Working Capital Management Slides

8/13/2019 Working Capital Management Slides

1/25

WORKING CAPITAL

MANAGEMENT

TOPIC 10

1WRMAS


2/25

Learning Objectives

1. Define net working capital.2. Explain the short term financing.

3. List and describe the basic sources of short-

term credit.4. Calculate the effective cost of short-term

credit.

2WRMAS


3/25

3

NET WORKING CAPITAL Working CapitalThe firms total investment in current

assets.

Net working Capital (NWC)The differencebetween thefirms current assets and its current liabilities.

(NWC = Current AssetsCurrent Liabilities)

NWC measure of both a company's efficiency and its short-

term financial health. Working Capital Management- The administration of the

firms current assets and the financing needed to supportcurrent assets.

Managing net working capital is concerned with managing the

firms liquidity. This entails managing two related aspects ofthe firms operations:

1. Investment in current assets

2. Use of short-term or current liabilities

WRMAS


4/25

4

SHORT-TERM FINANCING Include all forms of financing that have maturities of 1 year or

less of current liabilities.

Two (2)issues: How much short-term financing should the firm use? What specific sources of short-term financing should the

firm select?

How Much Short-term Financing Should a Firm use?This question is addressed by hedging the principle of working-capital management.

What Specific Sources of Short-term Financing Should the FirmSelect?

Three factors influence the decision:- The effective cost of credit

- The availability of credit

- The influence of a particular credit source on other sources offinancing

WRMAS


5/25

5

Advantages of Current

Liabilities

Flexibility - Can be usedto match the timing of afirms needs for short-term financing

Interest Cost - Interestrates on short-termdebt are lower than onlong-term debt

Disadvantages of Current

Liabilities

Risk- Short-term debt

must be repaid or rolled

over more often

Uncertainty -

Uncertainty of interest

costs from year to year

SHORT-TERM FINANCING

Other things remaining the same, the greater the firms reliance onshort-term debt or current liabilities in financing its assets, thegreater the risk of illiquidity

WRMAS


6/25

6

DETERMINING THE APPROPIATE LEVEL

OF WORKING CAPITAL

Hard to derive the level of working capital for firm.

Involves interrelated decisions regarding investments in

current assets and use of current liabilities. , can be a

significant problem. HOWEVER, the HEDGING PRINCIPLE provides the basis for

firms working capital decisions.

WHAT IS HEDGING PRINCIPLE?

WRMAS


7/25

7

HEDGING PRINCIPLES

Also known as Principle of Self-liquidating debt

Involves matching the cash flow generating characteristics ofan asset with the maturity of the source of financing used to

finance its acquisition

Under Principle Hedging:

-Asset needs of the firm not financed by spontaneoussourcesshould be financed in accordance with this rule:

Permanent-asset investments are financed with

permanent sources, and

Temporary investments are financed with temporarysources

WRMAS


8/25

8

Permanent and Temporary Assets Permanent investments

- Investments that the firm expects to hold for a period

longer than 1 year

Temporary Investments

- Current assets that will be liquidated and not replaced

within the current year

WRMAS


9/25

9

Temporary, Permanent and

Spontaneous Sources of FinancingSources of Financing

Temporary sources of financing- Current liabilities or short-term notes payable, unsecured

bank loans, commercial paper, loans secured by accountsreceivable and inventories

Permanent Sources of financing

- Intermediate-term loans, long-term debt, preferred stock andcommon equity

Spontaneous Sources of financing

- Arise in the firms day-to-day operation

- Trade credit is often made available spontaneously or ondemand from the firms supplies when the firm orders itssupplies or inventory

- Wages and salaries payable, accrued interest andaccruedtaxesalso provide valuable sources of spontaneous financing.

WRMAS


10/25

WRMAS 10

Temporary, Permanent and

Spontaneous Sources of Financing


11/25

11

COST OF SHORT-TERM CREDIT Interest= principalX rateX time

Cost of short-term financing = APR or annual percentage rate APR = interest or APR = interest

principal X time principal

What is APR?

It describes the interest rate for a whole year (annualized), ratherthan just a monthly (or quarterly/ daily) rate.

Example

A company plans to borrow $1,000 for 90days. At maturity, the

company will repay the $1,000 principal amount plus $30 interest.What is the APR?

APR = ($30/$1,000) X [1/(90/360)]

= .12 or 12%

X 1/time)

WRMAS


12/25

12

Effective Annual Rate (EAR)

APR does not consider compound interest. To account for the

influence of compounding, must calculate EAR or effectiveannual rate

EAR= (1 + i/m)m1

Where: iis the nominal rate of interest per year; mis number ofcompounding period within a year

Example

Number of compounding periods 360/90 = 4

Rate = 12% (previously calculated)

APY = (1 + 0.12/4)41 = 0.126 or 12.6%SO APR or EAR?

Because the differences between APR and EAR are usually small, wecan use the simple interest values of APR to compute the cost ofshort-term credit.

Cost of Short-term Credit

WRMAS


13/25

13

SOURCES OF SHORT-TERM CREDIT

Short-term credit sources can be classified into two (2)basic

groups:

Secured

Unsecured

Secured Loans

Involve the pledgeof specific assets as collateralin the event

the borrower defaults in payment of principal or interest

Primary Suppliers:

- Commercial banks, finance companies, and factors

The principal sources of collateral include accounts receivable

and inventories

WRMAS


14/25

14

Unsecured Loans

All sources that have as their security only the lenders faith inthe ability of the borrower to repay the funds when due

Major sources - accrued wages and taxes, trade credit,

unsecured bank loans, and commercial paper.

