Ch. 18: Management and Short-Term Financing  2002, Prentice Hall, Inc.

Working-Capital Management Current Assets cash, marketable securities, inventory, accounts receivable Long-Term Assets equipment, buildings, land Which earn higher rates of return? Which help avoid risk of illiquidity?

Working-Capital Management Current Assets cash, marketable securities, inventory, accounts receivable Long-Term Assets equipment, buildings, land Risk-Return Trade-off: Current assets earn low returns, but help reduce the risk of illiquidity.

Working-Capital Management Current Liabilities short-term notes, accrued expenses, accounts payable Long-Term Debt and Equity bonds, preferred stock, common stock Which are more expensive for the firm? Which help avoid risk of illiquidity?

Working-Capital Management Current Liabilities short-term notes, accrued expenses, accounts payable Long-Term Debt and Equity bonds, preferred stock, common stock Risk-Return Trade-off: Current liabilities are less expensive, but increase the risk of illiquidity.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock To illustrate, let’s finance all current assets with current liabilities,

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock To illustrate, let’s finance all current assets with current liabilities,

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use long-term financing to finance some of our current assets.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use long-term financing to finance some of our current assets.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use current liabilities to finance some of our fixed assets.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use current liabilities to finance some of our fixed assets.

Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!

Permanent Assets (those held > 1 year) The Hedging Principle Permanent Assets (those held > 1 year) should be financed with permanent and spontaneous sources of financing. Temporary Assets (those held < 1 year) should be financed with temporary sources of financing.

Balance Sheet Temporary Current Assets

Balance Sheet Temporary Temporary Current Assets Short-term financing

Balance Sheet Temporary Temporary Current Assets Short-term financing Permanent Fixed Assets

Balance Sheet Temporary Temporary Current Assets Short-term financing and Spontaneous Financing Permanent Permanent Fixed Assets Financing

The Hedging Principle Permanent Financing Spontaneous Financing intermediate-term loans, long-term debt, preferred stock, common stock Spontaneous Financing accounts payable that arise spontaneously in day-to-day operations (trade credit, wages payable, accrued interest and taxes) Short-term financing unsecured bank loans, commercial paper, loans secured by A/R or inventory

Cost of Short-Term Credit Interest = principal x rate x time ex: borrow $10,000 at 8.5% for 9 months Interest = $10,000 x .085 x 3/4 year = $637.50

Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the

Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR)

Cost of Short-Term Credit We can use this simple relationship: Interest = principal x rate x time to solve for rate, and get the Annual Percentage Rate (APR) interest 1 principal time APR = x

Cost of Short-Term Credit

Cost of Short-Term Credit interest 1 principal time APR = x

Cost of Short-Term Credit interest 1 principal time example: If you pay $637.50 in interest on $10,000 principal for 9 months: APR = x

Cost of Short-Term Credit interest 1 principal time example: If you pay $637.50 in interest on $10,000 principal for 9 months: APR = 637.50/10,000 x 1/.75 = .085 = 8.5% APR APR = x

Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: i m m APY = ( 1 + ) - 1

Cost of Short-Term Credit Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest: i m m i = the nominal rate of interest m = the # of compounding periods per year APY = ( 1 + ) - 1

Cost of Short-Term Credit What is the (APY) of a 9% loan with monthly payments? APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938 = 9.38%

Sources of Short-term Credit Unsecured

Sources of Short-term Credit Unsecured accrued wages and taxes

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit bank credit

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit bank credit commercial paper

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit bank credit commercial paper Secured

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit bank credit commercial paper Secured accounts receivable loans

Sources of Short-term Credit Unsecured accrued wages and taxes trade credit bank credit commercial paper Secured accounts receivable loans inventory loans