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Finance Chapter 16

Terms in this set (90)

current assets...most liquid and least liquid
most liquid=cash
lease liquid=inventory
Net working capital =

Liquidity =
current assets - current liabilities

the ability to meet cash obligations as they come due
current ratio
quick ratio
current assets/current liabilities

current assets-inventory/current liabilities
Working capital management is a continuing process that involves a number of day-to-day operations that are related to:
The firm's level of current assets
The proportions of short-term and long-term debt the firm uses to finance its assets
The level of investment in each type of current asset (e.g., cash, receivables, inventory...)
The specific sources and proportions of short-term credit the firm should employ
The operating cycle is the length of time it takes to
(1) produce inventory, (2) sell it, and (3) collect payment.

or in other words its the length of time it takes t0 1)purchase things 2) produce the product and 3) distribute/sell the product and collect payment
We can formally estimate the operating cycle as follows:
Operating cycle =
inventory conversion period + receivable conversion period

Inventory conversion period = time it takes to product and sell the product
Receivable conversion period = time it takes to collect on receivables
How to calculate the inventory conversion period:
average inv/cgs divided by 365
How to calculate the receivables conversion period
average AR/annal credit sales divided by 365
The cash conversion cycle is the
number of days that pass until we collect the cash from a sale, measured from when we actually pay for the inventory.
Cash conversion cycle =
operating cycle - payables deferral period
Payables deferral period =
tie=me from when we recieve inventory to when we actually have to pay for it
The cash conversion cycle is important because
it measures how long we need to finance inventory and receivables.
How to calculate the payables deferral period:
average accounts payable/cgs divided by 365
page 10
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Size and Nature of Current Assets Depends On:
type of product
length of operating cycle
sales level
inventory policies
credit policies
efficiency of management of current assets
What should the firm consider when determining the appropriate level of working capital investment?
Profitability (measured by EBIT/assets)
Risk that the firm may not be able to meet its financial obligations
conservative approach
holds a relatively large proportion of its total assets in the form on current assets
aggressive approach
holds a small proportion of total assets in the form of lower yielding CA therefore having less net working capital
the tradeoffs between each approach:
CA
profitability
fin risk
conservative: higher lower lower
aggressive: lower higher higher
page 4 how to calc rate of return
EBIT/TA
Overall, the optimal level of working capital investment represents the what
level that is expected to maximize shareholder wealth
this is a function of what
the variability of sales and cash flows and the degree of operating and financial leverage employed by the firm

therefore no single working capital policy will be optimal for all firms
Recall, short-term debt has maturities of
one year or less
All other debt is considered long-term
Cost difference between short-term and long-term debt
historically ST debt is cheaper
Risk of short-term versus long-term debt
Lenders normally feel that risk is greater for long-term debt, but borrowers often feel that there is more risk associated with short-term debt

risk of not being able to refinance ST debt when it matures
Short-term rates are more volatile than long-term rates, so interest expenses will be
subject to more variation over time.
why is ST debt riskier for firms
because the firm has to think about refinancing
Permanent current assets =
assets held to meet the firms minimum long-term needs
ex: saftey stocks of cash and inventory
Fluctuating current assets =
assets that are affected by the seasonal or cyclical nature of company sales
ex: firm must make larger investments in inventory and receivables during peak selling periods than other periods
Note that fixed assets and permanent current assets are expected to be upward sloping over time, so what happens to financing
the need to finance these assets over time will increase as well
what are the financing strategies of current assets
matching, conservative, aggressive
matching
maturity structure of a firms liab is made to correspond exactly to the life of its assets
conservative
uses a higher proportion of LT debt
aggressive
uses a higher proportion os ST debt
optimal proportions ?
No one combination of short- and long-term debt is necessarily optimal for all firms
page 17..how to calculate NI from EBIT
find I and T then do EBIT-I=answer-T=NI...
Short-term credit includes what
all debt obligations that originally were scheduled for repayment within 1 year.
secured credit
the debt is backed by a specific asset used as collateral
unsecured credit
no collateral in the form of assets
Cash-flow lenders
Lenders that rely on cash flows as the primary source of repayment
Asset-based lenders
Lenders that place greater emphasis on the value of collateral (e.g., lenders of RadioShack)
Spontaneous sources of short-term credit
Trade Credit
Accrued Expenses
Deferred Income
Negotiated sources of short-term credit
Bank credit
Commercial paper
Receivables loans
Inventory loans
Measuring the annual financing cost (AFC):
equation
(interest costs + fees / usable funds) x (365/maturity in days)

Note that usable funds incorporates the fact that, depending on the terms of the loan, not all of the loan amount may actually be available to the lender.
The AFC equation does not incorporate compounding and therefore will often underestimate the true, effective rate of the loan, which can be shown as the annual percentage rate (APR):
equation
(1+AFC)^m - 1

m=compounding periods per year
page 29 more compounding periods means
more cost (higher %)...
trade credit
when a business recieves merchandise from a supplier but doestn have to pay for the inventory until a later date

Trade credit is the most important source of short-term financing for business firms
Most trade credit is extended on an open account basis:
The customer firm sends a purchase order, the supplier firm evaluates the creditworthiness of the customer and ships the inventory with details on the credit policy
what are Promissory notes....theyre sometimes used
Formal, signed document outlining the trade credit arrangement
cost of trade credit
comes from forgoing the cash discount offered
AFC equation
annual finance cost:
(percentage discount/100-percentage discount) x (365/credit period-discount period)
page 33...what equation do you use when finding out the cost of forgoing the cash disc? and which number is the credit period and which is the disc period
AFC with percentages and credit period is net and disc period is /#...
accrued expenses
represent liabilities for services rendered to the firm that have not yet been paid

