Chapter 7- Short-term Finance and Planning2

Chapter

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

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•Short-Term Finance and Planning

•Short-Term Finance and Planning

Introduction

• Net working capital - short term financial decisions…Current assets minus current liabilities

• Working capital management - short-term financial decisions

• 3 important questions:

1) What is a reasonable level of cash to keep on hand (in bank) to pay bills?

2) How much should the firm borrow in the short

term?

3) How much credit should be extended to

customers?

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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?

Risk-Return Trade-off: Current assets earn low returns, but help

reduce the risk of illiquidity.3

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?

Risk-Return Trade-off: Current liabilities are less expensive, but increase

the risk of illiquidity.4

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.

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Balance Sheet

Temporary Temporary

Current Assets Short-term financing

Permanent Permanent

Fixed Assets Financing

and

Spontaneous

Financing

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The Hedging Principle

Permanent 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.

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Figure 15-1

© 2011 Pearson Prentice Hall. All rights reserved.8

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Sources and Uses of Cash

• Balance sheet identity (rearranged)• NWC + fixed assets = long-term debt + equity• NWC = cash + other CA – CL• Cash = long-term debt + equity + CL – CA other than

cash – fixed assets

• Sources• Increasing long-term debt, equity or current liabilities• Decreasing current assets other than cash or fixed

assets

• Uses• Decreasing long-term debt, equity or current liabilities• Increasing current assets other than cash or fixed assets

Cash Conversion Cycle (CCC)

- to evaluate the effectiveness of the working capital management.

- To minimize working capital: speeding up the collection of cash from sales, increasing inventory turns and slowing down the

disbursement of cash.

CCC = days of sales outstanding (DSO) + days of sales in

inventory (DSI) + days of payable outstanding (DPO)

Where:

DSO = account receivable/(sales/365)

DSI = inventories/(COGS/365)

DPO = account payable/(COGS/365)

*** number of days in 1 year – 360 or 365 (depends on the questions)10

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The Operating Cycle

• Operating cycle – time between purchasing the inventory and collecting the cash from selling the inventory

• Inventory period – time required to purchase and sell the inventory

• Accounts receivable period – time required to collect on credit sales

• Operating cycle = inventory period + accounts receivable period

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Cash Cycle

• Cash cycle• Amount of time we finance our inventory• Difference between when we receive cash

from the sale and when we have to pay for the inventory

• Accounts payable period – time between purchase of inventory and payment for the inventory

• Cash cycle = Operating cycle – accounts payable period

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Figure 19.1

Company Industry Operating cycle

Account payable period

Cash cycle

Tesco PLC

Retail 37 69 -32

SP Setia Property development

367 96 271

Proton Manufacturing

101 81 20

Air Asia Service 11 7 4

Cash cycles (day) for selected listed companies

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Short-Term Financial Policy

• Size of investments in current assets• Flexible (conservative) policy – maintain a

high ratio of current assets to sales• Restrictive (aggressive) policy – maintain a

low ratio of current assets to sales

• Financing of current assets• Flexible (conservative) policy – less short-term

debt and more long-term debt• Restrictive (aggressive) policy – more short-

term debt and less long-term debt

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Carrying vs. Shortage Costs

• Managing short-term assets involves a trade-off between carrying costs and shortage costs• Carrying costs – increase with increased levels

of current assets, the costs to store and finance the assets

• Shortage costs – decrease with increased levels of current assets

• Trading or order costs• Costs related to safety reserves, i.e., lost sales and

customers and production stoppages

The optimal investment in current assets

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Figure 19.4

Financing Policies for Current Assets (Flexible VS Restrictive)

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Financing Policies for Current Assets (Compromise policy)

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Choosing the Best Policy

• Cash reserves• High cash reserves mean that firms will be less likely to experience

financial distress and are better able to handle emergencies or take advantage of unexpected opportunities

• Cash and marketable securities earn a lower return and are zero NPV investments

• Maturity hedging• Try to match financing maturities with asset maturities• Finance temporary current assets with short-term debt• Finance permanent current assets and fixed assets with long-term debt

and equity• Interest Rates

• Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debt

• Firms can get into trouble if rates increase quickly or if it begins to have difficulty making payments – may not be able to refinance the short-term loans

• Have to consider all these factors and determine a compromise policy that fits the needs of the firm

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Cash Budget

• Forecast of cash inflows and outflows over the next short-term planning period

• Primary tool in short-term financial planning

• Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs

• Allows a company to plan ahead and begin the search for financing before the money is actually needed

Example of cash budget

• The following is the sales budget for ABC Inc:

• Credit sales are collected as follows:• 20% in the month of the sale• 30% in the month after sale• 50% in the second month after sale.

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Year Sales ( in thousand)

Feb 2013 RM150

Mar 2013 RM170

Apr 2013 RM190

May 2013 RM220

June 2013 RM250

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Cash Budget Information

• Other expenses• Wages, taxes and other expense are 30% of

sales• Cash purchases of RM50,000 , RM25,000 and

35,000 respectively in Apr, May and June 2013. • A major capital expenditure of $100,000 is

expected in May 2013

• The initial cash balance is $80,000 and the company maintains a minimum balance of $500,000

• Interest on accumulated loan is at 12% annual interest and is paid in the following month.

