Working Capital Management Slides
Content
WORKING CAPITAL MANAGEMENT
TOPIC 10
WRMAS
1
Learning Objectives
1. Define net working capital. 2. Explain the short term financing. 3. List and describe the basic sources of shortterm credit. 4. Calculate the effective cost of short-term credit.
WRMAS
2
NET WORKING CAPITAL
• Working Capital – The firm’s total investment in current assets. • Net working Capital (NWC) – The difference between the firm’s current assets and its current liabilities. (NWC = Current Assets – Current Liabilities) • NWC measure of both a company's efficiency and its shortterm financial health. • Working Capital Management- The administration of the firm’s current assets and the financing needed to support current assets. • Managing net working capital is concerned with managing the firm’s liquidity. This entails managing two related aspects of the firm’s operations: 1. Investment in current assets 2. Use of short-term or current liabilities
WRMAS 3
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 workingcapital management. • What Specific Sources of Short-term Financing Should the Firm Select? Three factors influence the decision: - The effective cost of credit - The availability of credit - The influence of a particular credit source on other sources of financing
WRMAS 4
SHORT-TERM FINANCING
Advantages of Current Liabilities Disadvantages of Current Liabilities
• Flexibility - Can be used
to match the timing of a firm’s needs for shortterm financing • Interest Cost - Interest rates on short-term debt are lower than on long-term debt
• Risk - Short-term debt
must be repaid or rolled over more often • Uncertainty Uncertainty of interest costs from year to year
Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
WRMAS 5
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 firm’s working capital decisions. WHAT IS HEDGING PRINCIPLE?
WRMAS
6
HEDGING PRINCIPLES
• Also known as Principle of Self-liquidating debt • Involves matching the cash flow generating characteristics of an 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 spontaneous sources should be financed in accordance with this rule: Permanent-asset investments are financed with permanent sources, and Temporary investments are financed with temporary sources
WRMAS
7
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
8
Temporary, Permanent and Spontaneous Sources of Financing
Sources of Financing • Temporary sources of financing - Current liabilities or short-term notes payable, unsecured bank loans, commercial paper, loans secured by accounts receivable and inventories • Permanent Sources of financing - Intermediate-term loans, long-term debt, preferred stock and common equity • Spontaneous Sources of financing - Arise in the firm’s day-to-day operation - Trade credit is often made available spontaneously or on demand from the firm’s supplies when the firm orders its supplies or inventory - Wages and salaries payable, accrued interest and accrued taxes also provide valuable sources of spontaneous financing.
WRMAS 9
Temporary, Permanent and Spontaneous Sources of Financing
WRMAS
10
COST OF SHORT-TERM CREDIT
Interest = principal X rate X time Cost of short-term financing = APR or annual percentage rate APR = interest or APR = interest X 1/time) principal X time principal What is APR? It describes the interest rate for a whole year (annualized), rather than just a monthly (or quarterly/ daily) rate.
Example A company plans to borrow $1,000 for 90 days. 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%
WRMAS 11
Cost of Short-term Credit
Effective Annual Rate (EAR) • APR does not consider compound interest. To account for the influence of compounding, must calculate EAR or effective annual rate EAR = (1 + i/m)m – 1 • Where: i is the nominal rate of interest per year; m is number of compounding period within a year Example Number of compounding periods 360/90 = 4 Rate = 12% (previously calculated) APY = (1 + 0.12/4)4 –1 = 0.126 or 12.6% SO APR or EAR? Because the differences between APR and EAR are usually small, we can use the simple interest values of APR to compute the cost of short-term credit.
WRMAS 12
SOURCES OF SHORT-TERM CREDIT
• Short-term credit sources can be classified into two (2) basic groups:
• Secured • Unsecured
Secured Loans • 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 • The principal sources of collateral include accounts receivable and inventories
WRMAS 13
Sources Of Short-term Credit
Unsecured Loans • All 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.
WRMAS
14
UNSECURED LOANS
Accrued Wages and Taxes • 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. Trade Credit • Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms associated with trade credit involve a cash discount for early payment. • Terms such as 2/10 net 30 means: 2 percent discount is offered for payment within 10 days, or the full amount is due in 30 days (2 percent penalty is involved for not paying within 10 days)
WRMAS 15
Unsecured Loans
What 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. b. 2/15 net 30 2/15 net 45
WRMAS 16
Unsecured Loans
• Line 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. – Usually require that the borrower maintain a minimum balance in the bank through the loan period or a compensating balance. • Revolving Credit – Variant of the line of credit form of financing – A legal obligation is involved
WRMAS 17
Unsecured Loans
• Transactions Loans • Made for a specific purpose • The type of loan that most individuals associate with bank credit 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 compensating balance requirement of 15% of the loan amount. You plan to borrow the money for nine months and currently do not have an account with this bank. What is the effective cost of the loan? (.85)(loan amount) = $10,000 Loan 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%
WRMAS 18
Unsecured Loans
Exercise 2 The U.R. Bloom Corporation established a line of credit with a local bank. The maximum amount that can be borrowed under the 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 the compensating balance will also have to be borrowed at the 14% rate.
a. If the firm needs $100,000 for 6 months, what is the annual
b.
cost of the loan? What is the effective annual rate (EAR)?