The firm has little to no control over managing the timing of the payout of these expenses
Deferred Income =
consists of payments received for goods and services that the firm has agreed to deliver at a later date
Example: advance payment made by customers
who are one of the most important sources for both secured and unsecured short term credit
Commercial banks are one of the most important sources for both secured and unsecured short-term credit
These loans represent the primary source of negotiated short-term funds
prime rate
the rate that banks have charged on loans made to their most credit worthy customers

Prime has been as low as 3.25% (2008-2009) to 20% (1981)
LIBOR
london inter bank offered rate the rate at which banks in the eurocurreny market lend to eachother
Short-term bank financing is available under the following arrangements
Single loans (notes)
Lines of credit
Revolving credit agreements
Single loans (notes)
= single bank loan used to fund a particular undertaking.
Length of the loan is typically 30 days to a year
Lines of credit
an agreement that permits the firm to borrow funds up to a predetermined limit any time during the life of the agreement
Revolving credit agreements
a gaurenteed line of credit
Discounted loans =
interest is deducted when the loan is made (i.e., the firm receives less than the face value of the loan), so the borrower does not receive the full loan amount
page 4
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Compensating Balances
Sometimes a lender bank will require that the borrower hold a certain percentage (normally 5-20%) of the loan balance in deposit with the bank, called a compensating balance

The compensating balance can be either an absolute minimum value required or an average minimum balance over a certain period of time
If the compensating balance is in excess of what the borrower usually has in its account, then
If the compensating balance is in excess of what the borrower usually has in its account, then what needs to happen with the additional deposit requirement?
needs to be subtracted from the usable funds in the denominator of the AFC calc
page 7
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The line of credit agreement doesnt what
legally commit the bank to making loans to the firm under any and all conditions
Revolving credit agreements =
the bank is legally committed to making loans to a company up to the predetermined credit limit specified in the agreement
commitment fee
These agreements require a commitment fee, which is charged on any unused portion of the committed funds
Many firms use these agreements as a form of insurance, where the cost of the promised financing is equal to the commitment fee if no money is borrowed
page 11 how to calc commitment fee
take funds-amount borrowing times the fee...
commercial paper consists of
ST unsecured promissory notes issued by major corporations
whos able to borrow these
how long do commercial papers range from and adv and disadv of these papers
Only firms with excellent credit ratings are able to borrow funds in this manner

Commercial paper maturities range from a day to nine months (anything with a longer maturity would have to be registered with the SEC)
It is an attractive financing source because commercial paper rates tend to be below the prime lending rate.
A disadvantage of borrowing via commercial paper is that it isn't always a reliable source of funds
how is commercial paper sold and what do you subtract from usable funds
on a discount basis (i.e., the firm receives less than the stated amount of the note at issue and then pays the investor face value at maturity). interest and the fee
page 16
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what is one of the most commonly used forms of collateral for secured short-term borrowing
AR.....they are a desired form of collateral since they are relatively liquid and their value is relatively easy to recover if the borrower becomes insolvent
disadvantage of AR
the borrower may attempt to defraud the lender by pledging nonexistent accounts
page 20 so with AR when its 2 points above use that in the what equation.
I
factoring AR
involves the outright sale of the firms recievables to a fin inst known as a factor
When factoring receivables occurs, the title to the receivables is transferred to the
financial institution (i.e., the factor) and the receivables no longer shows up on the firms balance sheet
The factor also assumes the risk of default on the receivables
AR factoring charges
The factor charges a factoring commission/service fee of 1-3% of the factored receivables to cover the costs of credit checking, collection, and bad-debt losses
The factor also charges an interest rate of 2-5 percentage points over prime on advances to the firm
the net financing cost to the firm for factoring receivables needs to account for the fact that
that the firm no longer needs to pay for internal credit department expenses and bad-debt expenses, since the firm is no longer the holders of the receivables
page 24 when factoring AR what do we subtract from usable funds
reserve for returns and the factoring commish
Inventory Loans
Inventories are another commonly used form of collateral for secured short-term loans
Lenders will be concerned with the characteristics of the inventory used as collateral
questions to ask about the inventory
Is the inventory Perishable?

Is the inventory easily identifiable?

How easy can the inventory be liquidated (if needed)?
If the borrower holds the collateral:
Floating lean agreement
the lender receives a security interest or general claim on al of the firm's inventory.
Over time the amount of inventory may increase, and the floating lien is designed to cover the additional acquisitions.




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this method is usually implemented when the average value of the inventory items are small and or the inventory turns over frequently
If the borrower holds the collateral:
Trust receipts
- whenever the firm sells a portion of the inventory, the proceeds are immediately forwarded to the lender, which is used to reduce the balance of the loan
If the lender or independent entity holds the inventory:
Terminal warehouse financing arrangement
the inventory being used is stored in a bonded warehouse operated by a public warehousing company
If the lender or independent entity holds the inventory:
Field warehouse financing agreement
- the inventory used as collateral is separated from the rest of the firm inventory and is officially under the control of the field warehouse company
page 31
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how to calculate the AFC for accounts recievable
Average level of receivables $2,500,000 Less: Factoring commission
(0.025 x $2,500,000) -62,500 Less: Reserve for returns
(0.10 x $2,500,000) -250,000
Equals: Amount of advance before deducting
interest $2,187,500
Less: Interest on advance
[0.12 x $2,187,500 x (60/365)] -43,151
Equals: Usable funds (amount advanced by factor) $2,144,349
a. AFC (before cost savings and bad-debt loss savings): = [ ($43,151 + $62,500)/$2,144,349] x (365/60) = 29.97%

then with the bad debt loss and cost savings you add them up and then add them to the top
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