978-1259709685 Chapter 26 Lecture Note Part 2

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Slide 26.14 Carrying Costs and Shortage Costs

Slide 26.15 Appropriate Flexible Policy

Slide 26.16 Appropriate Restrictive Policy

Lecture Tip: The just-in-time inventory system is designed to reduce the

inventory period. In essence, companies pay their suppliers to

carry the inventory for them. Reducing the inventory period

reduces the operating cycle and thus the cash cycle. This reduces

the need for financing.

Ask the students to consider what type of cost is being minimized and what

costs are likely to increase. Ask them if JIT inventory policies are

appropriate for all industries. It makes sense for industries that

have substantial carrying costs with relatively low shortage costs,

but not for industries where shortage costs outweigh carrying

costs.

.A Alternative Financing Policies for Current Assets

Ideally, we could always finance short-term assets with short-term debt and

long-term assets with long-term debt and equity. However, this is

not always feasible.

Slide 26.17 Alternative Financing Policies

Lecture Tip: Some students tend to think permanent assets consist only of

fixed assets. Emphasize that a certain level of current assets is also

“permanent.” Consider the following example:

Januar Februar

March April

Current Assets 20,000 30,000 20,000 20,000

Fixed Assets 50,000 50,000 50,000 50,000

Permanent

Assets

70,000 70,000 70,00

70,00

Temporary Assets 0 10,000 0 0

Ask students to consider what the levels of permanent assets and temporary

assets are for each month.

A flexible policy would finance $80,000 with long-term debt

and have excess cash of $10,000 to invest in marketable securities

in January, March and April. Overall, the interest expense on the

extra $10,000 borrowed long-term will outweigh the interest

received from the marketable securities.

A more restrictive policy would finance $70,000 with long-term

debt. In February, the firm would borrow $10,000 on a short-term

basis to cover the cost of temporary assets in that month. The

short-term loan would be repaid in March.

.B Which is Best?

Things to consider:

1. Cash reserves – more important when a firm has unexpected

opportunities on a regular basis or where financial distress is a

strong possibility, zero NPV at best, and may hurt firm’s overall

return

2. Maturity hedging – match liabilities to assets as closely as possible, avoid

financing long-term assets with short-term liabilities (risky due to

possibility of increase in rates and the risk of not being able to

refinance)

3. Relative interest rates – short-term rates are usually, but not always, lower;

they are almost always more volatile

Lecture Tip: Personal financial situations provide ample examples of

maturity matching. We tend to use 30-year loans when we buy

houses (expectation that a house has a long useful life) and 4 –5

year loans for cars. Why wouldn’t we finance these assets with

short-term loans? What if you borrowed $200,000 to buy a house

using a 1-year note? In one year, you either have to pay off the

loan with cash or refinance. If you refinance, you have the

transaction costs associated with obtaining a new loan and the

possibility that rates increased substantially during the year.

Adjustable loans may adjust annually, but the initial rate is

generally lower than a fixed rate loan and there are limits to how

much the loan rate can increase in any given year and over the life

of the loan. Also, there are no transaction costs associated with the

rate adjustment on an ARM.

The level of current assets and current liabilities depends largely on the

industry involved. The same is true for the cash cycle.

26.3. Cash Budgeting

Cash budget – a schedule of projected cash receipts and disbursements

A cash budget requires sales forecasts for a series of periods. The other cash

flows in the cash budget are generally based on the sales estimates.

We also need to know the average collection period on receivables

to determine when the cash inflow from sales actually occurs.

Slide 26.18 Cash Budgeting

.A Cash Outflow

Common cash outflows:

Accounts payable – what is the accounts payables period?

Wages, taxes and other expenses – usually expressed as a percent of sales

(implies that they are variable costs)

Fixed expenses, when applicable

Capital expenditures – determined by the capital budget

Long-term financing expenses – interest expense, dividends, sinking fund

payments, etc.

Short-term borrowing – determined based on the other information

.B The Cash Balance

Net cash inflow is the difference between cash collections and cash

disbursements

Slide 26.19 –

Slide 26.22 Example

26.6. The Short-Term Financial Plan

Slide 26.23 The Short-Term Financial Plan

.A Unsecured Loans

Line of credit – formal or informal prearranged short-term loans

Commitment fee – charge to secure a committed line of credit

Compensating balance – deposit in a low (or no)-interest account as part of a

loan agreement

Cost of a compensating balance – if the compensating balance requirement is

on the used portion, less money than what is borrowed is actually

available for use. If it is on the unused portion, the requirement

becomes a commitment fee.

