Fin500 PPT CH15

Foundations of Finance
Tenth Edition
Chapter 15
Working-Capital Management
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Learning Objectives
15.1 Describe the risk-return trade-off involved in managing
working capital.
15.2 Describe the determinants of net working capital.
15.3 Compute the firm’s cash conversion cycle.
15.4 Estimate the cost of short-term credit.
15.5 Identify the primary sources of short-term credit.
Working Capital
• Gross working capital
– The firm’s total investment in current assets.
• Net working capital
– The difference between the firm’s current assets and its
current liabilities.
• This chapter focuses on net working capital.
Short-Term Sources of Financing
• Include current liabilities, i.e., all forms of financing that
have maturities of 1 year or less.
• Two issues to consider
– How much short-term financing should the firm use?
– What specific sources of short-term financing should
the firm select?
How Much Short-Term Financing
Should a Firm Use?
• This question is addressed by hedging principle of
working-capital management.
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 needed and for
the period that financing is required
– The influence of a particular credit source on the cost
and availability of other sources of financing
Managing Current Assets and
Liabilities
Current Assets
• A firm’s current assets are assets that are expected to be
converted to cash within 1 year, such as cash and
marketable securities, accounts receivable, inventories.
The Risk-Return Trade-Off
• Holding more current assets will reduce the risk of
illiquidity.
• However, liquid assets like cash and marketable securities
earn relatively less compared to other assets. Thus, larger
amounts of liquid investments will reduce overall rate of
return.
• The trade-off: Increased liquidity must be traded off
against the firm’s reduction in return on investment.
Use of Current versus Long-Term
Debt
• Other things remaining the same, the greater the firm’s
reliance on short-term debt or current liabilities in financing
its assets, the greater the risk of illiquidity.
• The trade-off: A firm can reduce its risk of illiquidity
through the use of long-term debt at the expense of a
reduction in its return on invested funds. This trade-off
involves an increased risk of illiquidity versus increased
profitability.
The Advantages of Current
Liabilities: Return
• Flexibility
– Current liabilities can be used to match the timing of a
firm’s needs for short-term financing. Example:
Obtaining seasonal financing versus long-term financing
for short-term needs.
• Interest Cost
– Interest rates on short-term debt are lower than on long-
term debt.
The Disadvantages of Current
Liabilities: Risk
• Risk of illiquidity can increase for two reasons:
– Short-term debt must be repaid or rolled over more
often.
– Uncertainty of interest costs from year to year.
Determining the Appropriate Level
of Working Capital
The Appropriate Level of Working
Capital
• Managing working capital involves interrelated decisions
regarding investments in current assets and use of
current liabilities.
• Hedging principle or principle of self-liquidating debt
provides a guide to the maintenance of appropriate level
of liquidity.
The Hedging Principle
• The 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 be financed
with a short-term loan or current liability.
• On the other hand, investment in equipment that is
expected to last for a long time should be financed with
long-term debt.
Figure 15.1 The Hedging Principle
Illustrated
Permanent and Temporary Assets
• Permanent investments
– Investments that the firm expects to hold for a period
longer than one year
• Temporary investments
– Current assets that will be liquidated and not replaced
within the current year
Sources of Financing
• Total assets will be equal to sum of temporary, permanent,
and spontaneous sources of financing.
Temporary and Permanent Sources
• 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, and common equity.
Spontaneous Sources of Financing
• Spontaneous sources of financing arise spontaneously
in the firm’s day-to-day operations.
– Trade credit is often made available spontaneously
or on demand from the firm’s suppliers when the firm
orders its supplies or more inventory of products to
sell. Trade credit appears on balance sheet as
accounts payable.
– Wages and salaries payable, accrued interest, and
accrued taxes also provide valuable sources of
spontaneous financing.
Table 15.1 The Hedging Principle Applied
to Working-Capital Management
Using the Cash Conversion Cycle
The Cash Conversion Cycle
• A firm can minimize its working capital by speeding up
collection on sales, increasing inventory turns, and slowing
down the disbursement of cash. This is captured by the
cash conversion cycle (CCC).
Cash conversion cycle (CCC) = days of sales outstanding

(DSO) + days of sales in inventory (DSI) − days of payables
outstanding (DPO)
Table 15.2 The Determinants of Dell
Computer Corporation’s Cash
Conversion Cycle for 1995–2012
Estimating the Cost of Short-Term
Credit Using the Approximate
Cost-of-Credit Formula
Cost of Short-Term Credit
APR Example
• A company plans to borrow $1,000 for 90 days. At maturity,
the company will repay the $1,000 principal amount plus
$30 interest. What is the APR?
Annual Percentage Yield (APY)
• APR does not consider compound interest. To account for
the influence of compounding, we must calculate APY or
annual percentage yield.
APY Example
• In the previous example,
– # of compounding periods
– Rate = 12%
APR or APY?
• Because the differences between APR and APY are
usually small, we can use the simple interest values
of APR to compute the cost of short-term credit.
Evaluating Sources of Short-Term
Credit
Sources of Short-Term Credit
• Short-term credit sources can be classified into two basic
groups:
– Unsecured sources
– Secured sources
Unsecured Loans
• Unsecured loans include all of those sources that have
as their security only the lender’s faith in the ability of
the borrower to repay the funds when due.
• Major sources:
– Accrued wages and taxes, trade credit, unsecured
bank loans, and commercial paper
Secured Loans
• Involve the pledge of specific assets as collateral in the
event 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
Unsecured Sources: Accrued Wages
and Taxes
• Because employees are paid periodically (biweekly or
monthly), firms accrue a wage-payable account that is, in
essence, a loan from their employees.
• Similarly, if taxes are deferred or paid periodically, the firm
has the use of the tax money.
Unsecured Sources: Trade Credit
• Trade credit arises spontaneously with the firm’s
purchases. Often, the credit terms offered with trade credit
involve a cash discount for early payment.
• For example, the terms
means a 2 percent discount is offered for payment within

