c17 Brigham Fm3ce_ppt

FINANCIAL MANA MANAGEMENT GEMENT THEORY & PRACTICE

ADAPTED FOR THE THIRD CANADIAN C ANADIAN EDITION BY:

 JIMMY WANG LAURENTIAN UNIVERSITY

CHAPTER 17 WORKING CAPIT CAPITAL MANAGEMENT AND SHORTSHORTTERM FINANCING

CHAPTER 17 WORKING CAPIT CAPITAL MANAGEMENT AND SHORTSHORTTERM FINANCING

CHAPTER 17 OUTLINE •

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17-1 Overview of Working Capital Management 17-2 Using and Financing Operating Current Assets

•

17-3 The Cash Conversion Cycle

•

17-4 The Cash Budget

•

17-5 Short-T Short-Term erm Financing Financing

CHAPTER 17 OUTLINE (cont’d) •

17-6 Accruals and Accounts Payable (Trade Credit)

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17-7 Short-Term Bank Loans

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17-8 Commercial Paper

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17-9 Bankers’ Acceptances

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17-10 Calculating Financing Costs

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17-11 Secured Short-Term Financing

17-1 Overview of Working Capital Management •

Two basic questions to answer: 1. What is the appropriate amount of working capital (both in total and for each account)? 2. How should working capital be financed?

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Improving the firm’s working capital position requires the cooperation from all operating divisions of the firm, such as:  ─ Experts in logistics  ─ Operations management  ─ IT

The Role of Financial Managers •

•

•

Evaluate the effectiveness of the firm’s operating departments, relative to other firms in its industry

Evaluate the profitability of alternative proposals for improving working capital management Decide how much cash the company should keep on hand and how much short-term financing should be used to finance working capital

Basic Definitions •

(Gross) working capital: Total current assets

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Net working capital: Current assets (CA) – Current liabilities (CL)

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Net operating working capital (NOWC): Operating CA – Operating CL = (Cash + A/R + Inv.)  – (A/P + Accruals)

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Please note the difference between Operating CA and CA and between Operating CL and CL

Definitions (cont ’d  ) •

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Cash is defined as the total value of the shortterm financial assets held to support ongoing operations and is a part of NOWC. Short-term investments is defined as the total value of short-term financial assets held for future purposes; thus it is not included in calculating NOWC.

Definitions (cont ’d  ) •

Working capital management:  –

•

Establishing working capital policy and then the day-to-day control of cash, inventories, receivables, accruals, and accounts payable

Working capital policy:  –

The level of each current asset

 –

How current assets are financed

Operating Working Capital A simple cycle of operations:

CASH CASH RECEIVABLES RECEIVABLES

RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY

17-2 Using and Financing Operating Current Assets Two issues: 1. Efficient use of operating current assets 2. Financing operating current assets

(1) Alternative Net Operating Working Capital Policies •

Relaxed  –

•

Restricted  –

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Current assets maximized while A/P and accruals minimized Current assets minimized while A/P and accruals maximized; NOWC turned over more frequently

Moderate  –

Between the two extremes

Comparison of Three Alternative Policies Policy

Level

Total Assets

of CA

Turnover

ROE

Risk

Relaxed

high

low

low

Restricted

low

high

high high

Moderate

low

all are moderate

The optimal strategy is the one that management believes will maximize the firm’s long -term free cash flow and thus the stock’s intrinsic value.

(2) Alternative Short-Term Financing Policies •

•

•

Maturity matching (or “self-liquidating”): Match the maturity of the assets with the maturity of the financing

Aggressive: Use short-term financing to finance permanent assets Conservative: Use permanent capital for permanent assets and temporary assets

Maturity-Matching vs. Aggressive Financing Policy $

Temp. NOWC

} Perm NOWC

S-T Loans L-T Fin: Stock & Bonds,

Fixed Assets Lower dashed line, more aggressive.

 Years

Conservative Financing Policy $

Marketable Securities Zero S-T debt

Perm NOWC

L-T Fin: Stock & Bonds

Fixed Assets  Years

Choosing Among the Approaches •

•

In general, short-term debt has a lower cost than long-term debt. But short-term debt is riskier for the borrowing firm for two reasons: 1. Long-term debt maintains a relatively stable cost over time 2. Short-term debt may not be renewed

Choosing Among the Approaches (cont’d) •

Short-term loans’ advantages over long-term loans: 1. Can be negotiated much faster 2. Offer greater flexibility

•

The final decision depends on: 1. The firm’s specific conditions 2. Managers’ risk preferences

