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Chapter 4 Financing Current Assets

The document discusses different working capital financing policies including maturity matching, aggressive, and conservative approaches and describes how firms can finance current assets using short-term sources like accounts payable, commercial paper, and bank loans or long-term sources such as equity and bonds. It also analyzes the costs and benefits of different short-term financing options like trade credit, bank loans, and commercial paper.

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Aschalew Ye Giwen Liji
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268 views33 pages

Chapter 4 Financing Current Assets

The document discusses different working capital financing policies including maturity matching, aggressive, and conservative approaches and describes how firms can finance current assets using short-term sources like accounts payable, commercial paper, and bank loans or long-term sources such as equity and bonds. It also analyzes the costs and benefits of different short-term financing options like trade credit, bank loans, and commercial paper.

Uploaded by

Aschalew Ye Giwen Liji
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER Four

Financing
Current Assets
1
Working Capital Financing Policy 2
• The manner in which the permanent and
temporary working capital are financed is
called the firm’s working capital /current
assets/ financing policy.
• Two sources from which funds can be
raised for working capital investment: (i)
short term sources (current liabilities),
and (ii) long-term sources such as share
capital and long-term debt.
Three alternative working capital (current 3
assets) financing policies.

•Maturity matching,
•Aggressive and
•Conservative
Maturity Matching Financing
Policy 4
• A policy by which a firm finances its
temporary current assets with short term
financing whereas
• The permanent component of current assets
and all fixed assets would be financed with
long-term debt and equity capital.
• Expected profits and risk level of this policy
are between the aggressive and the
conservative policies.
5
Aggressive Financing Policy
6

• A policy by which the firm finances its


temporary current asset and possibly
some of its permanent current assets
with short term funds and the balance
with long term funds.
• Would result in higher expected
profitability (low cost)
• Would involve a greater degree of risk
(danger).
7
8
Conservative Policy
• Conservative financing policy is a
financing policy by which a firm finances
all its permanent current assets, all fixed
assets and some of its temporary current
assets with long term funds.
• Would result in a lower profitability
(high cost).
• Would involve a lesser degree of risk
(danger).
9
Financing Current Assets

◼ Working capital financing policies


◼ A/P (trade credit)
◼ Commercial paper
◼ S-T bank loans
Working capital financing
policies
• Moderate – Match the maturity of the
assets with the maturity of the
financing.
• Aggressive – Use short-term financing
to finance permanent assets.
• Conservative – Use permanent capital
for permanent assets and temporary
assets.
Moderate financing policy

$ Temp. C.A.
S-T
Loans

Perm C.A. L-T Fin:


Stock,
Bonds,
Fixed Assets Spon. C.L.

Years
Lower dashed line would be more aggressive.
Conservative financing policy
Marketable
$ securities
Zero S-T
Debt

L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets

Years
Short-term credit
• Any debt scheduled for repayment within one
year.
• Major sources of short-term credit
• Accounts payable (trade credit)
• Bank loans
• Commercial loans
• Accruals
• From the firm’s perspective, S-T credit is
more risky than L-T debt.
• Always a required payment around the corner.
• May have trouble rolling over loans.
Advantages and disadvantages
of using short-term financing
• Advantages
• Speed
• Flexibility
• Lower cost than long-term debt
• Disadvantages
• Fluctuating interest expense
• Firm may be at risk of default as a result of
temporary economic conditions
Accrued liabilities

• Continually recurring short-term


liabilities, such as accrued wages or
taxes.
• Is there a cost to accrued liabilities?
• They are free in the sense that no
explicit interest is charged.
• However, firms have little control
over the level of accrued liabilities.
What is trade credit?

• Trade credit is credit furnished by a


firm’s suppliers.
• Trade credit is often the largest source
of short-term credit, especially for
small firms.
• Spontaneous, easy to get, but cost can
be high.
The cost of trade credit

• A firm buys $3,000,000 net ($3,030,303


gross) on terms of 1/10, net 30.
• The firm can forego discounts and pay
on Day 40, without penalty.

