates on short-term debt are lower Interest rates on short-term debt are lower

than on long-term debtthan on long-term debt

Disadvantages of Current Disadvantages of Current LiabilitiesLiabilities

RiskRisk Short-term debt must be repaid or rolled Short-term debt must be repaid or rolled

over more oftenover more often

UncertaintyUncertainty Uncertainty of interest costs from year to Uncertainty of interest costs from year to

yearyear

Appropriate Level of Appropriate Level of Working CapitalWorking Capital

Involves interrelated decisions Involves interrelated decisions Can be a significant problemCan be a significant problem Can utilize a type of benchmark Can utilize a type of benchmark

Hedging Principle or Principle of self-Hedging Principle or Principle of self-liquidating debtliquidating debt

Hedging PrincipleHedging Principle

Also known as Principle of Self-Also known as Principle of Self-liquidating debtliquidating debt

Involves matching the cash flow Involves matching the cash flow generating characteristics of an asset generating characteristics of an asset with the maturity of the source of with the maturity of the source of financing used to finance its acquisitionfinancing used to finance its acquisition

Permanent and Permanent and Temporary AssetsTemporary Assets

Permanent investments Permanent investments Investments that the firm expects to hold for Investments that the firm expects to hold for

a period longer than 1 yeara period longer than 1 year

Temporary InvestmentsTemporary Investments Current assets that will be liquidated and not Current assets that will be liquidated and not

replaced within the current yearreplaced within the current year

Temporary FinancingTemporary Financing

Temporary sources of financing are Current Temporary sources of financing are Current liabilities:liabilities: short-term notes payableshort-term notes payable unsecured bank loansunsecured bank loans commercial papercommercial paper loans secured by accounts receivable and loans secured by accounts receivable and

inventoriesinventories

Permanent FinancingPermanent Financing

Permanent Sources of financing include:Permanent Sources of financing include: Intermediate-term loansIntermediate-term loans long-term debtlong-term debt preferred stock and common equitypreferred stock and common equity

Spontaneous FinancingSpontaneous Financing

Spontaneous Sources of financingSpontaneous Sources of financing Arise in the firm’s day-to-day operationArise in the firm’s day-to-day operation Trade credit is often made available Trade credit is often made available

spontaneously or on demand from the firms spontaneously or on demand from the firms supplies when the firm orders its supplies or supplies when the firm orders its supplies or inventoryinventory

Also includes accrued payablesAlso includes accrued payables

Hedging PrincipleHedging Principle

Asset needs of the firm not financed by Asset needs of the firm not financed by spontaneous sources should be financed spontaneous sources should be financed in accordance with this rule:in accordance with this rule:

Permanent-asset investments are Permanent-asset investments are financed with permanent sources, and financed with permanent sources, and temporary investments are financed with temporary investments are financed with temporary sourcestemporary sources

Cost of Short-term CreditCost of Short-term Credit

Interest = principal X rate X timeInterest = principal X rate X time Cost of short-term financing = APR or Cost of short-term financing = APR or

annual percentage rateannual percentage rate APR = interest/(principal X time)APR = interest/(principal X time)

oror APR = (interest/principal) X (1/time)APR = (interest/principal) X (1/time)

APRAPR

A company plans to borrow $1,000 for 90 A company plans to borrow $1,000 for 90 days. At maturity, the company will days. At maturity, the company will repay the $1,000 principal amount plus repay the $1,000 principal amount plus $30 interest. What is the APR?$30 interest. What is the APR?

APR = ($30/$1,000) X [1/(90/360)]APR = ($30/$1,000) X [1/(90/360)] .12 or 12%.12 or 12%

APYAPY

APR does not consider compound APR does not consider compound interest. To account for the influence of interest. To account for the influence of compounding, must calculate APY or compounding, must calculate APY or annual percentage yieldannual percentage yield

APY = (1 + i/m)APY = (1 + i/m)mm – 1 – 1 Where:Where: I is the nominal rate of interest I is the nominal rate of interest

per year; m is number of compounding per year; m is number of compounding period within a yearperiod within a year

APY CalculationAPY Calculation

A company plans to borrow $1,000 for 90 A company plans to borrow $1,000 for 90 days. At maturity, the company will days. At maturity, the company will repay the $1,000 principal amount plus repay the $1,000 principal amount plus $30 interest. What is the APY? $30 interest. What is the APY?

