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TOPIC 10
WRMAS
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
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
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SHORT-TERM FINANCING
Advantages of Current Liabilities Disadvantages of Current Liabilities
to match the timing of a firms needs for shortterm financing Interest Cost - Interest rates on short-term debt are lower than on long-term debt
Other things remaining the same, the greater the firms reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity
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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
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Temporary Investments
- Current assets that will be liquidated and not replaced within the current year
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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
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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 firms 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)
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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
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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
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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%
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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.
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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.
Unsecured Loans
Cost of CP = Cost incurred by using CP Net fund available from CP
Principal - cost
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%
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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?
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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 firms accounts to a financial institution called a factor. A factor is a firm that acquires the receivables of other firms.
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