B6005 Financial Management
Lecture 11 Current Liability Management
Balance Sheet
Asset L&E
Current Assets Fixed Assets
Current Liabilities LT Liabilities
B6005 Dr. Siri Chutikamoltham
Learning Objectives Understand working capital financing policy Understand benefits and costs of major current liabilities Understand the trade-offs of long term and short term debt Calculate costs of trade credits Calculate costs of different types of loans
B6005 Dr. Siri Chutikamoltham
Working Capital Financing Policies
Moderate: Match the maturity of the assets with the maturity of the financing. Aggressive: Use short-term financing to finance permanent assets. Conservative: Use permanent capital for permanent assets and temporary assets.
B6005 Dr. Siri Chutikamoltham
Moderate Financing Policy
$ Temp. NOWC
}
Perm NOWC
S-T Loans L-T Fin: Stock & Bonds,
Fixed Assets Lower dashed line, more aggressive.
B6005 Dr. Siri Chutikamoltham
Years
5
Conservative Financing Policy
$ Marketable Securities Zero S-T debt
Perm NOWC
L-T capital: Stock & LT Bonds
Fixed Assets Years
B6005 Dr. Siri Chutikamoltham
Short-Term Liabilities Accounts payable (trade credit) Short-term bank loans Accruals Commercial paper
B6005 Dr. Siri Chutikamoltham
Accruals
Major Accruals: wage accruals, tax accruals, customer deposits. Is there a cost to accruals? Accruals are free in that no explicit interest is charged. Can firms control accruals? Firms have little control over the level of accruals. Levels are influenced more by industry custom, economic factors, and tax laws.
B6005 Dr. Siri Chutikamoltham
Commercial Paper (CP)
Short term notes issued by large, strong companies. A cheap source of fund for issuers. CP trades in the market at rates just above T-bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.
B6005 Dr. Siri Chutikamoltham
What is trade credit?
Trade credit is credit furnished by a firms suppliers. Trade credit is often the largest source of shortterm credit for small firms. Trade credit is spontaneous and relatively easy to get, but the cost can be high.
B6005 Dr. Siri Chutikamoltham
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Terms of Sales
Trade credit terms of 1/10, net 30 means: Customers will get a discount of 1% if the account is paid within 10 days; otherwise the account must be paid in full within 30 days.
From the suppliers perspective:
sales = $100 Sales of the goods or service = $99 Finance charge = $1 Payables amount for the first 10 days = free trade credit. The amount owed from Day 11th to 30th = costly trade credit.
B6005 Dr. Siri Chutikamoltham
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Cost of Trade Credit to Customer
Annualized opportunity cost of forgoing the discount = a/ (1-a) x 365/(c-b) a = discount percentage b = discount period c = credit period Ex. 1/10, net 30 a = 1, b = 10, c = 30
Note: Can use 360 or 365 days when annualize. The typical discount ranges from 0.5% to 10%. Discount period is generally 10 days. Credit period ranges from 30 90 days.
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Example: Annualized Nominal Cost of Credit
Terms 1/10, net 30 Annualized nominal cost of foregoing the discount = 1%/(1-1%) x 365/(30-10) = 0.01/(1-0.01) x 365/(20) = 18.09%
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Pop Quiz
What is the annualized cost of foregoing the discount if the credit terms are 2/10, net 30?
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Back to SKI
SKI buys equipments in the amount of $506,985 per year, net of discount, on terms of 1/10, net 30, but routinely pays on Day 40 (stretching its AR!!). Find free and costly trade credit. Net daily purchases = $506,985/365 = $1,389. Annual gross purchase = $506,985/(1-0.01) = $512,106 Difference = 512,106 506,985 = $5,121.
B6005 Dr. Siri Chutikamoltham
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Gross/Net Purchase Breakdown
Company buys goods worth $506,985. Thats the net cash price. They must pay $5,121 more if they dont take discounts. Think of the extra $5,121 as a financing cost similar to the interest on a loan. Should SKI take the discount?