WRMAS
19
Unsecured Loans
Commercial Paper • A short-term promise to pay that is sold in the market for short-term debt securities • The largest and most credit worthy companies are able to use commercial paper.
• Advantages of commercial paper:
a. Compensating-balance requirement -No minimum balance requirements are associated with commercial paper b. Amount of credit - Offers the firm with very large credit needs a single source for all its short-term financing c. Prestige - Signifies credit status d. Interest rates - Rates are generally lower than rates on bank loans
WRMAS 20
Unsecured Loans
Cost of CP = Cost incurred by using CP Net fund available from CP
Principal - cost
x
1 Times
Example Gelangar Cements is planning to issue $2 million in 270-day maturity notes carrying a rate of 16% per annum. Due to the size 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%
WRMAS
21
Unsecured Loans
Exercise 3 Question 1 BTY Sdn Bhd plans to issue commercial paper for the first time in its 85-year history. The firm plans to issue $400,000 in 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 effective cost of credit to BTY?
WRMAS
22
SECURED LOANS
Pledging Accounts Receivable • Under pledging, the borrower simply 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 • Flexible source of financing • Can be costly Factoring Accounts Receivable • Factoring accounts receivable involves the outright sale of a firm’s accounts to a financial institution called a factor. • A factor is a firm that acquires the receivables of other firms.
WRMAS
23
Secured Sources of Loans
Inventory Loans • Loans secured by inventories. • The amount of the loan depends on the marketability & perishability of the inventory. • Types: – Floating lien agreement – Chattel Mortgage agreement – Field warehouse-financing agreement – Terminal warehouse agreement
WRMAS
24
Secured Sources of Loans
Types of Inventory Loans • Floating Lien Agreement - The borrower gives the lender a lien against all its inventories. The simplest but least-secure form. • Chattel Mortgage Agreement - The 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 - The inventories pledged as collateral are transported to a public warehouse that is physically removed from the borrower’s premises.
WRMAS 25
TOPIC 10
WRMAS
1
Learning Objectives
1. Define net working capital. 2. Explain the short term financing. 3. List and describe the basic sources of shortterm credit. 4. Calculate the effective cost of short-term credit.
WRMAS
2
NET WORKING CAPITAL
• Working Capital – The firm’s total investment in current assets. • Net working Capital (NWC) – The difference between the firm’s current assets and its current liabilities. (NWC = Current Assets – Current Liabilities) • NWC measure of both a company's efficiency and its shortterm financial health. • Working Capital Management- The administration of the firm’s current assets and the financing needed to support current assets. • Managing net working capital is concerned with managing the firm’s liquidity. This entails managing two related aspects of the firm’s operations: 1. Investment in current assets 2. Use of short-term or current liabilities
WRMAS 3
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 workingcapital management. • What Specific Sources of Short-term Financing Should the Firm Select? Three factors influence the decision: - The effective cost of credit - The availability of credit - The influence of a particular credit source on other sources of financing
WRMAS 4
SHORT-TERM FINANCING
Advantages of Current Liabilities Disadvantages of Current Liabilities
• Flexibility - Can be used
to match the timing of a firm’s needs for shortterm financing • Interest Cost - Interest rates on short-term debt are lower than on long-term debt
• Risk - Short-term debt
must be repaid or rolled over more often • Uncertainty Uncertainty of interest costs from year to year
Other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
WRMAS 5
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 firm’s working capital decisions. WHAT IS HEDGING PRINCIPLE?
WRMAS
6
HEDGING PRINCIPLES
• Also known as Principle of Self-liquidating debt • Involves matching the cash flow generating characteristics of an 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 spontaneous sources should be financed in accordance with this rule: Permanent-asset investments are financed with permanent sources, and Temporary investments are financed with temporary sources
WRMAS
7
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
8
Temporary, Permanent and Spontaneous Sources of Financing
Sources of Financing • Temporary sources of financing - Current liabilities or short-term notes payable, unsecured bank loans, commercial paper, loans secured by accounts receivable and inventories • Permanent Sources of financing - Intermediate-term loans, long-term debt, preferred stock and common equity • Spontaneous Sources of financing - Arise in the firm’s day-to-day operation - Trade credit is often made available spontaneously or on demand from the firm’s supplies when the firm orders its supplies or inventory - Wages and salaries payable, accrued interest and accrued taxes also provide valuable sources of spontaneous financing.
