FIN303 CHAPTER 22 REVIEW
FIN303 CHAPTER 22 REVIEW FIN303
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Giulia Dias Roncoletta
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This 5 page Class Notes was uploaded by Giulia Dias Roncoletta on Monday February 15, 2016. The Class Notes belongs to FIN303 at University of Miami taught by Douglas R. Emery in Winter 2016. Since its upload, it has received 25 views. For similar materials see Corporate Finance Management in Finance at University of Miami.
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Date Created: 02/15/16
CHAPTER 22 22.1 OVERVIEW OF WORKING CAPITAL MANAGEMENT Working Capital Management: manage the decision making for investments, making sure shareholder’s wealth is maximized, and investments have a positive NPV. Financing Working Capital 3 different approaches to ﬁnancing working capital (1) Maturity Matching: the ﬁrm hedges its risk by matching the maturity of its assets and liabilities, ﬁnances long-term debt with long-term equity, short-term liability to short term asset. Relies on short term ﬁnancing funds for short term assets, long-term ﬁnancing for long- term assets, and permanents with long-term. (Base-Case Scenario) (2) Conservative: the ﬁrms depends on all its long-term assets to ﬁnance all of the ﬁrms permanents assets, and some of its current assets. They use long term because the funds are always available. Builds a margin of safety. (3) Aggressive: the ﬁrm uses more short-term ﬁnancing than long-term, it’s supposed to raise proﬁtability. high risk, high returns.. * If interest rates rise, aggressive approach ﬁrms are in a bad place, since the interest rates of long-term ﬁnancing are locked in lower, they will have lower ﬁnancing costs, BUT * if interest rates fall, aggressive approach wins, since the cost for the interest rates for long-term ﬁnancing might be locked high * a ﬁrm with ready capital market access can be more aggressive * a ﬁrm without ready capital market access should be more conservative - expect a decline in interest rates =aggressive approach because can shorten the average maturity of the ﬁrms debt by matching long term debts with short term assets - expect a rise in interest rates = conservative approach because can lengthen the average maturity of the ﬁrms debt by ﬁnancing more with long term assets rather than short term debts. 22.2 CASH CONVERSION CYCLE Cash conversion cycle: the length of time between the payment of A/P (accounts payable) and the receipt of cash from A/R (accounts receivable) Cash Inventory Receivables Payable Conversion = Conversion + Collection - Deferral Cycle Period Period Period Inventory Conversion Period: is the average time between buying inventory and selling goods Inventory Conversion Period = Inventory . Cost of Sales/365 Receivables Collection Period: (or Days’ sales outstanding - DSO) is the average number of days it takes to collect on account receivable. Receivables Collection Period = Receivables . Sales/365 Payable Deferral Period: is the average length of time between the purchase of the materials and labor that go into inventory and the payment of cash for these materials and labor. Payables Deferral Prd = Accounts Payable + Wages, beneﬁts, and payroll taxes payable (Cost of sales + Selling, general, and administrative expenses)/365 22.3 CASH MANAGEMENT - a ﬁrm’s cash management can be broken into two parts, (1) how much liquidity (cash plus marketable securities) should the ﬁrm have? (2) what should be the relative proportions of cash and marketable securities in maintaining that liquidity? Demand For Money - Three basic motives for holding cash: (1) Transaction Demands: everyday payments like wages, raw materials, taxes, and interest. This exists due to imbalances of cash in and out ﬂow. The larger the ﬁrms, the more transactions, the more closely (timely) they match, the less cash needed to maintain liquidity. (2) Precautionary Demands: the essential margin of safety required to meet unexpected needs. The more uncertainty in cash in and out ﬂows, the more precautionary needed. (3) Speculative Demand: based on desire to make proﬁt out of unexpected opportunities that require cash. - Readily available bank borrowing can be used for speculative demand, there is no need to hold cash for this reason anymore. Compensating Balance: an account balance that the ﬁrm agrees to maintain. Provides indirect payment to the bank for its loans and other services. - Now direct fees are more common. Float Management: Float: the difference between the available or collected balance at the bank and the ﬁrm;s book or ledger balance. Float = Available balance - book balance Disbursement Float: when writing a check, after written, your book or ledger balance is reduced by the amount of the check, but your available balance at the bank is not reduced until the check clears. Collection Float: when you receive a check and deposit it to the bank, the time between the funds being credited to your account from the moment you deposited it to the bank is called collection ﬂoat (the amount). Bank balance only changes when funds are credited, only book balance changes. 