978-1259709685 Chapter 26 Lecture Note Part 2

subject Type Homework Help
subject Pages 6
subject Words 1588
subject Authors Jeffrey Jaffe, Randolph Westerfield, Stephen Ross

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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
y
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
0
70,00
0
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 investors 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 issuers 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

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