Chapter 18 Working Capital Management Updated 2-2015

Working Capital Management Working capital management involves day-to-day activities of managing firm’s current assets & current liabilities. Ex: How much cash & marketable securities should a firm carry? Inventories: How much inventories should a firm carry? Should inventories be bought on cash or credit? Trade credit (account payables) offered by suppliers (spontaneus financing). If inventories are bought on credit (affect account payables), then when should the payment be made? Who should credit sales (account receivables) be offered to and on what basis? Short-term financing also affects current liabilities. H/L H/L

Firm’s Liquidity Working capital management relates with firm’s overall liquidity. Two basic measures of firm’s overall liquidity. NWC is very different (due to differences in firm sizes) but current ratio is equal. Current ratio is a better measure of comparison of liquidity among firms. Firm A Firm B Current Assets $50,000 $5,000 Current Liabilities $25,000 $2,500 Net Working Capital = CA-CL Current Ratio = CA÷CL 2.0X

Firm’s Liquidity Managing a firm’s overall liquidity requires balancing firm’s investments in current assets in relation to its current liabilities. This can be accomplished by minimizing the use of current assets by efficiently managing its inventories and account receivables and by seeking out the most favorable account payables terms and monitoring its use of short-term borrowing.

Working Capital Management & Risk-Return Tradeoff Working capital management will change firm’s liquidity and involve a risk-return tradeoff. Ex.: Holding cash & marketable securities can help improving firm’s liquidity. But they provide low rates of return. So, a firm can enhance its profitability by reducing its cash & marketable securities. But firm will expose to a higher default risk or not being able to pay its bills on time (liquidity problem) if it does not have enough cash & marketable securities.

Working Capital Management Policy Managing firm’s working capital involves deciding on the strategy to finance firm’s current assets with financing sources. Short-term financing Long-term financing Each financing source comes with advantages and disadvantages, financial manager has to decide on the optimal source for firm.

Principle of Self-Liquidating Debt Match the maturity of assets and liabilities (financing sources) This principle states that the maturity of the source of financing should be matched with the length of time (maturity) that the financing is needed (assets). Asset Investments: Temporary vs. Permanent Source of financing: Spontaneous Temporary (Short-term) Permanent (Long-term) Ex.: A seasonal increase in inventories during Christmas season should be financed with current liability or short-term loan.

Temporary and Permanent Asset Investments Temporary investments in assets include current assets that will be liquidated and not replaced within current year. Ex: current assets such as cash & marketable securities, accounts receivables, and seasonal fluctuation in inventories. Permanent investments are composed of investments in assets that the firm expects to hold for a period longer than one year. Ex: Minimum level of current assets (i.e. accounts receivables & inventories) to serve customer base and fixed assets.

Spontaneous, Temporary, and Permanent Sources of Financing Spontaneous sources of financing arise spontaneously from day-to-day operations of the business Ex: Trade credit, wages & salaries payables, tax payables, interest payables Temporary sources of financing typically consist of current liabilities the firm incurs on a discretionary basis. The firm’s management must make an overt decision to use temporary sources of financing. Ex: Unsecured bank loans, commercial paper, short-term loans secured by firm’s inventories or account receivables Permanent sources of financing are called permanent since the financing is available for a longer period of time than a current liability. Ex: Intermediate term loans, bonds, preferred stocks & common stocks

Fig. 2 shows the use of principle of self-liquidating debt to guide a firm’s financing decision. Figure 2

Managing Current Liabilities (debt obligations to be repaid within one year) Unsecured current liabilities (trade credit, unsecured bank loans, commercial paper) Secured current liabilities (loans secured by specific assets i.e. inventories or accounts receivable)

Table 1

Calculating Cost of Short-term Financing When evaluating alternative financing sources, it is important to consider the costs. Cost of short-term credit is calculated by: Interest ($) = Principal × Rate × Time Ex.: What will be the interest payment on a 4-month loan for $35,000 that carries an annual interest rate of 12%? Interest = Principal × Rate × Time = $35,000 × 12% × 4/12 = $1,400 Equation 7