Number of compounding periods 360/90 Number of compounding periods 360/90 = 4= 4

Rate = 12% (previously calculated)Rate = 12% (previously calculated) APY = (1 + .12/4)APY = (1 + .12/4)44 –1 = .126 or 12.6% –1 = .126 or 12.6%

APR or APYAPR or APY

Because the differences between APR Because the differences between APR and APY are usually small, use the and APY are usually small, use the simple interest values of APR to compute simple interest values of APR to compute the cost of short-term creditthe cost of short-term credit

Short-term Sources of Short-term Sources of FinancingFinancing

Include all forms of financing that have Include all forms of financing that have maturities of 1 year or less (or current maturities of 1 year or less (or current liabilities)liabilities)

Two issues:Two issues: How much short-term financing should the How much short-term financing should the

firm use? (Hedging Principle)firm use? (Hedging Principle) What specific sources of short-term What specific sources of short-term

financing should the firm select?financing should the firm select?

What Specific Sources of What Specific Sources of Short-term Financing Short-term Financing Should the Firm Select?Should the Firm Select?

Three factors influence the decision:Three factors influence the decision: The effective cost of creditThe effective cost of credit The availability of creditThe availability of credit The influence of a particular credit source The influence of a particular credit source

on other sources of financingon other sources of financing

Sources of Short-term Sources of Short-term CreditCredit

Short-term credit sources can be Short-term credit sources can be classified into two basic groups:classified into two basic groups:

Secured Secured UnsecuredUnsecured

Secured LoansSecured Loans

Involve the pledge of specific assets as Involve the pledge of specific assets as collateral in the event the borrower defaults in collateral in the event the borrower defaults in payment of principal or interestpayment of principal or interest

Primary Suppliers:Primary Suppliers: Commercial banks, finance companies, and Commercial banks, finance companies, and

factorsfactors

The principal sources of collateral include The principal sources of collateral include accounts receivable and inventoriesaccounts receivable and inventories

Unsecured LoansUnsecured Loans

All sources that have as their security All sources that have as their security only the lender’s faith in the ability of the only the lender’s faith in the ability of the borrower to repay the funds when dueborrower to repay the funds when due

Major sources:Major sources: accrued wages and taxes, trade credit, accrued wages and taxes, trade credit,

unsecured bank loans, and commercial unsecured bank loans, and commercial paperpaper

Cash DiscountsCash Discounts

Often, the credit terms associated with Often, the credit terms associated with trade credit involve a cash discount for trade credit involve a cash discount for early payment. early payment.

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

A 2 percent penalty is involved for not A 2 percent penalty is involved for not paying within 10 days.paying within 10 days.

Effective Cost of Passing Effective Cost of Passing Up a DiscountUp a Discount

Terms 2/10 net 30 Terms 2/10 net 30 Means a 2 percent discount is available Means a 2 percent discount is available

for payment in 10 days or full amount is for payment in 10 days or full amount is due in 30 days. due in 30 days.

The equivalent APR of this discount is:The equivalent APR of this discount is: APR = .02/.98 X [1/(20/360)]APR = .02/.98 X [1/(20/360)] The effective cost of delaying payment The effective cost of delaying payment

for 20 days is 36.73%for 20 days is 36.73%

Unsecured Sources of Unsecured Sources of LoansLoans

Bank Credit:Bank Credit: Lines of creditLines of credit Transaction loans (notes payable)Transaction loans (notes payable)

Commercial PaperCommercial Paper

Line of CreditLine of Credit

Line of CreditLine of Credit Informal agreement between a borrower Informal agreement between a borrower

and a bank about the maximum amount of and a bank about the maximum amount of credit the bank will provide the borrower at credit the bank will provide the borrower at any one time. any one time.