Net daily purchases = $3,000,000 /


365
= $8,219.18
Breaking down net and gross
expenditures
• Firm buys goods worth $3,000,000. That’s
the cash price.
• They must pay $30,303 more if they don’t
take discounts.
• Think of the extra $30,303 as a financing cost
similar to the interest on a loan.
• Want to compare that cost with the cost of a
bank loan.
Breaking down trade credit

• Payables level, if the firm takes discounts


• Payables = $8,219.18 (10) = $82,192
• Payables level, if the firm takes no discounts
• Payables = $8,219.18 (40) = $328,767
• Credit breakdown
Total trade credit $328,767
Free trade credit - 82,192
Costly trade credit $246,575
Nominal cost of costly trade credit
• The firm loses 0.01($3,030,303)
= $30,303 of discounts to obtain $246,575 in
extra trade credit:

kNOM = $30,303 / $246,575


= 0.1229 = 12.29%

• The $30,303 is paid throughout the year, so the


effective cost of costly trade credit is higher.
Nominal trade credit cost formula
Discount % 365 days
k NOM = 
1 - Discount % Days taken - Disc. period
1 365
= 
99 40 - 10
= 0.1229
= 12.29%

16-22
Effective cost of trade credit

• Periodic rate = 0.01 / 0.99 = 1.01%


• Periods/year = 365 / (40-10) = 12.1667
• Effective cost of trade credit
• EAR = (1 + periodic rate)n – 1
= (1.0101)12.1667 – 1 = 13.01%
Commercial paper (CP)

• Short-term notes issued by large, strong


companies. B&B couldn’t issue CP--it’s
too small.
• CP trades in the market at rates just
above T-bill rate.
• CP is bought with surplus cash by banks
and other companies, then held as a
marketable security for liquidity
purposes.
Bank loans

• The firm can borrow $100,000 for 1 year at


an 8% nominal rate.
• Interest may be set under one of the
following scenarios:
• Simple annual interest
• Discount interest
• Discount interest with 10% compensating
balance
• Installment loan, add-on, 12 months
Must use the appropriate EARs to
evaluate the alternative loan terms

• Nominal (quoted) rate = 8% in all


cases.
• We want to compare loan cost rates
and choose lowest cost loan.
• We must make comparison on EAR =
Equivalent (or Effective) Annual
Rate basis.
Simple annual interest

• “Simple interest” means no discount or add-on.

Interest = 0.08($100,000) = $8,000

kNOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, kNOM = EAR


Discount interest

• Deductible interest = 0.08 ($100,000)


= $8,000
• Usable funds = $100,000 - $8,000
= $92,000

INPUTS 1 92 0 -100
N I/YR PV PMT FV
OUTPUT 8.6957
Raising necessary funds with a
discount interest loan
• Under the current scenario, $100,000 is
borrowed but $8,000 is forfeited because it
is a discount interest loan.
• Only $92,000 is available to the firm.
• If $100,000 of funds are required, then the
amount of the loan should be:
Amt borrowed = Amt needed / (1 –
discount)
= $100,000 / 0.92 = $108,696
Discount interest loan with a
10% compensating balance
Amount needed
Amount borrowed =
1 - discount - comp. balance
$100,000
= = $121,951
1 - 0.08 - 0.1

◼ Interest = 0.08 ($121,951) = $9,756


◼ Effective cost = $9,756 / $100,000 = 9.756%

16-30
Add-on interest on a 12-month
installment loan
• Interest = 0.08 ($100,000) = $8,000
• Face amount = $100,000 + $8,000 = $108,000
• Monthly payment = $108,000/12 = $9,000
• Avg loan outstanding = $100,000/2 = $50,000
• Approximate cost = $8,000/$50,000 = 16.0%
• To find the appropriate effective rate, recognize that
the firm receives $100,000 and must make monthly
payments of $9,000. This constitutes an annuity.
Installment loan
From the calculator output below, we have:

kNOM = 12 (0.012043)
= 0.1445 = 14.45%

EAR = (1.012043)12 – 1 = 15.45%

INPUTS 12 100 -9 0
N I/YR PV PMT FV
OUTPUT 1.2043
What is a secured loan?

• In a secured loan, the borrower pledges assets as


collateral for the loan.
• For short-term loans, the most commonly pledged
assets are receivables and inventories.
• Securities are great collateral, but generally not
available.

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