Calculating Cost of Short-term Financing Annual Percentage Rate (APR) is computed as follows: Equation 8

Calculating Cost of Short-term Financing Ex.: Rio Corporation plans to borrow $35,000 for a 4-month period and repay $35,000 principal amount plus $1,400 interest at maturity. What is the APR? APR = ($1400/$35000)×(1÷4/12)=12% APY (or EAR) = (1+12%/3)3-1=12.49% Equation 8

Cost of Bank Loans We can apply Equation 8 (APR) to calculate the cost of bank loans. Firms generally borrow money from bank through a line of credit. A line of credit entitles firm to borrow up to the stated amount. Firm is generally required to maintain a minimum balance (known as compensating balance) in the bank throughout loan period. Compensating balance increases the annualized cost of loan to the borrower.

Checkpoint 3 Calculating APR for a Line of Credit M&M Beverage Company has a $300,000 line of credit that requires a compensating balance equal to 10 percent of the loan amount. The rate paid on the loan is 12 percent per annum, $200,000 is borrowed for a six-month period, and the firm does not currently have a deposit with the lending bank. The dollar cost of the loan includes the interest expense as well as the opportunity cost of maintaining an idle cash balance in the compensating balance (10% of the loan). To accommodate the cost of the compensating balance requirement, assume that the added funds will have to be borrowed and simply left idle in the firm’s checking account. What is the annual rate on this loan if there was no compensating balance requirement? What is the annual rate on this loan with compensating balance requirement? What is the annual rate on this loan with compensating balance requirement and the bank also requires firm to pay interest rate in advance? Q.1 Q.2 Q.3

Checkpoint 3 Q.1: What is the annual rate on this loan be if there was no compensating balance requirement? Equation 8 INT = 200,000*12%*1/2 = 12,000 EAR = (1+12%/2)2 -1= 12.36%

Assume the firm wants to use full amount of $200,000 B-10%B = 200,000 B-0.1B = 200,000 0.9B = 200,000 B = 222,222.22 Check: 222,222.22-22,222.22 = 200,000 B - CB Checkpoint 3 Q.2: What is the annual rate on this loan with compensating balance requirement? $13,333.33 $13,333.33 $13,333.33 INT = 222,222.22*12%*1/2 = 13,333.33 13,333.33 222,222.22-22,222.22 EAR = (1+13.33%/2)2 -1=13.77%

Checkpoint 3 Q.3: What is the annual rate on this loan with compensating balance and the bank also requires firm to pay interest rate in advance? $13,333.33 13,333.33 222,222.22-22,222.22-13,333.33 Firm can use only $186,666.67 EAR = (1+14.29%/2)2 -1= 14.80%

Assume the firm wants to use full $200,000 Checkpoint 3 B-10%*B-12%*B*1/2 = 200,000 B-0.1B-0.06B = 200,000 0.84B = 200,000 B = 238,095.23 Check: 238,095.23-23,809.52-14,285.71 = 200,000 B - CB - INT EAR = (1+14.29%/2)2 -1= 14.80%

Summary: APR EAR Q.1 No CB 12.00% 12.36% Q.2 CB 13.33% 13.77% Q.3 CB & Discount loan 14.29% 14.80% Conclusion?

Cost of Trade Credit Trade credit is given by firm’s suppliers. Day 0 Day 10 Day 30 20 days Cost of Trade Credit Buy $100 Discount $3 Pay $97 Pay $100 Trade credit is given by firm’s suppliers. Credit term generally includes discount for early payment. Ex: 3/10, net 30  the full amount is due in 30 days but 3% discount is offered for payment within 10 days. What is the cost of not taking the 3% discount? The 3% cash discount is the interest cost of extending the payment period an additional 20 days (from day 10 to day 30) For a $100 invoice, the cost is calculated as follows: APR = ($3/$97) × (1÷20/365) = 56.44% APY (or EAR) = (1+56.44%/18.25)18.25 -1= 74.34% Equation 8

Exercises (End of Chapter) Q. 3:   Q. 4:

Exercises (End of Chapter) Q. 7:   Q. 13:

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