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Chapter 1 0 – 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 ?

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Chapter 10 – Working-Capital Management and Short-term Financing


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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?


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    Working-Capital Management

    CurrentAssets

    • Cash, marketable securities, inventory, accounts receivable.

      Long-TermAssets

    • Equipment, buildings, land.

      Risk-Return Trade-off:

      Current assets earn low returns, but help reduce the risk of illiquidity.


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    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?


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    Working-Capital Management

    CurrentLiabilities

    • 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.


    Slide6 l.jpg

    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock

    To illustrate, let’s finance all current assets with current liabilities,


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    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock

    To illustrate, let’s finance all current assets with current liabilities,


    Slide8 l.jpg

    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock

    To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.


    Slide9 l.jpg

    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock

    To illustrate, let’s finance all current assets with current liabilities, and finance all fixed assets with long-term financing.


    Slide10 l.jpg

    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock


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    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.


    Slide12 l.jpg

    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.


    Slide13 l.jpg

    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!


    Slide14 l.jpg

    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock


    Slide15 l.jpg

    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.


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    Balance Sheet

    Current Assets Current Liabilities

    Fixed Assets Long-Term Debt

    Preferred Stock

    Common Stock

    Suppose we use currentliabilities to finance some of our fixedassets.


    Slide17 l.jpg

    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!


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    The Hedging Principle

    PermanentAssets (those held > 1 year)

    • Should be financed with permanent and spontaneous sources of financing.

      TemporaryAssets (those held < 1 year)

    • Should be financed with temporary sources of financing.


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    Balance Sheet

    Temporary

    Current Assets


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    Balance Sheet

    Temporary Temporary

    Current Assets Short-term financing


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    Balance Sheet

    Temporary Temporary

    Current Assets Short-term financing

    Permanent

    Fixed Assets


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    Balance Sheet

    Temporary Temporary

    Current Assets Short-term financing

    Permanent Permanent

    Fixed Assets Financing

    and

    Spontaneous

    Financing


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    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.


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    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


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    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 credit26 l.jpg
    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)


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    APR = x

    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

    principal time



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    APR = x

    Cost of Short-Term Credit

    interest 1

    principal time


    Cost of short term credit30 l.jpg

    APR = x

    Cost of Short-Term Credit

    interest 1

    principal time

    Example: If you pay $637.50 in interest on $10,000 principal for 9 months:


    Cost of short term credit31 l.jpg

    APR = x

    Cost of Short-Term Credit

    interest 1

    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


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    Cost of Short-Term Credit

    Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:


    Cost of short term credit33 l.jpg

    APY = ( 1 + ) - 1

    Cost of Short-Term Credit

    Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

    i m

    m


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    APY = ( 1 + ) - 1

    Cost of Short-Term Credit

    Annual Percentage Yield (APY) is similar to APR, except that it accounts for compound interest:

    i m

    m

    i = the nominal rate of interest

    m = the # of compounding periods per year


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    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%



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    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.


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    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.


    Sources of short term credit39 l.jpg
    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.

    • Bank credit.


    Sources of short term credit40 l.jpg
    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.

    • Bank credit.

    • Commercial paper.


    Sources of short term credit41 l.jpg
    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.

    • Bank credit.

    • Commercial paper.

  • Secured


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    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.

    • Bank credit.

    • Commercial paper.

      Secured

    • Accounts receivable loans.


    Sources of short term credit43 l.jpg
    Sources of Short-term Credit

    Unsecured

    • Accrued wages and taxes.

    • Trade credit.

    • Bank credit.

    • Commercial paper.

      Secured

    • Accounts receivable loans.

    • Inventory loans.


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