Chapter 20.pdf

A firm’s short term financing issues are determined by the amount of long-term capital it raises. A firm that issues large amounts of long-term debt or common stock, or that retains a large part of its earnings, may find that it has permanent excess cash. Other firms raise...

A firm’s short term financing issues are determined by the amount of long-term capital it raises. A firm that issues large amounts of long-term debt or common stock, or that retains a large part of its earnings, may find that it has permanent excess cash. Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempts to finance all long-term and part of current assets with long-term financing. © 2020 McGraw-Hill Education Limited 3  Some observations: ▪ Matching Maturities: Financial managers generally attempt to match the maturities of their firm’s assets and liabilities. ▪ Permanent Working Capital Requirements: Most firms have a permanent investment in net working capital (current assets less current liabilities). They plan to have a positive net working capital at all times. ▪ Advantages of Liquidity: Current assets can be converted into cash more easily than can long-term assets. So firms with large holdings of current assets enjoy greater liquidity. © 2020 McGraw-Hill Education Limited 7 Working Capital: Short-term or current assets and current liabilities are collectively known as working capital. The Components of Working Capital ▪ Some common current assets and liabilities Current Assets Current Liabilities Cash and cash equivalents Bank indebtedness Accounts receivable Accounts payable and accrued liabilities Inventories Current portion of obligations under finance lease Prepaid expenses Current portion of long- term debt © 2020 McGraw-Hill Education Limited 8  Net Working Capital: Current assets minus current liabilities. Often called working capital. Operating cycle: Period of time from the purchase of raw materials to the collection of cash from the sale of finished goods. Operating Cycle = Inventory period + accounts receivable period © 2020 McGraw-Hill Education Limited 9 Figure 20.3 - A simple cycle of operations: Cash Raw materials Receivables inventory Finished goods Inventory © 2020 McGraw-Hill Education Limited 10  Cash Conversion Cycle: Period of time between firm’s payment for materials and collection on its sales. Cash Conversion Cycle = (Inventory period + accounts receivable period) – accounts payable period = Operating cycle - accounts payable period © 2020 McGraw-Hill Education Limited 11  The Working Capital Trade-Off ▪ There are costs and benefits associated with the firm’s investment in working capital ▪ Carrying costs: Costs of maintaining current assets, including opportunity cost of capital. ▪ Shortage costs: Costs incurred from shortages in current assets ▪ An important job of the financial manager is to find the level of current assets that minimizes the sum of carrying costs and shortage costs. © 2020 McGraw-Hill Education Limited 18  Financial analysts trace the sources and uses of cash in the statement of cash flows like the one shown in Table 20.5 (on next slide) Information is organized into 3 sections: cash flow from operations, cash flow from investments, and cash flow from financing activities. The positive entries in that table correspond to activities that generated cash and the negative ones to activities that used cash. © 2020 McGraw-Hill Education Limited 22  Three common steps in creating a cash budget: 1. Forecast the sources of cash. 2. Forecast the uses of cash. 3. Calculate whether the firm is facing a cash shortage or surplus. The company then uses these forecasts to draw up a plan for investing cash surpluses or financing any deficit. © 2020 McGraw-Hill Education Limited 24 Dynamic’s financial manager must find short-term financing to cover the firm’s forecasted cash requirements. For simplicity we will assume that Dynamic has just two short-term financing options: Bank loan. Dynamic has an existing arrangement with its bank, allowing it to borrow up to $100 million at an interest rate of 10% per year. It can borrow and repay the loan whenever it chooses, but the company may not exceed its credit limit. Stretching payables. Dynamic can also raise capital by putting off payment of its bills. The financial manager believes that Dynamic can defer up to $100 million in each quarter. © 2020 McGraw-Hill Education Limited 29  Evaluating the Plan ▪ Short-term financial plans must be developed by trial and error. ▪ You lay out one plan, think about it then try again with different assumptions about the financing and investment alternatives. ▪ You continue until you can think of no further improvements. © 2020 McGraw-Hill Education Limited 32  Bank Loans are