working capital management: current asset management and short-term financing corporate finance dr....
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Working Capital Management:Working Capital Management:Current Asset ManagementCurrent Asset Managementand Short-Term Financingand Short-Term Financing
Corporate FinanceDr. A. DeMaskey
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Learning Objectives
• Questions to be answered:– What is working capital management?
– What is the appropriate amount of current assets for the firm to carry, both in total and for each specific account?
– How should current assets be financed?
– What are the major sources of short-term financing?
– What are the costs associated with each type of financing?
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Working Capital Terminology
• Gross working capital– Total current assets
• Net operating working capital– Current assets - Current liabilities
• Working capital policy:– The level of each current asset.– How current assets are financed.
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Working Capital Terminology
• Working capital management: – Includes both establishing working capital
policy and then the day-to-day control of:• Cash
• Inventories
• Receivables
• Short-term liabilities
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Alternative Current AssetInvestment Policies
Current Assets ($)
Sales ($)
Restricted
Moderate
Relaxed
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Cash Conversion Cycle
• The cash conversion cycle focuses on the time between payments made for materials and labor and payments received from sales:– Inventory conversion period– Receivables collection period– Payables deferral period
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Goal of Cash Management
• Cash is a non-earning assetnon-earning asset.
• To minimize the amount of cash in order to conduct normal business activities.
• To have sufficient cash in order to:– Take trade discounts.– Maintain credit rating.– Meet unexpected cash needs.
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Reasons for Holding Cash
• Transactions balances
• Compensating balances
• Precautionary balances
• Speculative balances
Primary reasons
Secondary reasons
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Cash Budget: The Primary Cash Management Tool
• PurposePurpose: Uses forecasts of cash inflows, outflows, and ending cash balances to predict loan needs and funds available for temporary investment.
• TimingTiming: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.
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Data Required for Cash Budget
1. Sales forecast.
2. Information on collections delay.
3. Forecast of purchases and payment terms.
4. Forecast of cash expenses: wages, taxes, utilities, and so on.
5. Initial cash on hand.
6. Target cash balance.
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Ways to Minimize Cash Holdings
• Use lockboxes.• Insist on wire transfers from customers.• Synchronize inflows and outflows.• Use a remote disbursement account.• Increase forecast accuracy to reduce the need for a
cash “safety stock.”• Hold marketable securities instead of a cash “safety
stock.”• Negotiate a line of credit (also reduces need for a
“safety stock”).
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Working Capital Financing Policies
• Maturity MatchingMaturity Matching: Matches the maturity of the assets with the maturity of the financing.
• AggressiveAggressive: Uses short-term (temporary) capital to finance some permanent assets.
• ConservativeConservative: Uses long-term (permanent) capital to finance some temporary assets.
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Years
$
Perm C.A.
Fixed Assets
Temp. C.A.
What are “permanent” assets?
S-TLoans
L-T Fin:Stock,Bonds,Spon. C.L.
Maturity Matching Financing Policy
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Years
$
Perm C.A.
Fixed Assets
Temp. C.A.
More aggressive the lower the dashed line.
S-TLoans
L-T Fin:Stock,Bonds,Spon. C.L.
Aggressive Financing Policy
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Conservative Financing Policy
Fixed Assets
Years
$
Perm C.A.L-T Fin:Stock,Bonds,Spon. C.L.
Marketable Securities
Zero S-Tdebt
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Working Capital Policy
• The choice of working capital policy is a classic risk/return tradeoff.
• The aggressive policyaggressive policy promises the highest return but carries the greatest risk.
• The conservative policyconservative policy has the least risk but also the lowest expected return.
• The moderatemoderate (maturity matching) policypolicy falls between the two extremes.
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Marketable Securities
• Interest-bearingInterest-bearing short-term securities• Level of liquid assets held
– Interest rate– Transaction costs– Variability in cash flows
• Choosing marketable securities– Default risk– Marketability or liquidity– Maturity– Purchasing power risk– Rate of return
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Short-Term Financing
• Short-term debt is riskierriskier than long-term debt for the borrower. – Short-term rates may riserise.
– May have trouble rolling debt overrolling debt over.
• Advantages of short-term debt.– Typically lower costlower cost.
– Can get funds relatively quicklyquickly with lowlow transactions costs.
– Can repay without penaltywithout penalty.
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Major Sources of Short-Term Financing
• Short-term creditShort-term credit: Debt requiring repayment within one year.
• Major sourcesMajor sources:– Accruals– Accounts payable (trade credit)– Bank loans– Commercial paper
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Trade Credit
• Trade creditTrade credit is credit furnished by a firm’s supplierssuppliers.– Free trade credit– Costly trade credit
• Trade credit is often the largest sourcelargest source of short-term credit for small firms.
• Trade credit is spontaneousspontaneous and relatively easy to geteasy to get, but the cost can be highhigh.
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Bank Loans
• Mature in one year or less.
• Compensating balance requirement
• Types of bank loans:– Line of credit– Revolving credit agreement
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Interest Cost of Bank Loans
• Regular, or simple, interest
• Discount interest
• Add-on interest
• Annual percentage rate
• Interest rate with compensating balance requirement
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Effective Annual Percentage Rate
• To be able to compare loan cost rates and choose the alternative with the lowest cost.
• Because the loans have different terms, we must make the comparison on the basis of EARs.
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Commercial Paper
• Unsecured promissory note
• Issued by large, financially sound firms
• Average maturity of five months
• Interest rate is less than prime rate but slightly more than T-Bill rate
• Commercial paper market is impersonal