Ch.

18:

Management
and Short-Term Financing
, Prentice Hall, Inc.

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
Preferred Stock
Common Stock

Long-Term Debt

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
Preferred Stock
Common Stock

Long-Term Debt

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
Current Assets

Temporary
Short-term financing

Balance Sheet
Temporary
Current Assets
Permanent
Fixed Assets

Temporary
Short-term financing

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
ex: 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)

APR =

interest
x
principal

1
time

Cost of Short-Term Credit

Cost of Short-Term Credit

APR =

interest
principal

1
time

Cost of Short-Term Credit

APR =

interest
principal

1
time

example: If you pay $637.50 in

interest on $10,000 principal for 9
months:

Cost of Short-Term Credit

APR =

interest
principal

1
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:

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:

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