Chapter 10 Working-Capital

Management and Short-term

Financing
 Working-Capital Management

Current Assets
Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
Equipment, buildings, land.

Which earn higher rates of return?

Which help avoid risk of illiquidity?
 Working-Capital Management
Current Assets
Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
Equipment, buildings, land.

Risk-Return Trade-off:
Current assets earn low returns, but
help reduce the risk of illiquidity.
 Working-Capital Management

Current Liabilities
Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
Bonds, preferred stock, common stock.

Which are more expensive for the firm?

Which help avoid risk of illiquidity?
 Working-Capital Management
Current Liabilities
Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
Bonds, preferred stock, common stock.

Risk-Return Trade-off:
Current liabilities are less expensive,
but increase the risk of illiquidity.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

To illustrate, lets finance all current assets

with current liabilities,
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

To illustrate, lets finance all current assets

with current liabilities,
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

To illustrate, lets finance all current assets

with current liabilities, and finance all
fixed assets with long-term financing.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

To illustrate, lets finance all current assets

with current liabilities, and finance all
fixed assets with long-term financing.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use long-term financing to

finance some of our current assets.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use long-term financing to

finance some of our current assets.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use long-term financing to

finance some of our current assets.
This strategy would be less risky, but more
expensive!
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use current liabilities to finance

some of our fixed assets.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use current liabilities to finance

some of our fixed assets.
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use current liabilities to finance

some of our fixed assets.
This strategy would be less expensive, but
more risky!
 The Hedging Principle

Permanent Assets (those held > 1 year)

Should be financed with permanent and
spontaneous sources of financing.
Temporary Assets (those held < 1 year)
Should be financed with temporary
sources of financing.
 Balance Sheet
Temporary
Current Assets
 Balance Sheet
Temporary Temporary
Current Assets Short-term financing
 Balance Sheet
Temporary Temporary
Current Assets Short-term financing

Permanent
Fixed Assets
 Balance Sheet
Temporary Temporary
Current Assets Short-term financing

Permanent Permanent
Fixed Assets Financing
and
Spontaneous
Financing
 The Hedging Principle
Permanent Financing
Intermediate-term loans, long-term debt,
preferred stock, common stock.
Spontaneous Financing
Accounts payable that arise spontaneously
in day-to-day operations (trade credit,
wages payable, accrued interest and taxes).
Short-term financing
Unsecured bank loans, commercial paper,
loans secured by A/R or inventory.
 Cost of Short-Term Credit

Interest = principal x rate x time

Example: Borrow $10,000 at 8.5% for 9

months.

Interest = $10,000 x .085 x 3/4 year

= $637.50
 Cost of Short-Term Credit
We can use this simple relationship:
Interest = principal x rate x time
to solve for rate, and get the
 Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)
 Cost of Short-Term Credit

We can use this simple relationship:

Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)

interest 1
APR = x
principal time
Cost of Short-Term Credit
 Cost of Short-Term Credit

interest 1
APR = x
principal time
 Cost of Short-Term Credit

interest 1
APR = x
principal time

Example: If you pay $637.50 in

interest on $10,000 principal for 9
months:
 Cost of Short-Term Credit

interest 1
APR = x
principal time

Example: If you pay $637.50 in

interest on $10,000 principal for 9
months:

APR = 637.50/10,000 x 1/.75 = .085

= 8.5% APR
 Cost of Short-Term Credit

Annual Percentage Yield (APY) is

similar to APR, except that it
accounts for compound interest:
 Cost of Short-Term Credit

Annual Percentage Yield (APY) is

similar to APR, except that it
accounts for compound interest:

m
APY = (1+ ) i
m
- 1
 Cost of Short-Term Credit

Annual Percentage Yield (APY) is

similar to APR, except that it
accounts for compound interest:

m
APY = (1+ ) i
m
- 1
i = the nominal rate of interest
m = the # of compounding periods per year
 Cost of Short-Term Credit

What is the (APY) of a 9% loan with

monthly payments?

APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938

= 9.38%
Sources of Short-term Credit
Unsecured
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Bank credit.
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Bank credit.
Commercial paper.
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Bank credit.
Commercial paper.
Secured
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Bank credit.
Commercial paper.
Secured
Accounts receivable loans.
Sources of Short-term Credit
Unsecured
Accrued wages and taxes.
Trade credit.
Bank credit.
Commercial paper.
Secured
Accounts receivable loans.
Inventory loans.