WRMAS 9
Temporary, Permanent and Spontaneous Sources of Financing
WRMAS
10
COST OF SHORT-TERM CREDIT
Interest = principal X rate X time Cost of short-term financing = APR or annual percentage rate APR = interest or APR = interest X 1/time) principal X time principal What is APR? It describes the interest rate for a whole year (annualized), rather than just a monthly (or quarterly/ daily) rate.
Example A company plans to borrow $1,000 for 90 days. 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%
WRMAS 11
Cost of Short-term Credit
Effective Annual Rate (EAR) • APR does not consider compound interest. To account for the influence of compounding, must calculate EAR or effective annual rate EAR = (1 + i/m)m – 1 • Where: i is the nominal rate of interest per year; m is number of compounding period within a year Example Number of compounding periods 360/90 = 4 Rate = 12% (previously calculated) APY = (1 + 0.12/4)4 –1 = 0.126 or 12.6% SO APR or EAR? Because the differences between APR and EAR are usually small, we can use the simple interest values of APR to compute the cost of short-term credit.
WRMAS 12
SOURCES OF SHORT-TERM CREDIT
• Short-term credit sources can be classified into two (2) basic groups:
• Secured • Unsecured
Secured Loans • 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 • The principal sources of collateral include accounts receivable and inventories
WRMAS 13
Sources Of Short-term Credit
Unsecured Loans • All 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.
WRMAS
14
UNSECURED LOANS
Accrued Wages and Taxes • 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. Trade Credit • Trade credit arises spontaneously with the firm’s purchases. Often, the credit terms associated with trade credit involve a cash discount for early payment. • Terms such as 2/10 net 30 means: 2 percent discount is offered for payment within 10 days, or the full amount is due in 30 days (2 percent penalty is involved for not paying within 10 days)
WRMAS 15
Unsecured Loans
What 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. b. 2/15 net 30 2/15 net 45
WRMAS 16
Unsecured Loans
• Line 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. – Usually require that the borrower maintain a minimum balance in the bank through the loan period or a compensating balance. • Revolving Credit – Variant of the line of credit form of financing – A legal obligation is involved
WRMAS 17
Unsecured Loans
• Transactions Loans • Made for a specific purpose • The type of loan that most individuals associate with bank credit 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 compensating balance requirement of 15% of the loan amount. You plan to borrow the money for nine months and currently do not have an account with this bank. What is the effective cost of the loan? (.85)(loan amount) = $10,000 Loan 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%
WRMAS 18
Unsecured Loans
Exercise 2 The U.R. Bloom Corporation established a line of credit with a local bank. The maximum amount that can be borrowed under the 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 the compensating balance will also have to be borrowed at the 14% rate.
a. If the firm needs $100,000 for 6 months, what is the annual
b.
cost of the loan? What is the effective annual rate (EAR)?
WRMAS
19
Unsecured Loans
Commercial Paper • A short-term promise to pay that is sold in the market for short-term debt securities • The largest and most credit worthy companies are able to use commercial paper.
• Advantages of commercial paper:
a. Compensating-balance requirement -No minimum balance requirements are associated with commercial paper b. Amount of credit - Offers the firm with very large credit needs a single source for all its short-term financing c. Prestige - Signifies credit status d. Interest rates - Rates are generally lower than rates on bank loans
WRMAS 20
Unsecured Loans
Cost of CP = Cost incurred by using CP Net fund available from CP
Principal - cost
x
1 Times
Example Gelangar Cements is planning to issue $2 million in 270-day maturity notes carrying a rate of 16% per annum. Due to the size 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%
WRMAS
21
Unsecured Loans
Exercise 3 Question 1 BTY Sdn Bhd plans to issue commercial paper for the first time in its 85-year history. The firm plans to issue $400,000 in 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 effective cost of credit to BTY?
WRMAS
22
SECURED LOANS
Pledging Accounts Receivable • Under pledging, the borrower simply 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 • Flexible source of financing • Can be costly Factoring Accounts Receivable • Factoring accounts receivable involves the outright sale of a firm’s accounts to a financial institution called a factor. • A factor is a firm that acquires the receivables of other firms.
WRMAS
23
Secured Sources of Loans
Inventory Loans • Loans secured by inventories. • The amount of the loan depends on the marketability & perishability of the inventory. • Types: – Floating lien agreement – Chattel Mortgage agreement – Field warehouse-financing agreement – Terminal warehouse agreement
WRMAS
24
Secured Sources of Loans
Types of Inventory Loans • Floating Lien Agreement - The borrower gives the lender a lien against all its inventories. The simplest but least-secure form. • Chattel Mortgage Agreement - The 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 - The inventories pledged as collateral are transported to a public warehouse that is physically removed from the borrower’s premises.
WRMAS 25