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ABC Inc’s Cash budget for Apr-June 2013 (in thousand)

Feb Mar Apr May June

Sales 150 170 190 220 250

Cash Collection:

Cash sales (20%) 30 34 38 44 50

2nd collection (30%) 45 51 57 66

3rd collection (50%) 75 85 95

Total cash collection 164 186 211

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Cash disbursement:

Wages, taxes & other expenses

57 66 75

Cash purchases 50 25 35

Capital expenditure 100

Total cash disbursement

107 191 110

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Change in net cash (cash collection-cash disbursement)

57 -5 101

Beginning balance 80 500 500

Interest expenses - (3.63) (3.71)

Additional financing 363 8.63 (97.29)

Ending balance 500 500 500

Accumulated financing 363 371.63 274.34

Cost of Short-term Credit

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Interest = principal rate timeCost of short-term financing = annual percentage

rate (APR)APR = (interest / principal) * (1 / time)A company plans to borrow $1,000 for 180 days.

At maturity, the company will repay the $1,000 principal amount plus $40 interest. What is the APR?

APR = ($40/$1,000) [1/(180/360)]= .04 (180/90)= .08 or 8%

Annual Percentage Yield (APY)

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APR does not consider compound interest. To account for the influence of compounding, we must calculate APY or annual percentage yield

APY = (1 + i/m)m – 1 Where:

i is the nominal rate of interest per year; m is number of compounding period within a year

In the previous example, # of compounding periods 360/180 = 2 Rate = 8%

APY = (1 + .08/2)2 –1= .0816 or 8.16%

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.

Sources and Costs of Short-term Credit


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Short-term credit sources can be classified into two basic groups:

Unsecured sources -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 -Since 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.


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Unsecured source: Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms offered with trade credit involve a cash discount for early payment.

Terms such as 2/10 net 30 means a 2% discount is offered for payment within 10 days, or the full amount is due in 30 days

A 2% penalty is involved for not paying within 10 days.Effective Cost of Passing Up a Discount -Terms 2/10 net 30 -The equivalent APR of this discount is:

APR = $.02/$.98 [1/(20/360)]= .3673 or 36.73%

-The effective cost of delaying payment for 20 days is 36.73%


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Unsecured source: bank credit

Commercial banks provide unsecured short-term credit in two forms:1) Lines 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 line of credit tends to be floating. -Revolving Credit- is a variant of the line of credit form of financing, a legal

obligation is involved

2) Transaction loans (notes payable) -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.


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Unsecured source: 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 (1/2 to 1%) than the prime rate on commercial

loans. New issues of commercial paper are placed directly or dealer placed. Advantages: 1) Interest rates

Rates are generally lower than rates on bank loans 2)Compensating-balance requirement

No minimum balance requirements are associated with commercial paper

3)Amount of credit Offers the firm with very large credit needs a single source for all its

short-term financing4)Prestige Signifies credit status


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Secured sources -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

-Secured Sources of Loans

* Secured loans have assets of 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


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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)

If the firm pledges specific invoices each invoice must be evaluated for creditworthiness. (more expensive)

Credit Terms: Interest rate is 2–5% higher than the bank’s prime rate. In addition, handling fee of 1–2% of the face value of receivables is charged.

While pledging has the attraction of offering considerable flexibility to the borrower and providing financing on a continuous basis, the cost of using pledging as a source of short-term financing is relatively higher compared to other sources.

Factoring Accounts Receivable


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• 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 1–3 percent of the value of all receivables factored.

Secured Sources: Inventory Loans


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• 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:• Floating lien agreement• Chattel Mortgage agreement• Field warehouse-financing agreement• Terminal warehouse agreement

Types of Inventory Loans


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Floating or blanket Lien AgreementThe borrower gives the lender a lien against all its inventories.

Chattel Mortgage AgreementThe inventory is identified and the borrower retains title to the

inventory but cannot sell the items without the lender’s consent.

Field warehouse-financing 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.

EXERCISES:


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Calculate the effective cost of the following trade credit terms when payment is made on the net due date (360 days in 1 year)

a) 2/10, net 30

b) 3/15, net 30

a) (0.02/0.98) x [1/(20/360)]= 0.36734 or 36.73%

b) (0.03/0.97) x [1/(15/360)] = 0.74226 or 74.23%

Compute the EAR for a & b.

a) [1+(0.3673/18)]^18 - 1 = 43.85%

b) [1+(0.7423/24)]^24 - 1 = 107.73%


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The Rosewood Corporation established a line of credit with a local bank. The maximum amount that can be borrowed under the terms of the agreement is $500,000 at a rate of 10 percent. A compensating balance averaging 15 percent of the loan is required. Prior to the agreement, Rosewood had maintained an account at the bank averaging $25,000. Any additional funds needed for the compensating balance will also have to be borrowed at the 10 percent rate. If the firm needs $280,000 for 6 months, what is the annual cost of the loan?

