1. CHAPTER 17 Financing Current Assets
Working capital financing policies
A/P (trade credit)
Commercial paper
S-T bank loans

2. 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.

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

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

5. 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

6. 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.

7. Is there a cost to accruals
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.

8. 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.

9. 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.

10. 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.

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

12. Nominal Cost of Costly Trade Credit
Firm loses 0.01($3,030,303) = $30,303
of discounts to obtain $250,000 in
extra trade credit, so
kNom = = = 12.12%.
$30,303
$250,000
But the $30,303 is paid all during the year, not at year-end, so EAR rate is higher.

13. Nominal Cost Formula, 1/10, net 40
Pays 1.01% 12 times per year.

14. Effective Annual Rate, 1/10, net 40
Periodic rate = 0.01/0.99 = 1.01%.
Periods/year = 360/(40 – 10) = 12.
EAR = (1 + Periodic rate)n – 1.0
= (1.0101)12 – 1.0 = 12.82%.

15. 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.

16. 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.

17. 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.

18. 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,
kNom = EAR.

19. Simple Interest, Paid Monthly
Monthly interest = (.08/12)(100,000)
= $ 1 12
...
100,000
-100,000.00
N I/YR PV PMT FV
0.6667
INPUTS
OUTPUT
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20. kNom = (Monthly rate)(12) = 0.66667(12) = 8.00%.
or: NOM%, P/YR, EFF% = 8.30%.
Note: If interest were paid quarterly, then:
Daily, EAR = 8.33%.

21. 8% Discount Interest, 1 Year
Interest deductible = 0.08($100,000)
= $8,000.
Usable funds = $100,000 – $8,000
= $92,000. 1
i = ?
92,000
-100,000
INPUTS 1 92
-100 N
I/YR PV
PMT FV
OUTPUT
8.6957% = EAR

22. Discount Interest (Continued)
Amount needed
1 - Nominal rate (decimal)
Amt. borrowed =
= = $108,696.
$100,000
0.92

23. Need $100,000. Offered loan with terms of 8% discount interest, 10% compensating balance.
Amount needed
1 - Nominal rate - CB
Amount borrowed =
= = $121,951.
$100,000
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24. EAR correct only if borrow for 1 year.
Interest = 0.08($121,951) = $9,756.
EAR correct only if borrow for 1 year.
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25. 8% Discount Interest with 10% Compensating Balance (Continued)1
i = ?
121,951 Loan
-121,951
+ 12,195
-109,756
-9,756 Prepaid interest
-12,195 CB
100,000 Usable funds
INPUTS 1
100000 N
I/YR PV
PMT FV
OUTPUT
9.756% = EAR
This procedure can handle variations.

26. 1-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
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27. 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:
Months 1 2 12
i = ?
...
100,000
-9,000
-9,000
-9,000

28. 1 P/YR to reset calculator.12
100000
-9000
INPUTS N
I/YR PV
PMT FV
OUTPUT
1.2043% = rate per month
kNom = APR = (1.2043)(12) = 14.45%.
EAR = ( ) = 15.45%.
NOM enters nom rate
P/YR enters 12 pmts/yr
EFF% = = %.
P/YR to reset calculator.

29. 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.

30. 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.

31. 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.

32. 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.