Sources Of Short-term Credit

WRMAS


15/25

15

UNSECURED LOANSAccrued Wages and Taxes

Since employees are paid periodically (biweekly or monthly),

firms accruea 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.

Trade Credit

Trade credit arises spontaneously with the firms purchases.

Often, the credit terms associated with trade credit involve acash discount for early payment.

Terms such as 2/10 net 30 means:

2 percent discount is offered for payment within 10 days, or thefull amount is due in 30 days (2 percent penalty is involved fornot paying within 10 days)

WRMAS


16/25

16

Unsecured LoansWhat is effective cost of passing up a discount?

The equivalent APR of this discount is:

APR = .02/.98 X [1/(20/360)]

So, the effective cost of delaying payment for 20 days is 36.73%

a/b net c

Exercise 1

Calculate the effective cost of the following trade credit terms if the

discount is foregone and payment is made on the net due date.

a. 2/15 net 30

b. 2/15 net 45

WRMAS


17/25

17

Line of Credit

Informal agreement between a borrowerand a bank aboutthe 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. Usually require that the borrower maintain a minimum

balancein the bank through the loan period or a

compensating balance.

Revolving Credit Variant of the line of creditform of financing

A legalobligation is involved

Unsecured Loans

WRMAS


18/25

18

Transactions Loans

Made for a specific purpose

The type of loan that most individuals associate with bankcredit and is obtained by signing a promissory note

Example: Bank Credit

Your company needs to pay $10,000 for the overhaul of five trucks.

A bank offers you a loan at 18%per annum with a compensatingbalance requirement of 15%of the loan amount. You plan toborrow the money for nine months and currently do not have anaccount with this bank. What is the effective cost of the loan?

(.85)(loan amount) = $10,000Loan amount = ($10,000/.85) = $11,765

Interest on loan = (.18)($11,765)(9/12) = $1,588

APR= ($1,588/$10,000) [1/(9/12)] = 0.2117 @ 21.17%

Unsecured Loans

WRMAS


19/25

19

Exercise 2

The U.R. Bloom Corporation established a line of credit with alocal bank. The maximum amount that can be borrowed underthe terms of the agreement is $125,000 at a rate of 14%.

A compensating balance averaging 10% of the loan is required.Prior to the agreement, URB had maintained an account at the

bank averaging $10,000. Any additional funds needed for thecompensating balance will also have to be borrowed at the 14%rate.

a. If the firm needs $100,000 for 6 months, what is the annualcost of the loan?

b. What is the effective annual rate (EAR)?

Unsecured Loans

WRMAS


20/25

20

Commercial Paper

A short-term promise to pay that is sold in the market forshort-term debt securities

The largest andmost credit worthy companies are able to use

commercial paper.

Advantages of commercial paper:

a. Compensating-balance requirement -No minimum balancerequirements are associated with commercial paper

b. Amount of credit - Offers the firm with very large creditneeds a single source for all its short-term financing

c. Prestige- Signifies credit status

d. Interest rates - Rates are generally lower than rates onbank loans

Unsecured Loans

WRMAS


21/25

21

Cost of CP = Cost incurred by using CP x 1

Net fund available from CP Times

Principal - cost

Example

Gelangar Cements is planning to issue $2 million in 270-daymaturity notes carrying a rate of 16% per annum. Due to thesize of this firm, its commercial paper will be placed at a cost of$8,000. What is the effective cost of credit to Gelangar?

APR= ($240,000 + $8,000)/($2,000,000 - $8,000 - $240,000) [1/(270/360)]

= .1887 @ 18.87%

Unsecured Loans

WRMAS


22/25

22

Exercise 3

Question 1BTY Sdn Bhd plans to issue commercial paper for the firsttime in its 85-year history. The firm plans to issue $400,000in 120-day maturity notes. The paper will carry a 13%quarterly compounded rate with discounted interest and will

cost BTY $8,000 in advance to issue. What is the effectivecost of credit to BTY?

Unsecured Loans

WRMAS


23/25

23

SECURED LOANS

WRMAS

Pledging Accounts Receivable

Under pledging, the borrower simply pledges accountsreceivableas collateral for a loan obtained from either acommercial bank or a finance company

The amount of the loan is stated as a percentage of the facevalue of the receivables pledged

Flexible source of financing Can be costly

Factoring Accounts Receivable

Factoring accounts receivable involves the outright sale of a

firms accounts to a financial institution called a factor.

A factor is a firm that acquiresthe receivablesof other firms.


24/25

24

Inventory Loans

Loans secured by inventories.

The amount of the loan depends on the marketability &

perishabilityof the inventory.

Types:

Floating lien agreement

Chattel Mortgage agreement

Field warehouse-financing agreement

Terminal warehouse agreement

Secured Sources of Loans

WRMAS


25/25

25

Types of Inventory Loans

Floating Lien Agreement - The borrower gives the lender alienagainst all its inventories. The simplest but least-secureform.

Chattel Mortgage Agreement - The inventory is identifiedandthe borrower retains title to the inventory but cannot sell theitems without the lenders consent.

Field warehouse-financing agreement - Inventories used ascollateral are physically separatedfrom the firms otherinventories and are placed under the control of a third-party

field-warehousing firm. Terminal warehouse agreement - The inventories pledged as

collateral are transportedto a public warehouse that isphysically removed from the borrowers premises.

Secured Sources of Loans

WRMAS

Documents

Working Capital Management Slides