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					Working-Capital
Management

        Chapter 14
Working-Capital Management

 What   is Working Capital?
 The   firm’s investment in current
   assets




            Keown Martin Petty - Chapter 15   2
Working-Capital Management

 Net   Working Capital
  The   difference between the firm’s
   current assets and current
   liabilities



             Keown Martin Petty - Chapter 15   3
  Working-Capital Management
 Current   Assets
  cash,marketable securities, inventory,
   accounts receivable
 Long-Term     Assets
  equipment,   buildings, land
 Which    earn higher rates of return?
  Long-term    assets
 Which    help avoid risk of illiquidity?
  Current   Assets
                  Keown Martin Petty - Chapter 15   4
  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.
                 Keown Martin Petty - Chapter 15   5
    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?
                   Keown Martin Petty - Chapter 15   6
   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.
                   Keown Martin Petty - Chapter 15   7
              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.
                   Keown Martin Petty - Chapter 15   8
              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!     Keown Martin Petty - Chapter 15   9
              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!     Keown Martin Petty - Chapter 15   10
    The Hedging Principle

 Permanent   Assets (those held > 1 year)
  shouldbe financed with permanent and
   spontaneous sources of financing.
 Temporary   Assets (those held < 1 year)
  should be financed with temporary
   sources of financing.



                 Keown Martin Petty - Chapter 15   11
           Balance Sheet
Temporary                      Temporary
Current Assets                 Short-term financing

Permanent                      Permanent
Fixed Assets                   Financing
                                  and
                               Spontaneous
                               Financing

                 Keown Martin Petty - Chapter 15      12
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
                  Keown Martin Petty - Chapter 15   13
Sources of Short-term Credit
 Unsecured
 accrued  wages and taxes
 trade credit
 bank credit
 commercial paper

 Secured
 accounts receivable loans
 inventory loans
              Keown Martin Petty - Chapter 15   14
Working Capital
Working Capital
   Working capital – The firm’s total investment
    in current assets.

   Net working capital – The difference between
    the firm’s current assets and its current
    liabilities.

   This chapter focuses on net working capital.

                  Keown Martin Petty - Chapter 15   16
 Managing Net Working Capital
 Managing net working capital is
   concerned with managing the firm’s
   liquidity. This entails managing two
   related aspects of the firm’s
   operations:
    1.   Investment in current assets
    2.   Use of short-term or current liabilities

                  Keown Martin Petty - Chapter 15   17
Risk-Return Trade-off




          Keown Martin Petty - Chapter 15   18
Use of Current versus Fixed
Assets
   Holding more current assets will reduce the risk of
    illiquidity.
   However, liquid assets like cash and marketable
    securities earn relatively less compared to other
    assets. Thus larger amount liquid investments will
    reduce overall rate of return
   The Trade-off: Increased liquidity must be traded-off
    against the firm’s reduction in return on investment.


                     Keown Martin Petty - Chapter 15        19
Use of Current versus
Long-term Debt
   Other things remaining the same, the greater the
    firm’s reliance on short-term debt or current liabilities
    in financing its assets, the greater the risk of
    illiquidity.
   Trade-off: A firm can reduce its risk of illiquidity
    through the use of long-term debt at the expense of
    a reduction in its return on invested funds. Trade-off
    involves an increased risk of illiquidity versus
    increased profitability.


                     Keown Martin Petty - Chapter 15       20
Advantages of Current Liabilities:
Return

   Flexibility
       Current liabilities can be used to match the timing
        of a firm’s needs for short-term financing.
        Example: Obtaining seasonal financing versus
        long-term financing for short-term needs.

   Interest Cost
       Interest rates on short-term debt are lower than
        on long-term debt.

                      Keown Martin Petty - Chapter 15         21
Disadvantages of Current
Liabilities: Risk

 Risk of illiquidity increases due to:
    Short-term debt must be repaid or rolled over
     more often
    Uncertainty of interest costs from year to year




                   Keown Martin Petty - Chapter 15     22
The Appropriate Level of Working
Capital
Appropriate Level of
Working Capital
   Managing working capital involves
    interrelated decisions regarding
    investments in current assets and use of
    current liabilities.
   Hedging Principle or Principle of Self-
    Liquidating Debt provides a guide to the
    maintenance of appropriate level of
    liquidity.