22.4 SHORT-TERM FINANCING Short-term funds: are debt obligations that were originally scheduled for repayment in one year. Finance seasonal or temporary needs. Intermediate funds: are debt obligations that were originally scheduled to mature between 1-10 years from issuing date. Concerned with the long term proﬁtability of the company. 3 Main Sources of Short-Term Funds: (1) Trade Credit - borrowing from suppliers: - is credit extended from one ﬁrm to another, usually granted on the sales of goods and services (since permitted to pay by delivery). - Largest single source of short-term funds for businesses, 1/3 of current liabilities of non ﬁnancial ﬁrms. (specially for small ﬁrms) - Cash Discount: offered if payment is made more quickly - “2/10 net 30” means the buyer can take a 2% cash discount if payment is made within 10 days (discount period). Otherwise, full amount is due in 30 days (net period). - if cash discount was offered but not taken advantage of, the trade credit has a cost. - the “real” price is considered to be the discounted price, but then the discount rate is technically the interest of the borrowing of the real price. Original $100, w discount 2% = $98 = real price, technically borrowed $98, with a $2 worth of interest - APR for trade credit: is measured by dividing the cost by the borrowing amount, we established that the borrowing amount in a “2/10 net 30” of $100, was $98, therefore the cost was $2 (worth of interest) so the ﬁrst part to measure the APR is to divide $2/98. Then multiply by the borrowing period, which is net period - discount period, in this case (30-10=20), use that number to divide the total periods in a year (365) = (365/20). APR = (Periodic Rate)(# of periods in a year) - APY for trade credit: is a better measure of the true cost of the loan. Therefore to ﬁnd the APY, (in calc) for N use the borrowing period (30-10=20) divided by 365 (how many periods in a year), use the borrowing amount ($98) as the PV, and (-)$100 (the real price with interest) as the FV, 0=PMT, and compute for I. That will give you the APY of the cash discount. - trade credit is more ﬂexible, therefore there are less consequences when payments are late. - “stretches” happen when the company extends the net period without any increase in cost, therefore it lowers the ﬁnancing costs. - “2/10, net EOM” end of the month, 10 days = 10th of the month (2) Bank Loans - borrowing from banks: - Second largest source of shot-term ﬁnancing, but also provide intermediate-term ﬁnancing. - Creditworthy customers receive unsecured loans - Credit risky customers are asked to provide some security such as a lien on receivables or inventory. - 3 forms of short-term unsecured bank loans (1) a speciﬁc transaction loan: loan to build houses will be paid back when houses are sold. (2) a line of credit: agreement of max loan balance permitted at once, renewals granted annually if credit remains acceptable. require to be out of bank debt for certain amount, bank is not legally obligated to advance funds. (3) a revolving credit: agreement to borrow a maximum amount at any time during a speciﬁed period. Commitment fee is required, to pay for the banks availability of cash for you during that time. (*) “self-liquidating”: lender expects to generate sufﬁcient cash with assets being purchased to repay loan within a year. - Bank Term Loans are intermediate-term debts, - A Bank Term Loanis a loan for a speciﬁed amount that required the borrower to repay according to speciﬁc schedule. (1-10 years) Repay at regular intervals in equal installments. - Balloon Payment: a large ﬁnal payment after many payments - Bullet Maturity: require payment in one lump-sum, interest is paid periodically, but the principle is paid in one lump sum at the end. - Carry ﬂoating interests, that ﬂoat with the bank’s prime rate -Prime Rate is a benchmark rate that banks may use to price loans and charged to their best most creditworthy clients. - “money market rates” are offered when banks want to compete with commercial paper market. - Compensating Balances: banks require if to be between 10% and 20% of the size of the loan. it’s a required average deposit balance during a particular interest period. - Discount Loans: require the borrower to pay the interest in advance. - because of TVM, the interest cost is higher when paid in advance, and if compensating balance was also required, the true interest cost would be even higher. - APY for discounted installment loans: (paid in multiple payments) is calculated by solving for the periodic rate, then annualizing it. - ﬁnd the discount by multiplying the interest rate by the amount of months I.E. 12% 3 months, discount = 3% = (.12)(3/12) - Use cashﬂows: - “Floating lien” is used as security for bank loans (3) Commercial Paper - selling short-term debt securities in the open market: - only available for the largest, most creditworthy companies - this is an unsecured promissory note with a maturity of 270 days, unless speciﬁed otherwise by the Securities and Exchange Commission. - Sold either directly to through dealers (.05% commission annually) - 20% of all commercial paper is sold directly to investors - permanent source of funds for large ﬁnance companies. - Calculations for APR and APY are the same as for discounted loans - High rating papers (P-1/A-1+) = lowest cost of borrowing and the smallest chance of interrupted market access.
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