10 days, or the full amount is due in 30 days.
• In this case, a 2 percent penalty is incurred for not paying
within 10 days.
Table 15.3 The Rates of Interest on
Selected Trade Credit Terms
Effective Cost of Passing Up a
Discount
• Ex.: Terms
• The equivalent APR of this discount is:
• The effective cost of delaying payment for 20 days is

36.73 percent.
Unsecured Sources: Bank Credit
• Commercial banks provide unsecured short-term credit in
two forms:
– Lines of credit
– Transaction loans (notes payable)
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.
• Banks usually require that the borrower maintain a
minimum balance in the bank throughout the loan period
(known as compensating balance).
• Interest rate on a line of credit tends to be floating.
Revolving Credit
• Revolving credit is a variant of the line of credit form of
financing.
• A legal obligation is involved.
Transaction Loans
• A transaction loan is made for a specific purpose. This is
the type of loan that most individuals associate with bank
credit and is obtained by signing a promissory note.
Unsecured Sources: 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 debt securities.
• Maturity: Usually 6 months or less.
• Interest Rate: Slightly lower
than the prime rate on commercial loans.

• New issues of commercial paper are placed directly or
dealer placed.
Commercial Paper: Advantages
• Interest rates
– Rates are generally lower than rates on bank loans.
• Compensating-balance requirement
– No minimum balance requirements are associated
with commercial paper.
• Amount of credit
– A firm with very large credit needs is provided with a
single source for all its short-term financing.
• Prestige
– Signifies credit status
Secured Sources of Loans
• Secured loans have assets of the firm pledged as
collateral. If there is a default, the lender has first claim
to the pledged assets. Because of its liquidity, accounts
receivable is regarded as the prime source for collateral.
• Accounts-Receivable Loans
– Pledging Accounts Receivable
– Factoring Accounts Receivable
• Inventory Loans
Pledging Accounts Receivable (1 of 2)
• 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).
Pledging Accounts Receivable (2 of 2)
• If the firm pledges specific invoices, each invoice must be
evaluated for creditworthiness (more expensive).
• Credit Terms: Interest rate is 2 percent to 5 percent
higher than the bank’s prime rate. In addition, handling
fee of 1 percent to 2 percent of the face value of
receivables is charged.
• Although pledging offers considerable flexibility to the
borrower and provides financing on a continuous basis,
the cost of using pledging as a source of short-term
financing is relatively high compared to other sources.
Factoring Accounts Receivable
• Factoring accounts receivable involves the outright sale
of a firm’s accounts to a financial institution called a
factor.
• A factor is a firm (such as commercial financing firm or a
commercial bank) that acquires the receivables of other
firms. The factor bears the risk of collection in exchange
for a fee of 1 percent to 3 percent of the value of all
receivables factored.
Secured Sources: Inventory Loans
• These are loans secured by inventories.
• The amount of the loan that can be obtained depends on
the marketability and perishability of the inventory.
Types of Inventory Loans (1 of 2)
• Floating or Blanket Lien Agreement
– The borrower gives the lender a lien against all its
inventories.
• Chattel Mortgage Agreement
– The inventory is identified and the borrower retains
title to the inventory but cannot sell the items without
the lender’s consent.
Types of Inventory Loans (2 of 2)
• Field-Warehouse Agreement
– Inventories used as collateral are physically separated
from the firm’s other inventories and are placed under
the control of a third-party field-warehousing firm.
• Terminal-Warehouse Agreement
– Inventories pledged as collateral are transported to a
public warehouse that is physically removed from the
borrower’s premises.
Key Terms (1 of 3)
• Chattel mortgage agreement
• Commercial paper
• Compensating balance
• Factor
• Factoring accounts receivable
• Field-warehouse agreement
• Floating lien agreement
• Gross working capital
Key Terms (2 of 3)
• Hedging principle
• Inventory loans
• Line of credit
• Net working capital
• Operating net working capital
• Permanent investments
• Pledging accounts receivable
• Revolving credit agreement
Key Terms (3 of 3)
• Secured loans
• Temporary investments
• Terminal-warehouse agreement
• Trade credit
• Transaction loan
• Unsecured loans
Copyright
This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Fin500 PPT CH15

Uploaded by

Copyright:

Available Formats

Fin500 PPT CH15

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fin500 PPT CH15

Uploaded by

Copyright:

Available Formats

Foundations of Finance

Cash conversion cycle (CCC) = days of sales outstanding

means a 2 percent discount is offered for payment within

• The equivalent APR of this discount is:

• The effective cost of delaying payment for 20 days is

than the prime rate on commercial loans.

This work is protected by United States copyright laws and is

You might also like