                  Keown Martin Petty - Chapter 15   24
Hedging Principle
   Involves matching the cash flow generating
    characteristics of an asset with the maturity of the
    source of financing used to finance its acquisition.
   Thus a seasonal need for inventories should be
    financed with a short-term loan or current liability.
   On the other hand, investment in equipment expected
    to last for a long time should be financed with long-
    term debt.


                      Keown Martin Petty - Chapter 15       25
Permanent and Temporary Assets

   Permanent investments
       Investments that the firm expects to hold
        for a period longer than one year

   Temporary Investments
       Current assets that will be liquidated and
        not replaced within the current year

                    Keown Martin Petty - Chapter 15   26
Sources of Financing
   Total assets will equal the sum of
    temporary, permanent and spontaneous
    sources of financing.




               Keown Martin Petty - Chapter 15   27
Temporary & Permanent Source
   Temporary sources of financing consist of
    current liabilities such as short-term secured
    and unsecured notes payable.
   Permanent sources of financing include:
    intermediate-term loans, long-term debt,
    preferred stock common equity




                  Keown Martin Petty - Chapter 15    28
  Spontaneous Sources of
  Financing
 Spontaneous sources of financing arise
  spontaneously in the firm’s day-to-day
  operations.
   Trade credit is often made available spontaneously or
    on demand from the firm’s supplies when the firm
    orders its supplies or more inventory of products to
    sell.
      Trade credit appears on a balance sheet as accounts payable.
      Wages and salaries payable, accrued interest and accrued
       taxes also provide valuable sources of spontaneous financing.

                       Keown Martin Petty - Chapter 15            29
Also see table 15-1




          Keown Martin Petty - Chapter 15   30
Hedging Principle Summary
   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.

                   Keown Martin Petty - Chapter 15   31
Cash Conversion Cycle
    Cash Conversion Cycle
   A firm can minimize its working capital by
    speeding up collection on sales, increasing
    inventory turns, and slowing down the
    disbursement of cash.
   Cash Conversion cycle (CCC) captures the
    above.
   CCC = days of sales outstanding + days of
    sales in inventory – days of payables
    outstanding.
                    Keown Martin Petty - Chapter 15   33
Sources of Short-term Credit
Sources of Short-term Credit
 Short-term credit sources can be
 classified into two basic groups:
     Unsecured
     Secured




                  Keown Martin Petty - Chapter 15   35
Unsecured Loans
   Unsecured loans include all of those sources
    that have as their security only the lender’s
    faith in the ability of the borrower to repay
    the funds when due.
   Major sources:
       Accrued wages and taxes, trade credit, unsecured
        bank loans, and commercial paper


                     Keown Martin Petty - Chapter 15       36
Secured Loans
   Involve the pledge of specific assets as
    collateral in the event that the borrower
    defaults in payment of principal or interest.

   Primary Suppliers:
       Commercial banks, finance companies, and factors


   Principal sources of collateral:
       Accounts receivable and inventories
                     Keown Martin Petty - Chapter 15   37
Unsecured Source:
Trade Credit
   Trade credit arises spontaneously with the
    firm’s purchases. Often, the credit terms
    offered with trade credit involve a cash
    discount for early payment.
   Terms such as 2/10 net 30 means a 2%
    discount is offered for payment within 10
    days, or the full amount is due in 30 days
   A 2% penalty is involved for not paying
    within 10 days.
                  Keown Martin Petty - Chapter 15   38
Effective Cost of Passing Up a
Discount
Terms 2/10 net 30
The equivalent APR of this discount is:
APR = $.02/$.98 X [1/(20/360)]
      = .3673 or 36.73%

The effective cost of delaying payment for 20
days is 36.73%


                Keown Martin Petty - Chapter 15   39

				
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