17-3 The Cash Conversion Cycle The cash conversion cycle focuses on the time between payments made for materials and labour and payments received from sales: Cash Conversion Cycle

Inventory

=

Conversion Period

Receivables

+

Collection Period

 –

Payables Deferral Period

(17-4)

Inventory Conversion Period (ICP) •

•

•

Measures the average time required to process materials into finished goods and then to sell them Can be calculated as ICP = Inventory/Average daily COGS Alternatively, ICP = 365/Inventory Turnover

(17-1)

Receivables Collection Period •

Measures the average length of time required to collect cash following a sale

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Also called the days sales outstanding (DSO)

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Can be calculated as: Receivables Collection = DSO = Period

Receivables (17-2)

Sales/365

Payables Deferral Period (PDP) •

•

•

Measures the average length of time between the purchase of materials and labour and the payment of cash for them Can be calculated as PDP = Payables/Purchases per day Alternatively, PDP =

Payables Cost of goods sold/365

(17-3)

Cash Conversion Cycle (CCC) •

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The cycle starts with cash paid out for productive resources until cash is received from the sale of products. It represents the average length of time a dollar is tied up.

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It measures management effectiveness.

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The shorter, the better.

Shortening CCC •

CCC = ICP + DSO – PDP

1. Processing and selling goods more quickly 2. Speeding up A/R collections 3. Slowing down A/P payments 4. Any combination of the above

17-4 The Cash Budget •

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Purpose: Uses forecasts of cash flows to predict loan needs and funds available for temporary investment Timing: Daily, weekly, or monthly, depending upon budget’s purpose. Monthly for annual planning, daily for actual cash management.

Data Required for Cash Budget •

Sales forecast

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Information on collections delay

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Forecast of purchases and payment terms

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Forecast of cash expenses: wages, taxes, utilities, and so on

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Initial cash on hand

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Target cash balance

MicroDrive Inc.: Cash Budget (I)

MicroDrive Inc.: Cash Budget (II)

MicroDrive Inc.: Cash Budget (III)

Cash Budget Issue: Depreciation •

•

•

Only cash payments and receipts appear in the cash budget. As depreciation is a noncash charge, it is not explicitly included in the cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

Cash Budget Issue: Other Potential Cash Inflows in Addition to Collections •

Proceeds from fixed asset sales

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Proceeds from stock and bond sales

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Interest earned

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Court settlements

Cash Budget Issue: Interest Earned or Paid •

•

•

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Interest earned: Add line in the collections section Interest paid: Add line in the payments section Found as interest rate×surplus/loan line of cash budget for preceding month. Note: Interest on any other debt would need to be incorporated as well.

Cash Budget Issue: Bad Debts •

•

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Collections would be reduced by the amount of bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to lower surpluses and higher borrowing requirements.

MicroDrive Inc.: Cash Balance •

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Cash budget indicates the company will incur net cash loss in the first three months but have net cash gain in the latter three months. To maintain a monthly target cash balance of $10 million, MicroDrive will have to borrow in the first three months, and the total loan requirement is expected to peak at the end of September.

MicroDrive Inc.: Cash Balance (cont’d) •

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As sales increase steadily in the first few months and peak in September, increased payments for purchases, wages, and other items will exceed receipts from sales, leading to net cash outflow in the first few months. In the latter 3 months, sales, purchases, and payments for past purchases will fall sharply, while collections will increase following strong sales in the previous months, resulting in net cash gain. The cash surplus can be used to pay off the loans taken out in the first few months.

Cash Budgeting Applications •

•

•

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Estimating short-term borrowing needs Assessing minimum cash balance requirements Planning for business expansion Don’t confuse a cash budget with an income statement or free cash flows

17-5 Short-Term Financing •

Spontaneous financing

•

Short-term bank loans

Short-Term Debt: Advantages and Disadvantages •

Advantages:  –

 –

 –

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Can be obtained much faster than long-term credit May not be appropriate for seasonal or cyclical needs for funds Normally carry lower interest rates

Disadvantages:  –

Interest rates fluctuate widely over time

 –

May not be renewed due to tight credit condition

17-6 Accruals and Accounts Payable (Trade Credit) Spontaneous financing: •

•

Arises automatically, or spontaneously, from a firm’s operations Two types:  –

Accruals

 –

Accounts payable (trade credit)

Cost of Trade Credit •

Trade credit is not free!