Borrowed Funds = $280,000 - $25,000 0.85

Borrowed Funds = $304,411.8Rate = $304,411.80 × (.10/2) × 1 $280,000 (180/360)Rate = .1087 per year


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MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently decided to pledge all of its accounts receivable to its bank. The bank advances up to 80 percent of the face value of these receivables at a rate of 4 percent over the prime rate, while charging 2.5 percent on all receivables pledged for processing to cover billing and collection services. Prior to this arrangement MovieTone was spending $50,000 a year on its credit department. The prime rate is 6 percent.a. What is the average level of accounts receivable?b. What is the effective cost of using this short-term credit for one year?

a. 2 × $350,000 = $700,000

b. Rate = $56,000 + $105,000 - $50,000 × 1 = 0.1982 560,000 (360/360) Annual interest expense = 0.10 × 0.80 × $700,000 = $56,000

Processing fee = .025 × $350,000 x12 = $105,000

The EPG manufacturing Company uses commercial paper regular to support its needs for short-term financing. The firm plan to sell $100 million in 270-day-maturity paper, on which it expects to pay discounted interest at a rate of 12% per annum. In addition, EPG expects to incur a cost of approximately $100,000 in dealer placement fees an other expenses of issuing paper. What is the effective cost of credit to EPG?

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The Burlington Western Company plans to issue a commercial paper of $20 million. The commercial paper will carry a 270-day maturity and require interest based on a rate of 11% per annum. In addition, the firm will have to pay fees totaling $200,000 to bring the issue to market and place it. What is the effective cost of the commercial paper to Burlington Western?

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Calculate the effective cost of the following trade credit terms when payment is made on the net due date.

a) 3/15 net 45

b) 2/15 net 60

• Calculate the EAR for (a) and (b).

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Penn Inc. needs to borrow $250,000 for the next 6 months. The company has a line of credit with a bank that allows the company to borrow funds with an 8% interest rate subject to a 20% of loan compensating balance. Currently, Penn Inc. has no funds on deposit with the bank and will need the loan to cover the compensating balance as well as their other financing needs.

a) How much will Penn Inc. need to borrow?

b) What will be the annual percentage rate, or APR, for this financing?

c) If the company maintains $20,000 in its bank account, recalculate APR.

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A project for Jevon and Aaron, Inc. results in additional accounts receivable of RM400,000, additional inventory of RM180,000, and additional accounts payable of RM70,000. What is the additional investment in net working capital?

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A company collects 25 percent of its sales during the month of sale, 65 percent one month after the sale, and 10 percent two months after the sale. The company expects sales of RM50,000 in August, RM80,000 in September, RM90,000 in October, and RM60,000 in November. How much money is expected to be collected in October?

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Syarikat Untung Rugi Sdn. Bhd has projected the following budget for the second quarter of 2012:

ITEMS APRIL (RM) MAY (RM) JUNE (RM)

Credit sales 380,000 396,000 438,000

Credit purchases 147,000 175,500 200,500

Cash disbursement:

Wages, taxes & expenses

39,750 48,210 50,300

Interest on existing debt

11,400 11,400 11,400

Equipment purchases

83,000 91,000 0

The company predicts that 5 percent of its credit sales will never be collected. 40 percents of its sales will be collected in the month of sale, and the remaining 55 percent will be collected in the following month. Credit purchases will be paid in the month following the purchase. In March 2012, credit sales were RM210,000 and credit purchases were RM156,000. Using this information,

a) What is Syarikat Untung Rugi’s projected total disbursement for May 2012?

b) What is Syarikat Untung Rugi’s projected total cash receipts for April 2012?

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The Carmel Corporation’s projected sales for the first eight months of 2001 are as follows:

January: $100,000 May:$275,000

February:$110,000 June:$250,000

March:$130,000 July:$235,000

April:$250,000 August:$160,000

• Of Carmel’s sales, 20% is for cash, another 60% is collected in the month following sale, and 20 percent is collected in the second month following sale. November and December sales for 2000 were $220,000 and $175,000, respectively.

• Carmel purchases its raw materials two months in advance of its sales equal to 70% of its final sales price. The supplier is paid one month after it makes delivery.

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• In addition, Carmel pays $10,000 per month for rent and $20,000 each month for other expenditures. Tax prepayments for $23,000 are made in March and June.

• The company’s cash balance at December 31, 2000, was $22,000; a minimum balance of $20,000 must be maintained at all times.

• Assume that any short-term financing needed to maintain that cash balance would be paid off in the month following the month of financing, if sufficient funds are available.

• Interest on short-term loans (12% annually) is paid monthly. Borrowing to meet estimated monthly cash needs takes place at the beginning of the month.

Prepare a cash budget for Carmel covering the first seven months of 2001.

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Documents

Chapter 7- Short-term Finance and Planning2