Lecture Six 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.

Years $ Perm C.A. Fixed Assets Temp. C.A. Lower dashed line, more aggressive. } S-T Loans L-T Fin: Stock, Bonds, Spon. C.L. Moderate Financing Policy

Conservative Financing Policy Fixed Assets Years $ Perm C.A. L-T Fin: Stock, Bonds, Spon. C.L. Marketable Securities Zero S-T debt

What is short-term credit, and what are the major sources? S-T credit: Any debt scheduled for repayment within one year. Major sources: Accounts payable (trade credit) Bank loans Commercial paper Accruals

Is S-T credit riskier than L-T? To company, yes. Required repayment always looms. May have trouble rolling over loans. Advantages of short-term credit: Low cost-visualize yield curve. Can get funds relatively quickly. Can repay without penalty.

Is there a cost to accruals? Do firms have much control over amount of accruals? Accruals are free in that no explicit interest is charged. Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.

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.

B&B buys $3,030,303 gross, or $3,000,000 net, on terms of 1/10, net 30, and pays on Day 40. How much free and costly trade credit, and what’s the cost of costly trade credit? Net daily purchases = $3,000,000/360 = $8,333.

Gross/Net Breakdown Company 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.

Credit Breakdown: Total trade credit= $333,333 Free trade credit= 83,333 Costly trade credit= $250,000 Payables level if take discount: Payables = $8,333 (10) = $83,333. Payables level if don’t take discount: Payables = $8,333 (40) = $333,333.

Nominal Cost of Costly Trade Credit But the $30,303 is paid all during the year, not at year-end, so EAR rate is higher. Firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $250,000 in extra trade credit, so

Nominal Cost Formula, 1/10, net 40 Pays 1.01% 12 times per year. k Nom = x = x = x 12 = = 12.12%. Discount % 1 - Discount % 360 Days taken - Discount period

Effective Annual Rate, 1/10, net 40 Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 360/( ) = 12. EAR= (1 + Periodic rate) n = (1.0101) = 12.82%.

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.

A bank is willing to lend B&B $100,000 for 1 year at an 8 percent nominal rate. What is the EAR under the following five loans? 1.Simple annual interest, 1 year. 2.Simple interest, paid monthly. 3.Discount interest. 4.Discount interest with 10 percent compensating balance. 5.Installment loan, add-on, 12 months.

Why must we use EAR to evaluate the alternative loans? 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, 1-Year Loan “Simple interest” means not discount or add-on. Interest = 0.08($100,000) = $8,000. On a simple interest loan of one year, k Nom = EAR..

Simple Interest, Paid Monthly Monthly interest = (.08/12)(100,000) = $ , , NI/YRPVPMTFV (Cont…)...

k Nom = (Monthly rate)(12) = (12) = 8.00%. or: 8 NOM%, 12 P/YR, EFF% = 8.30%. Note: If interest were paid quarterly, then: Daily, EAR = 8.33%.

% Discount Interest, 1 Year Interest deductible = 0.08($100,000) = $8,000. Usable funds= $100,000 - $8,000 = $92,000. NI/YRPVPMTFV % = EAR 0 1 i = ? 92, ,000

Discount Interest (Continued) Amt. borrowed= = = $108,696. Amount needed 1 - Nominal rate (decimal) $100,

Need $100,000. Offered loan with terms of 8% discount interest, 10% compensating balance. (Cont...) Face amount of loan = = = $121,951. Amount needed 1 - Nominal rate - CB $100,

Interest = 0.08 ($121,951) = $9,756. EAR correct only if borrow for 1 year. (Cont...).

This procedure can handle variations. NI/YRPVPMTFV % = EAR 0 01 i = ? 121,951 Loan-121, , ,756 -9,756 Prepaid interest -12,195 CB 100,000 Usable funds 8% Discount Interest with 10% Compensating Balance (Continued)

Year Installment Loan, 8% “Add-On” Interest = 0.08($100,000) = $8,000. Face amount = $100,000 + $8,000 = $108,000. Monthly payment = $108,000/12 = $9,000. = $100,000/2 = $50,000. Approximate cost = $8,000/$50,000 = 16.0%. Average loan outstanding (Cont...)

Installment Loan To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below: -9,000100, i=? -9,000 Months 2...

NI/YRPVPMTFV % = rate per month 0 k Nom = APR = (1.2043)(12) = 14.45%. EAR = ( ) = 15.45% NOMenters nom rate 12 P/YRenters 12 pmts/yr EFF% = = 15.45%. 1 P/YR to reset calculator.

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.

What are the differences between pledging and factoring receivables? If receivables are pledged, the lender has recourse against both the original buyer of the goods and the borrower. When receivables are factored, they are generally sold, and the buyer (lender) has no recourse to the borrower.

What are three forms of inventory financing? Blanket lien. Trust receipt. Warehouse receipt. The form used depends on the type of inventory and situation at hand.

Legal stuff is vital. Security agreement: Standard form under Uniform Commercial Code. Describes when lender can claim collateral. UCC Form-1: Filed with Secretary of State to establish claim. Future lenders do search, won’t lend if prior UCC-1 is on file.