2

/

10,

net 30

0 10 30 |-----------------|---------------------------------------------------| pay $98 pay $100 |get to use $98 for 20 days at $2 |

Cost of Not Taking Discounts •

Nominal annual cost of trade credit =

Discount  percent 100  Discount  percent 

2 100  2



365 30  10





365 Days credit is outstandin g  Discount  period

2.04% 

365 20



37.2%

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Effective annual rate =

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(1 + 2.04%) 365/20 – 1 = 44.6%

(17-5)

17-7 Short-Term Bank Loans •

Loan application

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Interest rates

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Maturity

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Collateral

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Covenants

17-7 Short-Term Bank Loans (cont’d) •

Line of credit

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Commercial paper

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Bankers’ acceptances

Loan Application •

Historical financials

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Pro forma financials

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Income and EBITDA

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Types of assets

Interest Rates •

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Prime rate is the lowest interest rate that a bank lends money at. Prime rate can swing very quickly in either direction.

Collateral •

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The short-term loan is secured by a specific collateral item (asset). The item is registered under the Personal Property Security Act (PPSA).

Covenants •

Designed to protect the lender

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Specific terms written into the loans

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Examples of covenants:  –

Better current ratio

 –

Minimum interest payment payment coverage

 –

Minimum cash balance

Line of Credit •

One-year operating loan

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Interest rate floats based on prime

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Interest is paid only when funds are borrowed

17-8 Commercial Paper •

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CP is short-term unsecured promissory notes issued by large, strong companies. CP trades in the market at rates just above the T-bill rate. CP is bought with surplus cash by banks and other companies, then held as a marketable security for liquidity purposes.

17-9 Bankers’ Acceptances •

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•

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BAs are commonly used to finance goods with long payment terms—typically exports and imports. They are term drafts written by the purchasing firm/importer and “accepted” by a major bank. The bank is the ultimate guarantor for payment. BAs are bought and sold on the market before being redeemed from the firm or the bank.

17-10 Calculating Financing Costs •

Regular, or simple, interest  –

Interest-only loan

 –

Simple vs. effective interest rate

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Discount interest

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Effects of compensating balances

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Installment loans: Add-on interest

17-11 Secured Short-Term Financing •

Accounts receivable financing

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Inventory financing

Accounts Receivable Financing •

Pledging A/R  –

 –

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A/R used as security for a loan Lender not only has a claim against A/R but also has recourse to the borrower

Factoring or Selling A/R  –

 –

Lender/buyer has no recourse to the borrower/seller Providing not only money but also a credit department for the borrower

Inventory Financing •

Blanket liens

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Trust receipts

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Warehouse receipts

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Acceptable products

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Costs of financing

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Evaluation of inventory financing

Summary •

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Working capital refers to current assets, and net working capital (NWC) is defined as current assets minus current liabilities. Net operating working capital (NOWC) is defined as operating current assets minus operating current liabilities. The cash conversion period is the average time required to convert materials into finished goods and then to sell those goods.

Summary (cont’d) •

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The cash conversion cycle equals the length of time between the firm’s actual cash expenditures to pay for productive resources and its own cash receipts from the sale of products, i.e., the length of time between paying for labour and materials and collecting on receivables. Under a relaxed working capital policy, a firm would hold relatively large amounts of each type of current asset.

Summary (cont’d) •

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Under a restricted working capital policy, the firm would hold minimal amounts of these items. The cash budget is a schedule showing projected cash inflows and outflows over a period. The cash budget is used to predict cash surpluses and deficits, and it is the primary cash management planning tool.

Summary (cont’d) •

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Permanent net operating working capital is the NOWC that the firm holds even during slack times, whereas temporary NOWC is the additional NOWC needed during seasonal or cyclical peaks. The methods used to finance permanent and temporary NOWC define the firm’s short-term financing policy. There are three possible short-term financing policy alternatives: moderate, aggressive, and conservative.

Summary (cont’d) •

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The advantages of short-term credit are (1) the speed with which short-term loans can be arranged, (2) increased flexibility, and (3) the fact that short-term interest rates are generally lower than long-term rates. The principal disadvantage of short-term credit is the extra risk the borrower must bear because (1) the lender can demand payment on short notice and (2) the cost of the loan will increase if interest rates rise.

Summary (cont’d) •

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Accounts payable, or trade credit, arises spontaneously as a result of credit purchases. Firms should use all the free trade credit available, but they should use costly trade credit only if it is less expensive than other forms of short-term debt. A line of credit is an important short-term operating loan designed to finance seasonal working capital requirements.

Summary (cont’d) •

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Commercial paper is a short-term promissory note issued by large, strong firms with investment-grade credit ratings and sold primarily to large institutional investors. A bankers’ acceptance (BA) is a short-term note of a borrower, unconditionally guaranteed by a major bank.