the simplest and the most common form of short term financing. ▪ A line of credit is an agreement by a bank that a company may borrow at any time up to an established limit. ▪ Typically reviewed annually and may be cancelled. ▪ Revolving credit agreement: usually last a few years and formally commit he bank to lending up to the agreed limit ▪ Firm pays a commitment fee – fee charged by lender on the unused portion of a line of credit © 2020 McGraw-Hill Education Limited 33 ▪ An alternative to a line of credit is a term loan that provides all the money at the start of the loan and has a specified repayment schedule (more than one year). ▪ Some lines of credit and term loans are too large for a single lender. A syndicated loan is a loan provided by a group of banks that combine to provide the loan amount. © 2020 McGraw-Hill Education Limited 34  Secured Loans ▪ Banks do not make loans without assessing the firm’s credit risk because the riskiness of the borrower affects the bank’s risk. ▪ Sometimes a company must offer assets as security, depending on the assessment of the credit risk by the bank. ▪ The amount a bank will lend against security varies – Typical maximum loan amounts are between 50% and 75% of accounts receivable, 50% of finished goods inventories, and zero for raw material and work-in-progress inventories. © 2020 McGraw-Hill Education Limited 35  A/R financing – When loans are secured by receivables, the firm assigns or pledges them as collateral for the loan. ▪ If the firm fails to repay the loan, the bank can collect the pledged accounts receivable from the firm’s customers and use the cash to pay off the debt. Inventory financing – Banks also lend on the security of inventory, but they are choosy about what they will accept. Factoring – When the firm sells the receivables at a discount for the purpose of obtaining short –term financing © 2020 McGraw-Hill Education Limited 36  Commercial Paper ▪ Commercial paper is a short-term unsecured note issued by large, well-known corporations that regularly need to raise large amounts of cash. ▪ Commercial paper is backed by the quality of the corporations assets and its operating cash flows. Banker’s Acceptance ▪ Firm’s time draft that has been accepted by a bank and may be sold to investors as a short-term unsecured note issued by the firm and guaranteed by the bank. © 2020 McGraw-Hill Education Limited 37  Comparing the rates: Simple Interest = annual interest rate Amount of loan  = number of periods in the year Effective Annual Rate = m  quoted annual interest rate  1 +  −1  m  where m is the number of compounding periods in a year. © 2020 McGraw-Hill Education Limited 38 Discount Interest : With a discount interest loan, the bank deducts the interest up front. Example: you borrow $100,000 on a discount basis at 12% for 1 year. This means the bank will charge the $12,000 interest up front and give you $88,000. After a year, you will have to pay back $100,000 face value. Thus, effectively, you are paying $12,000 on $88,000 loan. Thus, the interest is 12,000/88,000 = 13.64% © 2020 McGraw-Hill Education Limited 39  Most firms attempt to finance all long-term assets with equity and long-term debt, and invest cash surpluses during part of the year and borrow during the rest of the year. Short-term financial planning is concerned with the management of the firm’s short-term or current assets and liabilities. The difference between current assets and current liabilities is called net working capital. © 2020 McGraw-Hill Education Limited 40  The cash conversion cycle is the length of time between the firm’s payment for materials and the date it gets paid by its customers. Higher investment in current assets entails higher carrying costs but lower expected shortage costs. The starting point for short-term financial planning is forecasting the sources and uses of cash. © 2020 McGraw-Hill Education Limited 41  Firms forecast their collection of accounts receivables and other cash inflows and subtract all forecast cash outflows. If the balance is insufficient to cover day-to-day operations, the company will require financing. A short-term financial plan is developed by trial and error. Companies look at the consequences of different assumptions about cash requirements, interest rates, limits on financing, etc. © 2020 McGraw-Hill Education Limited 42  Many sources and ways to finance short-term needs ▪ Bank loans – line of credit, term loan, syndicated loan ▪ Secured loans – A/R financing, inventory financing ▪ Factoring ▪ Commercial paper ▪ Banker’s acceptance ▪ The interest rate on short-term bank loans is usually quoted as a simple interest rate (or APR) but sometimes quoted on a discount basis. © 2020 McGraw-Hill Education Limited 43