FM562 Corporate Financial Management Unit I PDF

Corporate Financial Management Unit I: Review of the Framework of Financial Management Ms. Lourdes Francesca Revadillo, MBA Week 4  Working Capital Management The management of short-term assets (ST investm...

Corporate Financial Management Unit I: Review of the Framework of Financial Management Ms. Lourdes Francesca Revadillo, MBA Week 4  Working Capital Management The management of short-term assets (ST investments) and short-term liabilities (ST financing sources). Net Working Capital (NWC) o NWC = Current assets − current liabilities o Amount of current assets financed by long-term liabilities  Working Capital Management Working Capital Policy o Target levels for each current asset account o How current assets will be financed Current liabilities specifically used to finance working capital include only those current liabilities specifically used to finance current assets.  Cash Conversion Cycle The length of time from the payment for purchases of raw materials used to manufacture a product until the collection of accounts receivable associated with the sale of the product. Cash conversion Cycle (CCC) = (ICP + DSO) − DPO Inventory Conversion Period (ICP) Receivables collection period / Days Sales Outstanding (DSO) Payables deferral period / Days Payable Outstanding (DPO)  Inventory Conversion Period (ICP) Length of time it takes to convert materials into finished goods and then to sell those goods The amount of time the product remains in inventory in various stages of completion  Receivables Collection Period (DSO) Average length of time required to convert the firm’s receivables into cash  Payables Deferral Period (DPO) Average length of time between the purchase of raw materials and labor and the payment of cash for them  Cash Conversion Cycle Average length of time a dollar is tied up in current assets  Using Short-Term Financing Maturity – short-term debt generally is defined as a liability originally scheduled for repayment within one year Speed – a short-term loan can be obtained much faster than long-term credit Cost – short-term debt generally is less expensive (interest rate is lower) than long-term debt Risk – short-term debt is considered riskier than long-term debt.  Sources of Short-Term Financing Accruals Continually recurring short-term liabilities Liabilities, such as wages and taxes, that increase spontaneously with operations Accounts Payable Credit created when one firm buys on credit (Trade Credit) from another firm Short-Term Bank Loans Maturity typically 90 days or less Promissory note specifies terms and conditions, including amount, interest rate, repayment schedule, collateral, and any other agreements Compensating Balance of 10-20% of loan amount might be required to be maintained in a checking account  Sources of Short-Term Financing Line of credit (LOC) Specified maximum amount of funds available Revolving LOC – line of credit where funds are committed Commitment fee – fee charged on the unused balance of a revolving credit agreement Commercial Paper Unsecured short-term promissory notes issued by large, financially sound firms Discounted financial instrument – investors purchase for less than face value Maturity is 270 days or less Secured Loans Secured by short-term assets, especially accounts receivable and inventory Loan is not for 100 percent of the asset’s value  Cost of Short-term Credit The cost associated with using various sources of short-term financing  Cost of Short-term Credit First, compute the cost of using the funds for a given period, rPER  Cost of Short-term Credit Using rPER, compute the EAR and APR: m = number of borrowing periods in one year  Cost of Short-term Credit: Trade Credit Suppose a firm buys on credit from its supplier with terms of 2.5/10 net 40. o If the firm purchases products with an invoice price of $100, its effective price is $97.50 because it receives a $2.50 discount for paying on Day 10 of the billing cycle. o If the firm pays on Day 40, effectively it would pay $2.50 interest on a 30-day loan in the amount of $97.50.  Cost of Short-term Credit: Trade Credit Suppose a firm buys on credit from its supplier with terms of 2.5/10 net 40.  Cost of Short-term Credit: Bank Loan Suppose a firm borrows $50,000 at 9 percent for three (3) months Assume that the loan is a simple interest loan, where both the principal and interest are paid at maturity  Cost of Short-term Credit: Bank Loan Suppose a firm borrows $50,000 at 9 percent for three (3) months  Cost of Short-term Credit: Discount Interest Loan Suppose a firm borrows $50,000 at 9 percent for 90 days Assume that the loan is a discount interest loan, where interest is paid “up front”  Cost of Short-term Credit: Discount Interest Loan Suppose a firm borrows $50,000 at 9 percent for 90 days  Cost of Short-term Credit: Add-On Interest Loan Suppose a firm borrows $50,000 at 9 percent for three (3) months. Assume that the loan is an installment loan, where interest is “added on,” and both the interest and the principal are paid back in equal installments  Cost of Short-term Credit: Add-On Interest Loan Suppose a firm borrows $50,000 at 9 percent for three (3) months (90 days).  Cost of Short-term Credit: Add-On Interest Loan Suppose a firm borrows $50,000 at 9 percent for three (3) months (90 days). Repayment period = 3 months  Cost of Short-term Credit: Commercial Paper Suppose a firm issues a 3-month commercial paper with a $50,000 face value and a 9 percent interest. Transaction fees are 0.5 percent of the issue amount. Discount instrument  Cost of Short-term Credit: Commercial Paper Suppose a firm issues a 3-month commercial paper with a $50,000 face value and a 9 percent interest. Transaction fees are 0.5 percent of the issue amount. Principal Amount versus Required Amount Suppose a firm needs $50,000 to support operations. The firm plans to raise the funds by borrowing from the bank. The loan would be for three months, its interest rate would be 9 percent, and a 20 percent compensating balance would be required. The firm has no money in the bank. To use $50,000, the firm must borrow more than $50,000, because some of the loan proceeds must be used to satisfy the compensating balance requirement. Principal Amount versus Required Amount Firm needs $50,000; interest is 9 percent; compensating balance requirement is 20 percent of the amount borrowed If the firm borrows $62,500, the compensating balance requirement will be $12,500 = $62,500(0.20) The amount of funds the firms will be able to use is $50,000 = $62,500 − $12,500 Principal Amount versus Required Amount Firm needs $50,000; interest is 9 percent; compensating balance requirement is 20 percent of the amount borrowed  References Besley, S. & Brigham, E. F. (2022). CFIN (7th ed.). Cengage Learning.