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2005, Pearson Prentice Hall

Chapter 18 Working-Capital

Management and Short-termFinancing

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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?

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CurrentAssets Cash, marketable securities, inventory,

accounts receivable.

Long-TermAssets Equipment, buildings, land.

Risk-Return Trade-off:Current assets earn low returns, buthelp reduce therisk of illiquidity.

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Current Liabilities

Short-term notes, accrued expenses,

accounts payable.

Long-Term Debt and Equity

Bonds, preferred stock, common stock.

Which are more expensivefor the firm?

Which help avoid risk of illiquidity?

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CurrentLiabilities Short-term notes, accrued expenses,

accounts payable.

Long-Term Debt and Equity Bonds, preferred stock, common stock.

Risk-Return Trade-off:Current liabilities are less expensive,but increase therisk of illiquidity.

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Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

To illustrate, lets finance all current assets

with current liabilities,

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Balance Sheet



Preferred Stock

Common Stock


with current liabilities, and finance all

fixed assets with long-term financing.

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Balance Sheet



Preferred Stock

Common Stock


with current liabilities, and finance all

fixed assets with long-term financing.

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Balance Sheet



Preferred StockCommon Stock

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Balance Sheet




Suppose we use long-termfinancing tofinance some of our current assets.

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Balance Sheet





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Balance Sheet





This strategy would be less risky, but more

expensive!

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Balance Sheet



Preferred Stock

Common Stock

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Balance Sheet



Preferred Stock

Common Stock

Suppose we use current liabilitiesto financesome of our fixed assets.

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Balance Sheet



Preferred Stock

Common Stock

Suppose we use current liabilities to financesome of our fixed assets.

This strategy would be less expensive, but

more risky!

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The Hedging Principle

PermanentAssets(those held >1 year)

Should be financed with permanent and

spontaneous sources of financing.

TemporaryAssets(those held

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Balance Sheet

Temporary Temporary

Current Assets Short-term financing

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Balance Sheet

Temporary Temporary


PermanentFixed Assets

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Balance Sheet

Temporary Temporary


Permanent PermanentFixed Assets Financing

and

SpontaneousFinancing

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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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Cost of Short-Term Credit

Interest =principal x rate x timeExample: Borrow $10,000at 8.5%for 9

months.

Interest =$10,000 x.085 x3/4 year=$637.50

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We can use this simple relationship:

Interest = principal x rate x time

to solve for rate, and get the


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to solve for rate, and get theAnnual Percentage Rate (APR)


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APR = x



to solve for rate, and get theAnnual Percentage Rate (APR)

interest 1principal time


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APR = xinterest 1

principal time


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APR = xinterest 1

principal time

Example: If you pay $637.50in

interest on $10,000principal for 9

months:


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APR = xinterest 1

principal time

Example: If you pay $637.50in

interest on $10,000principal for 9

months:

APR = 637.50/10,000 x 1/.75 =.085

= 8.5% APR


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Annual Percentage Yield(APY)is

similar to APR, except that it

accounts for compound interest:


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APY = ( 1 + ) - 1




i m

m


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APY = ( 1 + ) - 1




i m

m

i = the nominal rate of interest

m = the # of compounding periods per year


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What is the (APY) of a 9% loan with

monthly payments?

APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938

= 9.38%

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Sources of Short-term Credit

Unsecured

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Unsecured

Accrued wages and taxes.

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Unsecured


Trade credit.

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Unsecured


Trade credit.

Bank credit.

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Unsecured


Trade credit.

Bank credit.

Commercial paper.

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Unsecured


Trade credit.

Bank credit.

Commercial paper.

Secured

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Unsecured


Trade credit.

Bank credit.

Commercial paper.

Secured

Accounts receivable loans.

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Unsecured


Trade credit.

Bank credit.

Commercial paper.

Secured

Accounts receivable loans.

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