B6005 Dr. Siri Chutikamoltham
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Free and Costly Trade Credit Payables amount if take discount: Payables = $1,389(10) = $13,890. Payables amount if dont take discount: Payables = $1,389(40) = $55,560. Total trade credit Free trade credit Costly trade credit
B6005 Dr. Siri Chutikamoltham
= $55,560 = 13,890 = $41,670
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Annualized Nominal Cost of Costly Trade Credit Firm loses 0.01($512,106) = $5,121 of discounts to obtain $41,670 in extra trade credit, so: rNom = $5,121 / $41,670 = 12.29% But the $5,121 is paid several times during the year, not at year-end, so EAR rate is higher than the nominal rate.
B6005 Dr. Siri Chutikamoltham
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Nominal Cost Formula 1/10, net 30 but pays on 40th day
rNom = Discount % 1 - Discount % 365 days Days Taken Discount Period
SKI pays a nominal trade credit cost of 1.01% for 12.167 times per year.
B6005 Dr. Siri Chutikamoltham
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Effective Annual Rate, 1/10, net 30, but pays on the 40th day Periodic rate = 0.01/0.99 = 1.01%. Periods/year = 365/(40 10) = 12.1667. EAR = (1 + Periodic rate)n 1.0 = (1.0101)12.1667 1.0 = 13.01%.
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What should be the EAR for SKI if they do not stretch the terms 1/10, net 30? rNOM = 20.13%
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Short-term vs Long-term Bank Loan
PROS 1. Lower Cost 2. Quickly 3. Repay w/o penalty CONS Roll Over (may not be able to) Riskier due to volatility of ST interest rates
B6005 Dr. Siri Chutikamoltham
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Compare Costs of Loans
A bank is willing to lend SKI $100,000 for 1 year at an 8 percent nominal rate. Which loan should SKI take? 1.Simple annual interest, 1 year. 2.Simple interest, paid monthly. 3.Discount interest. 4.Installment loan, add-on, 12 months.
B6005 Dr. Siri Chutikamoltham
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How should SKI evaluate the loans?
The nominal rate is 8% Compare effective cost of the loan and choose the lowest cost alternatives Because the loans have different terms, we must make comparison base on EAR
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1. Simple Annual Interest, 1-Year Loan Simple interest means the interest rate is compounded only once a year, and there is no discount or add-on. Interest = 0.08($100,000) = $8,000 KNOM = EAR = 8,000/100,000 = 8% For a simple interest loan of one year, kNom = EAR.
B6005 Dr. Siri Chutikamoltham
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2. Simple Interest, Paid Monthly EAR = (1 + periodic rate)^#times 1.0 = 8.3% Periodic Rate = 8% / 12 = 0.67% EAR = (1+0.67%)^12 1 = 8.3%
B6005 Dr. Siri Chutikamoltham
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3. An 8% Discount Interest Loan, calculate interest only once per year
Interest deductible = 0.08($100,000) = $8,000. Usable funds = $100,000 - $8,000 = $92,000.
0 i=? 92,000 1 N I/YR 92 PV 0 PMT -100 FV
1 -100,000
8.6957% Nominal rate? EAR = ?
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Discount Interest (Cont) IF SKI needs $100,000 usable fund, how much is the face amount of loan ?
Face Amt. Of Loan
Amount needed 1 - %Nominal interest rate
= $ 100,000 = $108,696.
0.92
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4. Add-on Loan 1-Year Installment Loan of $100,000, 8% Add-On
Interest = 0.08($100,000) = $8,000. Face amount of loan = $100,000 + $8,000 = $108,000, after the interest is added on. Monthly payment = $108,000/12 = $9,000.
(More...)
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Cost of Add-on Loan
To find the EAR, recognize that the firm has received $100,000 and must make monthly payments of $9,000. This constitutes an ordinary annuity as shown below:
i=?
...
Months 12 -9,000
30
100,000
-9,000 -9,000
B6005 Dr. Siri Chutikamoltham
12 N
100000 -9000 I/YR PV PMT 1.2043% = rate per month
0 FV
Annualized kNom = (1.2043%)(12) = 14.45%. Since loan amortization (of interest and principle) happens 12 times a year, there is a compounding. Must find EAR. EAR = (1.012043)^12 1 = 15.45%
B6005 Dr. Siri Chutikamoltham
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Summary
Major sources of short term financing Suppliers credits ( payables) Short term loans Goal: shorter cash conversion cycle = more suppliers credit, if only cheaper than other financing. Must evaluate costs of different types of credits, based on EAR
B6005 Dr. Siri Chutikamoltham
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