There is no legal commitment on the part There is no legal commitment on the part of the bank to provide the stated creditof the bank to provide the stated credit

Usually require that the borrower maintain Usually require that the borrower maintain a minimum balance in the bank through the a minimum balance in the bank through the loan period or a compensating balanceloan period or a compensating balance

Revolving CreditRevolving Credit

Revolving CreditRevolving Credit Variant of the line of credit form of financingVariant of the line of credit form of financing A legal obligation is involvedA legal obligation is involved

Transaction LoansTransaction Loans

Transactions loansTransactions loans Made for a specific purposeMade for a specific purpose The type of loan that most individuals The type of loan that most individuals

associate with bank credit and is obtained by associate with bank credit and is obtained by signing a promissory notesigning a promissory note

Commercial PaperCommercial Paper

The largest and most credit worthy The largest and most credit worthy companies are able to use commercial companies are able to use commercial paper– a short-term promise to pay that paper– a short-term promise to pay that is sold in the market for short-term debt is sold in the market for short-term debt securitiessecurities

Advantages of Advantages of Commercial PaperCommercial Paper

Interest ratesInterest rates Rates are generally lower than rates on bank loansRates are generally lower than rates on bank loans

Compensating-balance requirementCompensating-balance requirement No minimum balance requirements are associated No minimum balance requirements are associated

with commercial paperwith commercial paper Amount of creditAmount of credit

Offers the firm with very large credit needs a single Offers the firm with very large credit needs a single source for all its short-term financingsource for all its short-term financing

PrestigePrestige Signifies credit statusSignifies credit status

Secured Sources of LoansSecured Sources of Loans

Accounts Receivable loansAccounts Receivable loans Pledging Accounts ReceivablePledging Accounts Receivable Factoring Accounts ReceivableFactoring Accounts Receivable

Inventory loansInventory loans

Pledging Accounts Pledging Accounts ReceivableReceivable

Under pledging, the borrower simply pledges Under pledging, the borrower simply pledges accounts receivable as collateral for a loan accounts receivable as collateral for a loan obtained from either a commercial bank or a obtained from either a commercial bank or a finance companyfinance company

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

Flexible source of financingFlexible source of financing Can be costlyCan be costly

Factoring Accounts Factoring Accounts Receivable Receivable

Factoring accounts receivable involves Factoring accounts receivable involves the outright sale of a firm’s accounts to the outright sale of a firm’s accounts to a financial institution called a factora financial institution called a factor

A factor is a firm that acquires the A factor is a firm that acquires the receivables of other firmsreceivables of other firms

Inventory LoansInventory Loans

Loans secured by inventoriesLoans secured by inventories The amount of the loan depends on the The amount of the loan depends on the

marketability and perishability of the inventorymarketability and perishability of the inventory Types:Types:

Floating lien agreementFloating lien agreement Chattel Mortgage agreementChattel Mortgage agreement Field warehouse-financing agreementField warehouse-financing agreement Terminal warehouse agreementTerminal warehouse agreement

Types of Inventory LoansTypes of Inventory Loans

Floating Lien AgreementFloating Lien Agreement The borrower gives the lender a lien against The borrower gives the lender a lien against

all its inventories.all its inventories. The simplest but least-secure formThe simplest but least-secure form

Chattel Mortgage AgreementChattel Mortgage Agreement The inventory is identified and the borrower The inventory is identified and the borrower

retains title to the inventory but cannot sell retains title to the inventory but cannot sell the items without the lender’s consentthe items without the lender’s consent

Field warehouse-financing agreementField warehouse-financing agreement Inventories used as collateral are Inventories used as collateral are

physically separated from the firm’s other physically separated from the firm’s other inventories and are placed under the inventories and are placed under the control of a third-party field-warehousing control of a third-party field-warehousing firmfirm

Terminal warehouse agreementTerminal warehouse agreement The inventories pledged as collateral are The inventories pledged as collateral are

transported to a public warehouse that is transported to a public warehouse that is physically removed from the borrower’s physically removed from the borrower’s premises.premises.