Example: Consider a $50,000 line of credit with a 5% compensating balance

requirement. The quoted rate on the line is prime + 6%, and the

prime rate is currently 11%. Suppose the firm wants to borrow

$28,500. How much do they have to borrow? What is the effective

annual rate?

Loan Amount: 28,500 = (1 – .05)L

L = 28,500 / .95 = 30,000

Effective rate: Interest paid = 30,000(.17) = 5,100. Effective rate =

5,100/28,500 = .17895 = 17.895%

Lecture Tip: Credit cards are an excellent way to illustrate the concept of a

“personal” line of credit. The consumer can use the line of credit

on the credit card to purchase goods or services. The line of credit

remains active until we abuse the privilege (i.e. late payments).

There is often a cost for this line of credit in the form of annual

fees. This is in addition to the often high rates of interest. College

students are often targeted by credit card companies and end up

holding several cards at one time. The cost of the annual fees can

add up – especially if they do not need the additional credit to

begin with. Students also have the habit of charging to their limits

and then just making the minimum payment.

Lecture Tip: Trade credit represents another source of unsecured financing.

However, the cost of this form of borrowing is largely implicit,

since it is represented by the opportunity cost of not taking the

discount offered, if any. To compute the effective annual cost of

trade credit, we first use the credit terms to determine a periodic

opportunity cost.

For example, if the terms are 2/10 net 30, rational managers will either

pay $.98 per dollar of goods ordered on the 10th day, or

the full invoice cost on the 30th day. In the latter case, the firm is actually

paying $.02 to borrow $0.98 for 20 days. In one year, there are

365 / 20 = 18.25 such periods. Therefore, the annualized cost is (1

+ .02/.98)18.25 – 1 = 44.59%.

.B Secured Loans

Accounts Receivable Financing

Assigning receivables – receivables are security for a loan, but the

borrower retains the risk of uncollected receivables

Factoring – receivables are sold at a discount

Inventory Loans

Blanket inventory lien – all inventory acts as security for the loan

Trust receipt – borrower holds specific inventory in trust for the lender

(e.g., automobile dealer financing)

Field warehouse financing – public warehouse acts as a control agent to

supervise inventory for the lender

Purchase order (PO) financing is also a popular form of factoring

used by small and mid-sized companies.

Lecture Tip: Inventory needs to be non-perishable and marketable and not

subject to obsolescence in order to be useful for inventory loans.

Some view inventory financing as a means of raising additional

short-term funds after receivables financing has been exhausted;

however, it is standard practice in some industries, such as auto

sales.

Lecture Tip: An interesting discussion of inventory financing is the story of

Tino De Angelis, who has come to be known as the “salad oil

king.”

Mr. De Angelis, a former butcher, constructed an empire with a reported

value of $100 million (in 1963) based largely on his supposed

acumen in buying and selling vegetable oil. The magnitude of his

operation is apparent when you consider that at one point, he had

contracted to purchase 600 million pounds of the product, or one-

third of the total amount produced domestically.

Unfortunately, Mr. De Angelis’ business acumen was greatly exaggerated.

He resorted to borrowing against his inventory, which supposedly

consisted of millions of gallons of vegetable oil held in steel vats

spread across New Jersey. Unfortunately for his creditors, the vats

were largely empty. The resulting default caused millions of

dollars in losses to banks, insurance companies, brokerage firms

and the New York Stock Exchange. Mr. De Angelis was paroled in

1972 after serving seven years of a 20-year prison sentence.

.C Other Sources

Commercial paper – short-term publicly traded loans

Trade credit – accounts payable

Lecture Tip: In Corporate Liquidity, by Kenneth Parkinson and Jarl

Kallberg, commercial paper is called “the most important source

of short-term borrowing for large U.S. companies.” The

commercial paper market has grown dramatically over the last few

years. Parkinson and Kallberg describe a typical commercial

paper transaction:

–The issuer sells a note to an investor for an agreed-upon rate, principal

(usually in $1 million increments) and maturity date (270 days

or less).

–The issuer contracts with the issuing bank to prepare the note and deliver

it to the investor’s custodial bank.

–The investor instructs her bank to wire funds to the commercial paper

issuer upon delivery and verification of the note. Since

commercial paper is sold on a discounted basis, the amount of

funds wired is less than the face amount of the note.

–On the maturity date, the note is returned to the issuer’s paying agent and

the face amount of the note is transferred to the investor. The

note is marked paid and returned to the issuer.

Adapted from Parkinson and Kallberg, Corporate Liquidity, published by

Business One, Richard D. Irwin, Inc. page 256.

Slide 26.24 Quick Quiz